OIL & GAS JOURNAL: CERA: SEC reserves reporting system outdated (ShellNews.net) 25 Feb 05

Paula Dittrick

Senior Staff Writer

HOUSTON, The US Securities and Exchange Commission's system for reporting oil and natural gas reserves needs to be modernized to accurately describe existing asset values, Cambridge Energy Research Associates said in a recent report.

CERA released a lengthy report entitled "In Search of Reasonable Certainty: Oil and Gas Reserves Disclosures" during a Feb. 23 teleconference based in Washington, DC. Last year, the issue drew the attention of regulators and investors after Royal Dutch/Shell Group and other companies downgraded reserves (OGJ, Feb. 21, 2005, p. 5).

The CERA study involved 30 corporate participants, including exploration and production companies, law firms, accounting firms, and independent reserve auditors. The report addressed no specific company or specific reporting incident.

"The current system of reserves disclosure was born out of the energy maelstrom of the 1970s," said the report. It repeatedly referred to "the 1978 system" and called it rooted in the technologies and market structures of the 1950s and 1960s."

Because of changes in the intervening decades, the report said, "Investors are less able to draw valid conclusions about the intrinsic value and prospects of E&P companies, and this increased uncertainty may result in higher costs of capital for the industry than would otherwise be the case. What is reported increasingly fails to convey an accurate portrait of companies' positions."

Study authors Daniel Yergin, CERA chairman, and David Hobbs, CERA director of exploration and production strategy, noted that requirements for recognizing proved reserves have "in practice shifted from 'reasonable certainty' toward 'absolute certainty.'"

They continued, "In so doing, a principle-based reserve reporting system has increasingly become a rule-based one—without the kind of transparency and discussion that the SEC habitually employs elsewhere."

Absolute certainty makes reporting so conservative that "the overall picture" can become distorted because estimates of resources having "even limited uncertainty" are excluded from SEC filings, they said.

"The result can be to disconnect many companies' official reserves disclosures from the reality of their plans, strategies, and actual activities."

Demand challenges

Accurate reserves reporting becomes even more significant because the oil and gas industry faces the challenge of meeting growing demand.

"Even with increased efficiency, world oil demand could grow by as much as 50 million b/d by 2030—from today's 82 million b/d to more than 130 million b/d," the report said. "The increase alone is almost as much as the world was consuming in total at the time of the oil crisis in the 1970s."

In meeting this demand for oil and gas, the industry will require continuing technological advances, innovation, implementation of massive projects, increasing development of unconventional reserves, and flexible markets, the report said.

It's estimated that $4-6 trillion in new E&P investment will be required worldwide in the next 25 years.

"Reserves are at the heart of the confidence and credibility necessary to insure the industry has access to those funds and the capability to meet those huge needs," Yergin said.

Less than 20% of SEC registrants' reserves are in the US today, compared with more than 65% when the reserves reporting system was established, the report said. In addition, differences in fiscal regimes in countries outside the US reduce the comparability of SEC-based disclosures covering US and international reserves.

Regulators worldwide might consider establishing international reserve-reporting standards, Yergin said.

Misunderstandings

Investors and regulators need to realize that reserves estimates are approximations.

"It is a crucial misunderstanding to think of oil and gas reserves as being similar to inventory or a company's cash balances," Yergin said. "They are not a fixed quantity capable of physical inspection or exact enumeration."

Deregulation of gas markets in Europe, the US, and Canada means buyers and sellers no longer are compelled to enter into long-term contracts.

"Although the SEC recognizes this reality, its application has yet to be fully tested against scenarios for the larger, commodity-driven LNG business that will be critical to future US natural gas supplies," the report said.

The SEC requests that companies use yearend pricing to estimate the value of proved reserves. CERA concluded that reserves are a measure of long-term prospects that are more closely linked to longer-term price assessments than to one day's closing price.

Hobbs said, "The 1978 system's insistence on using the yearend price to calculate oil and gas reserves is not meaningful and creates confusing distortions for investors. The price at the end of the day at the end of the year is no sure guide either to what happened over the previous year or to what will happen in the coming year—or to indeed even to what happened on that particular day."

Recommendations

The report identified six primary areas of modernization that it recommended the SEC evaluate with the assistance and input of industry experts:

-- Reflect the way in which companies view assets and make decisions. This would involve the use of industry-accepted methods and technologies upon which companies rely when investing.

-- Encourage an open dialogue on industry developments by creating separation between the SEC functions of making rules and monitoring compliance.

-- Assure transparency by making the process for obtaining the regulators' view on best practices and interpretation of the regulatory regime's principles open to the public.

-- Adapt reporting requirements to reflect industry changes including: fiscal terms (royalty or tax, production-sharing agreement, service contracts), operating regimes (deepwater, Arctic,), commercial arrangements (liberalizing global gas markets), and technical capabilities.

-- Help users of reserves disclosures recognize inherent uncertainty in reserves estimates. "E&P companies recognize that there is uncertainty in a reserve calculation, and they communicate this effectively within their organizations," the report said. "By contrast, disclosure regulations that create a focus on a single number can prevent this uncertainty from being properly conveyed to and understood by investors and other stakeholders."

-- Disclose the basis of assurance that companies use in preparing and disclosing their reserves estimates. Some E&P companies use internal estimators, and others reinforce their internal process by hiring consultants to evaluate their reserves.

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