Oil & Gas Pains in New SEC Reporting Rules

The energy industry is feeling some fresh compliance pains with new rules for how they report oil and gas reserves—rules that everyone agrees were sorely needed to reflect modern business, but are still proving difficult to implement.

The Securities and Exchange Commission approved the new rules at the end of 2008, to go into effect for registration statements and annual reports starting Jan. 1, 2010. They replaced previous guidance on how to report reserves that was last updated in 1979, which long ago became outdated and irrelevant to the information investors really want. Still, now that a new era in energy reporting has arrived, companies are struggling with some of the new disclosure requirements.

“They ’re a sea change improvement over the prior rules … which were grossly outdated, but, like any new product, there are some bugs that need to get worked out,” says Marc Folladori, a partner in the law firm Mayer Brown. He and others expect to see “a lot of back and forth” between companies and SEC staff during the first round of filings in coming months.

“As we saw with the enhanced executive compensation disclosure rules adopted in 2006, I think we’ll see these get fine-tuned over time through comments and interpretations,” Folladori says.

Roesle

Don Roesle, chief executive of reservoir-evaluation consulting firm Ryder Scott, agrees. “The new rules are very much an advance over the old definitions and guidelines and give the industry a better opportunity to define and disclose their assets. But it will take a year or two for people to learn what the SEC’s intent really is,” he says.

The biggest sticking point by far is what kind of reserves can be reported as “proved undeveloped reserves,” or PUDs, under the new rules. Generally, the SEC staff view is that most PUDs must be developed within five years of booking them, with limited exceptions for certain projects, such as constructing offshore platforms or development in environmentally sensitive areas.

“The SEC has said anything extending beyond five years should be the exception and not the rule,” Folladori says.

That’s not what the energy industry wants to hear, since new fields can often take years to develop. The SEC guidance also says issuers should consider a number of factors before claiming an exception that would let them dodge the five-year limit, such as the level of development activity and the history of completing development of comparable long-term projects. But the SEC “doesn’t give companies checklist of what passes muster,” says Folladori.

The fear is that energy companies will make their best guesses about whether some reserves qualify as exceptions to the five-year limit, and then the SEC staff reviewing those filings will decide otherwise, forcing companies to exclude those reserves and revise their filings. Wall Street is not likely to take such news kindly.

Lee

“As we saw with the enhanced executive compensation disclosure rules adopted in 2006, I think we’ll see these get fine-tuned over time through comments and interpretations.”

—Marc Folladori,

Partner,

Mayer Brown

“The five-year limit has lots of people very upset,” says John Lee, a petroleum engineering professor at Texas A&M University who served as an SEC Academic Fellow while it was drafting the new rules. “The SEC guidance isn’t totally clear on that point.”

Indeed, Roesle says many companies are keeping legitimate reserves off the books for now, to avoid having to do so later at the request of SEC staff. “It ’s something companies are struggling with, because there are a lot of reasons development can take longer than five years,” says Roesle.

Prince

Jim Prince, a partner in the law firm Vinson & Elkins, says the new rules demonstrate the difficulty of enforcing principles-based rules. When the new rules were issued, he says, there was much angst about the lack of guidance and the potential for further loss of company-to-company comparability. “Now everyone wants to know what everybody else is going to do,” he says. “No one wants to be left behind as the one that takes what could turn out to be an overly conservative position.”

More Gas Pains

Companies are also grappling with what fits under the new definition of “reliable technology” that they can use to help them establish reserves estimates and categories. The guidance does state that “reliable technology” is something that has been field-tested and has demonstrated “consistency and repeatability,” but it doesn’t specify what consistency and repeatability is. Nor does it give any examples of what reliable technologies SEC staff would accept, Folladori says.

The new rules do give companies the option to book probable and possible reserves, which wasn’t allowed under the old rules. But considering the litigation risks associated with doing so (and later being proven wrong), Folladori says many companies won’t disclose such reserves “until they see how that plays out … There’s not a big desire to do that yet.”

His prediction: Investors may see a “modest increase in the reserves reported by companies,” but “it ’s not going to be a big jump.”

Folladori advises companies that have previously been disclosing probable and possible reserves in press releases or other informal formats (that is, ones that aren’t filed with the SEC) now to ensure those disclosures comply with the new rules, even if they aren’t in company filings.

OIL & GAS CD&IS

Below is an excerpt of the recent Q&A guidance from the SEC staff of the new oil and gas reporting rules.

Question: In a deterministic reserve evaluation, when you have determined specific, individual estimates for proved, probable and possible reserves, is it acceptable to sum up these separate reserve categories into one total reserve estimate?

