Financial Week: (Mis)counting crude

By Nicholas Rummell
September 10, 2007

The Securities and Exchange Commission is considering whether to ease accounting rules for oil companies to allow them greater latitude in how they calculate oil reserves, but some critics worry the rules are already too lax.

The current reserve requirements date back to the 1970s, and a number of new techniques, such as 3-D seismic interpretation and computer-enhanced reservoir simulation models, have improved oil companies’ reserve estimates, said James Eggers, an audit partner at KPMG’s energy practice. Furthermore, some technologies, such as flow testing, that are required by the SEC, are viewed as outdated by the industry, he said.

In a speech last month, John White, director of the SEC’s division of corporation finance, said that the SEC is reviewing current disclosure requirements for oil and gas reserves, and that it may request revisions.

New technologies are cheaper and easier to use, and industry groups such as the Society of Petroleum Engineers have pushed hard, even in recent months, for their adoption. So far the SEC has remained agnostic, but Mr. White seemed somewhat skeptical of allowing oil companies greater leeway. “Allowing use of such technologies would likely produce increased levels of proved reserves, but might decrease the reliability of the estimate,” Mr. White said.

Not surprisingly, oil companies have critics when it comes to how they calculate their reserves. “There is an appalling lack of transparency” regarding the reserve-setting process among oil companies, said Steve Kretzman, executive director of Oil Change International, an advocacy group that has criticized the oil industry over the last couple of years over cost issues. “All we know about what they have [in reserves] is what they tell us.” Mr. Kretzman said his organization will focus on this issue over the next year.

Currently, oil companies may report only proven reserves and must do so using flow testing, in which oil reserves must be tapped and flow at a certain rate. Proven reserves are those with roughly 90% certainty of being retrievable. Probable and possible reserves, or those with 50% and 10% certainty, respectively, may not be reported in filings.

In April 2004, the SEC made an exception and allowed some oil companies to use seismic data instead of flow testing to justify oil reserves in the Gulf of Mexico. Oil companies had lauded the SEC’s decision but wanted the agency to expand its allowance of modern technologies to other regions.

Concerns center also on the independence of reserves data, since many oil companies don’t use outside auditors to verify their estimated reserve levels. “We’re talking about an estimate that, for all the science and technology around it, is still an estimate,” Mr. Eggers said.

Despite the fact that reserve estimates are not completely accurate, they are considered one of the most important aspects of an oil company’s cash flow, since companies capitalize certain costs related to the exploration and development of oil properties and present them as assets on their balance sheets.

Reserve estimates are the “starting point” for rating oil companies, according to Ben Tsocanos, an oil and gas analyst at Standard & Poor’s. “It’s the single most significant factor in analyzing an oil and gas company.”

Although revisions are common, they often are small—only a few percentage points, Mr. Tsocanos said. Generally the revisions trend upward, meaning that oil companies guess conservatively.

Still, the industry has had its share of controversy regarding the issue in recent years. In 2004 both Royal Dutch Shell and El Paso Corp. were found to have systematically overbooked their reserves (gas reserves in El Paso’s case).

In 2004, Ohio’s attorney general and several public retirement systems led a class-action lawsuit against Exxon for allegedly inflating oil reserves just before its merger with Mobil in 1999, leading to shareholder losses. The lawsuit was dismissed in late 2005 for failing to meet certain procedural requirements.

The SEC has been advertising for applicants for a petroleum engineering fellowship since early this year. The agency is looking for a candidate with “significant experience in petroleum reservoir engineering with expertise in petroleum reserve estimation,” as well as familiarity with petroleum accounting, according to the advertisement posted on its website.

The SEC has two permanent petroleum engineers, as well as accounting staff, that review reserves listed in oil company filings. Generally, those staffers are interested in the likelihood that a proven reserve will be developed for use, the timing of the development and the cost—all of which play a part in future revenue and cash flow for oil companies. SEC staffers also typically query oil companies about any independent auditors that are used in determining the oil reserve levels.

International financial reporting standards also may be spurring the need for revisions of the oil reserve rules, KPMG’s Mr. Eggers said, because other countries have different definitions of what constitutes a proven reserve. “They’re looking to take a broad view of the reserve definition,” he said. FW

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