Royal Dutch Shell Plc  .com Rotating Header Image

S.E.C. rule changes on estimated reserves: ‘Welcome back to Alice in Wonderland’

In 2004, the oil and gas industry faced one of its most embarrassing scandals. After whistle-blowers reported concerns about the size of Royal Dutch/Shell’s reserves, the company surprised investors by slashing reserve estimates. “I am becoming sick and tired about lying,” Walter van de Vijver, a senior executive at Royal Dutch/Shell, wrote in a November 2003 e-mail made public shortly after his company’s problems came to light. The episode led to the ouster of several of the company’s top executives and an investor lawsuit worth more than $350 million, and helped propel the S.E.C. rule change.

A version of this article appeared in print on June 27, 2011, on page A12 of the New York edition with the headline: S.E.C. Shift Leads to Worries Of Overestimation of Reserves.

In 2008, the stocks of many natural gas companies were sinking because of the financial meltdown, recession fears and falling gas prices.

But they began to rebound after a sweeping rule change by the Securities and Exchange Commission, intended to modernize how energy companies report their gas reserves.

As part of that change, the commission acquiesced to industry pressure by giving these companies greater latitude in how they estimated reserves in areas that were not yet drilled. The new rules, which were several years in the making, were officially adopted only weeks before the S.E.C. chairman under President George W. Bush, Christopher Cox, stepped down.

Previously, companies were allowed to count gas only from areas close to their active wells as part of their “proved” reserves, the amount of gas that a company estimates to investors it will tap. This was meant to prevent companies from claiming reserves of gas based largely on guesswork.

After the rule change, companies were allowed to include gas located farther from producing wells in their reserves estimates, using modeling methods to predict how much gas could be produced from these yet-untapped areas. But the S.E.C. said that the companies, for reasons of trade secrecy, did not have to disclose precise details about the technology they used to estimate reserve sizes. Though the commission considered requiring third-party audits to verify the reserve estimates, the idea was dropped in the end.

The rule change was especially helpful to shale gas companies because it approved the use of new technology and modeling techniques that these companies rely on more heavily than traditional oil and gas companies.

Shale gas producers also especially benefited from the relaxed restrictions on how large an area companies could predict would be productive without drilling to test first. Shale formations tend to span much bigger areas than conventional oil and gas fields, and some shale gas producers say they can achieve relatively predictable results across these large areas.

Among 19 of the largest shale companies reviewed by The New York Times, at least seven increased — some by more than 200 percent — the amount of undeveloped reserves they reported in their federal filings immediately after the rule took effect, according to their S.E.C. filings. Investors cheered the rule change as it was adopted, and in the following months they sharply bid up the stocks of five of the seven companies.

The rule change also allowed these companies to reduce one of the costs that investors often rely on to compare the performance of energy companies: their finding and development costs. These costs now appeared drastically lower because they were being divided across a much larger reserve estimate. Five of the seven shale companies also reported huge decreases in their finding and development costs — by as much as 86 percent, according to a review by The Times of their federal filings. The average decrease in these costs for the oil and gas industry on the whole was about 48 percent for the year.

However, in internal e-mails and documents, many industry executives and federal officials have questioned whether some companies are overstating, perhaps intentionally, the amount of gas they can economically produce in a given period. This practice, known as overbooking, is illegal because it misleads investors trying to assess a company’s strength and banks that use reserves as collateral for loans.

“There is now plenty of production data available from the states to show that these wells are nowhere near what these guys are touting,” an official with a Texas oil and gas company who formerly worked at Enron wrote on Nov. 7, 2009, comparing the practices of shale companies to Enron’s. “I have discussed this numerous times with analysts that are friends of mine — they agree with me and then just shrug their shoulders.”

Asked about the rule change, officials at Chesapeake Energy, one of the leading shale gas companies, said its reserve numbers were accurate and comparable to those of other companies.

“We believe that the new modernized S.E.C. rules reasonably reflect the advancements in our industry’s ability to predictably produce oil and natural gas resources from unconventional formations,” Jim Gipson, a spokesman for Chesapeake, wrote in an e-mail. With advances in technology, he said, “exploration can be more accurately described as a manufacturing process because well outcomes become very predictable, substantially reducing risk.”

W. John Lee, a professor at Texas A&M University who worked for the S.E.C. as one of the main architects of the rule change, said the threat of S.E.C. action is also a powerful deterrent. “The S.E.C. is requiring more complete (transparent) disclosure in many cases,” Mr. Lee wrote in an e-mail, adding that the risk of overbooking was recognized when the rules were written. Steps were taken to minimize that risk by allowing companies to include only reserves from areas that would under most circumstances be drilled within five years, he added.

John Nester, an S.E.C. spokesman, said the new rules did not require third-party audits because there was a lack of qualified professionals available to do the work and companies themselves could do a better job checking their own reserve estimates.

Some industry experts say they think they are seeing a replay of events from last decade.

In 2004, the oil and gas industry faced one of its most embarrassing scandals. After whistle-blowers reported concerns about the size of Royal Dutch/Shell’s reserves, the company surprised investors by slashing reserve estimates. “I am becoming sick and tired about lying,” Walter van de Vijver, a senior executive at Royal Dutch/Shell, wrote in a November 2003 e-mail made public shortly after his company’s problems came to light. The episode led to the ouster of several of the company’s top executives and an investor lawsuit worth more than $350 million, and helped propel the S.E.C. rule change.

Companies could not apply the new rule until they submitted their 2009 federal filings to the S.E.C. in the early part of 2010. However, companies began describing to investors the coming increases in reserves shortly before the rule change was officially adopted in late 2008.

John E. Olson, an energy market analyst at Houston Energy Partners, says he believes shale companies have been aggressively booking their reserve estimates and playing down costs to make themselves appear more profitable.

Mr. Olson, who is famous for having been fired from Merrill Lynch in 1998 for refusing to recommend Enron stocks, compared the accounting practices of shale gas companies and the hype surrounding the industry to what he saw at Enron. Of the S.E.C. rule change, Mr. Olson said: “Welcome back to Alice in Wonderland.”

This website and sisters royaldutchshellgroup.com, shellnazihistory.com, royaldutchshell.website, johndonovan.website, and shellnews.net, are owned by John Donovan. There is also a Wikipedia segment.

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.

Comment Rules

  • Please show respect to the opinions of others no matter how seemingly far-fetched.
  • Abusive, foul language, and/or divisive comments may be deleted without notice.
  • Each blog member is allowed limited comments, as displayed above the comment box.
  • Comments must be limited to the number of words displayed above the comment box.
  • Please limit one comment after any comment posted per post.