Answer: No. Because the categories of proved, probable and possible reserves have different levels of certainty, it is not appropriate to sum up the individual deterministic estimates for these reserves into one total reserve estimate. The individual estimates for each category should be disclosed as separate estimates, with the difference in certainty for each estimate fully explained. [Oct. 26, 2009]

Question: For an issuer that intends to develop a large field involving the drilling of numerous wells in multiple stages, what constitutes a development project?

Answer: A development project is typically a single engineering activity with a distinct beginning and end, which, when completed, results in the production, processing or transportation of crude oil or natural gas. A project typically has a definite cost estimate, time schedule and investment decision; is approved for funding by management; may include all classifications of reserves; and will be fully operational after the completion of the initial construction or development. The scope and scale of a project are such that, if a project were terminated before completion, for whatever reason, a significant portion of the previously invested capital would be lost.

If an investment decision has been made to develop only a portion of the primary, secondary or tertiary reserves, the remainder of the reserves would not be considered to be proved reserves until such time as management has made an investment decision to develop those additional reserves, the requisite level of certainty has been demonstrated from the initial portion of the development or by other means, and the additional development is within five years of being initiated. [Oct. 26, 2009]

Question: Is it acceptable to assign probable or possible reserves below the Lowest Known Hydrocarbon (LKH) limit penetrated in a well bore under the new definition of the term “probable reserves”?

Answer: It may be acceptable to assign unproved reserves below the LKH if that volume of reserves meets the test for either probable or possible reserves. If there is no data below LKH, no reserves should be assigned. [Oct. 26, 2009]

Question: Can an issuer assign probable or possible reserves in an area in which it does not, or cannot, assign proved reserves?

Answer: Yes. However, disclosure of unproved reserves without associated proved reserves should be done only in exceptional cases, such as for (1) development projects where engineering, geological, marketing, financing and technical tasks have been completed, but final regulatory approval is lacking or (2) improved recovery projects, at or near primary depletion, that await production response. Reserves should not be assigned without well penetration of the subject reservoir (rock volume) in the contiguous area that yields technical information sufficient to support the attributed reserve category. Volumes that are not economically producible are not reserves of any classification and should not be disclosed. [Oct. 26, 2009]

Question: The definition of the term “probable reserves” does not include instructions regarding reserves below LKH. Does this mean that probable reserves cannot be assigned below proved areas, such as below LKH limit, and can be no higher classification than possible reserves?

Answer: No. Probable reserves may be assigned if reliable technology and data exist that, in the judgment of the evaluator, support characterizing those reserves as probable reserves. If no data exists below LKH, no unproved reserves can be assigned. [Oct. 26, 2009]

Question: Can an issuer assign probable or possible reserves to an un-penetrated fault block?

Answer: No. Un-penetrated, pressure-separated fault blocks should not be considered to contain reserves of any category until penetrated by a well. [Oct. 26, 2009]

Source

SEC Staff Oil and Gas C&DIs (Oct. 26, 2009).

The new rules also change how the value of reserves is calculated. Previously companies made their calculations based on energy prices at the end of the calendar year; now they must use a historical average for the prior 12 months. The practical effect in an era of steadily rising oil and gas prices, Prince says, will be to understate reported reserves. Companies might want to consider demonstrating the effect of that pricing sensitivity by also showing reserves under alternative pricing scenarios, which the new rules do allow, he says.

Horvath

Another issue causing some consternation has been the lack of a final accounting standards update from the Financial Accounting Standards Board, to harmonize accounting rules with the SEC’s new reporting rules, says Rocky Horvath, an assurance partner with BDO Seidman. FASB issued that standards update just last week.

“The transition disclosure requirements are still a bit up in the air,” Horvath said in an interview just before the FASB update arrived. “Companies are waiting for the standards update to be finalized to solidify their plans to meet the new disclosure requirements for the 2009 year.”

Broadly speaking, the final FASB update requires disclosure on how implementation of the new rules will affect income from continuing operations, net income, and any related per-share amounts if the effect is “significant and practicable to estimate.” Horvath said those calculations might require the preparation of two or more reserve reports.

And again, uncertainty is rearing its head. “It ’s not entirely clear what is considered ‘practicable ’ for purposes of assessing just how much work should, or should not, be performed to comply with this expected disclosure requirement,” he said.

While the transition reporting is a one-time-only hit companies have to address this year, “It could be a complicated exercise that will require more work,” Horvath warned.

In addition, he said FASB’s rules will require more detailed disclosure about equity-method investments and will require disclosure of reserves by geographic areas to be determined on both a quantitative (per SEC rules) and qualitative (per FASB) basis. That may mean more determinations for companies to make, and possible uncertainty about what they’ve determined.

Companies may get more guidance on the rules from the SEC itself. In an e-mail response, SEC spokesman John Heine told Compliance Week that the staff “is considering ways to address additional issues as they arise.” He did not say when any new guidance might arrive, or what form it might take.