Editors Note: This landmark speech has been downloaded from the following web address: http://financialservices.house.gov/media/pdf/072104bd.pdf. I have included the first portion of the speech here, the portion outlining the issues and calling for reform. In the next issue, I will include Dr. Dharan’s recommendations for those reforms.
Having useful and reliable information on oil and gas reserves is enormously important to the US policy makers, managers of the companies, investors, and the public. Over 150 publicly owned U.S. oil and gas producers file reserves data in their 10-K, and their reported total reserves of oil and gas is valued at over $3 trillion. Financial analysts covering the industry generally find that for energy companies, over 70 percent of the total market value is determined by the amount of proved reserves the company has.
Companies currently are required to provide unaudited estimates of proved reserves quantities to the Securities and Exchange Commission (SEC), using strict and conservative definitions provided in the SEC regulations for proved and proved developed reserves. In theory, given these strict definitions, and in this era of rising oil and gas prices and improving recovery techniques, it is hard to envision scenarios where companies could report significant downward “technical revisions” in proved reserves.
In practice, however, recent large downward revisions in proved reserves by Shell (20 percent reduction of proved oil and gas reserves) and El Paso (41 percent reduction of proved gas reserves), and smaller restatements by a handful of other companies such as Forest Oil, Vintage Petroleum, Nexen, Husky Energy, and Western Gas Resources, has shown that the reserves data are indeed vulnerable to disclosure quality risk.
These events confirm that despite their overall reliability, the current unaudited reserves data are viewed by investors and analysts as just not reliable enough. In fact, as investors learn more about how reserves are estimated and reported, it might come as surprising to them that items on a company’s balance sheet, such as cash and accounts receivable, which contribute to only a small part of the total value of the company, are subject to far more external audit and internal controls than proved reserves estimates despite the reserves being the main driver of an energy company’s upstream value.
Some in the industry argue that only small fixes are needed to improve the usefulness and reliability of reserves data. Others have called for more disclosures. However, the issue for the industry is really the credibility gap that affects the disclosures of reserves data, and resolving it requires potentially new regulations or at the least new industry action.
The credibility gap is caused by two related factors, quality credibility and reporting credibility. These two terms correspond to two fundamental characteristics of accounting information – relevance and reliability. The “quality credibility,” which affects the relevance of the reserves information for investors and other users, is caused by a lack of common technical standards and lack of training and certification programs to propagate the standards among all evaluators (Bold italics mine). The “reporting credibility,” which affects the reliability of the reported information, is caused by the fact that reserves disclosures are not audited by external auditors or by independent reserves evaluators.
It is also further affected by the fact that until recently companies had not paid attention to potential financial incentive conflicts for managers who manage the reserve estimation process, such as the effect of the reserves classification on capitalization versus expensing decisions, and other potential effects on managers’ compensation and bonuses. While the Sarbanes-Oxley Act has made companies pay serious attention to these conflicts by requiring companies to have their internal control processes certified, there is still a potential need to require external audits of the reserves estimation process to fully address the reporting credibility.
Making reserves disclosures more useful to investors would require addressing the credibility gap issue comprehensively, by improving both the relevance and reliability of the disclosures, which in turn requires significant improvements to the processes by which reserves data are currently estimated, audited and reported. Both the industry and the SEC need to take concrete steps that will result in the end-users perceiving the reserves data as reliable and useful for valuation purposes. In my following remarks, I elaborate on this assessment and discuss several proposals and recommendations for improvement. Importance of Reserves Disclosures Surveys of investors and petroleum industry managers show that investors want to believe the reserves numbers, but do not, for the most part, rely on them. A 2002 survey of investors and industry managers conducted by an accounting firm found that most oil and gas company executives thought that their corporations’ share prices were undervalued by investors relative to the true value of reserves and expected future cash flows from them. At the same time, most analysts interviewed for the survey said that the quality of disclosures of O&G firms were inadequate for use in valuing the companies, even though they agreed that reserves disclosures were important.
Academic research by accounting professors over two decades on the use of reserves disclosures by investors, including early work I have done in this area, has also shown that investors generally find reserves disclosures useful for valuing a company. Academic studies have shown generally that the reserves disclosures, including the standardized measure of cash flows and changes in the standardized measure, do have information value to investors. But the research findings also suggest that investors’ reliance on reserves disclosures varies widely with several other factors, including the size of the company and the accounting methods used for exploration costs.
Overall, the research findings suggest that the unaudited reserves disclosures of companies are not viewed by investors as adequately reliable for valuation purposes, unless the data are also supported by other audited financial disclosures of the company. Shell’s reserves restatement early this year shocked the markets and the industry for the magnitude of the downward restatement; 3.9 billion barrels of oil equivalent, or about 20 percent of Shell’s total proved reserves, were reclassified as a result of the restatement from proved category to other categories. Apart from Shell, however, there have been few reserve restatements by major US companies. As noted, only a handful of other companies have restated their proved reserves estimates this year. Still, many analysts and investors are surprised and confused by the revisions. After all, investors have a right to think that the reported proved reserves numbers are technically determined and should be reliable and not fuzzy. As noted above, the SEC does have a strict and conservative definition of what can be classified as proved reserves.
It is no wonder that investors and regulators are asking whether there may be fundamental estimation and reporting issues related to reserves estimation that need to be addressed. Given the strategic importance of reliable oil and gas reserves estimates, all major US energy producers with significant oil and gas reserves are currently required by the Securities and Exchange Commission to report their estimates of proved developed reserves and proved undeveloped reserves in their annual filings with the SEC. The SEC disclosure regulations (Reg 210.4-10) on reserves date back to the energy crisis of the late 1970s. Even though the reserves data are disclosed in the annual filings as footnotes to audited financial statements, the footnotes themselves are not audited by the auditing firms and are clearly labeled in the 10-K filings as “unaudited.” The SEC disclosure rules on reserves are highly respected. The SEC uses strict definitions of the terms “proved” and “proved developed” reserves, and there is general consensus in the industry and among analysts that the SEC’s definitions are quite conservative, if not too restrictive. Under SEC definitions, reserves can only go in the “proved” category reporting if there is “reasonable certainty” that they can be developed at current prices. In Reg. § 210.4-10 the SEC defines proved oil and gas reserves as “the estimated quantities of crude oil, natural gas, and natural gas liquids which geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions.” (Author’s Emphasis) As noted, the key highlighted phrase in the above definition is “reasonable certainty.” The SEC has interpreted this phrase especially quite strictly and appropriately so, and has generally required evidence from test wells, rather than allowing companies to rely on newer technologies for estimating reserves.
Specifically, the SEC requires that “Reservoirs are considered proved if economic producibility is supported by either actual production or [a] conclusive formation test.” The SEC’s definition for “proved developed” reserves is even more stringent: “Proved developed oil and gas reserves are reserves that can be expected to be recovered through existing wells with existing equipment and operating methods.” (Author’s Emphasis). A key element of this definition is that capital expenditures for the development of a field should be generally complete or fully committed to, in order to include the field as proved. Companies also provide additional reserves-related data to other federal agencies, including the Energy Information Administration’s Financial Reporting System. Finally, the Financial Accounting Standards Board (FASB), in its Statement No. 69, “Disclosures about Oil and Gas Producing Activities,” requires extensive unaudited footnote disclosures related to a “standardized measure of discounted future net cash flows relating to proved oil and gas reserve quantities,” and of annual changes in this standardized measure.