We recently attended a seminar hosted by Fulbright & Jaworski L.L.P. dealing with challenges facing boards of directors and, in particular, issues related to the Securities and Exchange Commission (SEC) and enforcement. The seminar, conducted in an Oprah Winfrey-style interview format, included as guests, David Woodcock, the director of the Fort Worth office of the SEC along with the general counsel of HCC Insurance Holdings, Randy Rinicella, the leader of the Houston forensic services for accounting firm PwC, Karyl Van Tassel, and the moderator, Gerry Pecht, a partner with the law firm sponsor. As you would expect, the discussion covered a wide range of topics extending from problems that are emerging from the new rules of the Dodd-Frank legislation to questions about potential investor fraud that may develop from the recently enacted Jumpstart Our Business Startups (JOBS) Act signed into law by President Barack Obama.
A question was posed about the subpoenas issued last year to several energy companies active in developing gas shale resources. Those subpoenas came to light following a series of articles in The New York Times about the potential for there not to be as much natural gas contained in some gas shale reservoirs as the producing companies were suggesting. According to Mr. Woodcock, these subpoenas were issued after reviews of the annual reports of the companies in light of the SEC revisions to the rules for reporting oil and gas reserves. A report by the law firm Sullivan & Cromwell LLP discussed how the changes were to be implemented. In that report, the law firm highlighted the most significant disclosure changes.
"Prices used to estimate reserves for both reserves disclosure and accounting purposes will now be a 12-month average price, based on the first-day-of-the-month price for each month, rather than a single-day, year-end price.
"Alternative technologies may be used to establish proved reserves if they satisfy a new principles-based definition of 'reliable technology.'
"Reasonable certainty for the purpose of estimating proved reserves is defined to mean a high degree of confidence or at least a 90% probability that the quantities will be recovered.
"Non-traditional resources, such as bitumen extracted from oil sands and oil and gas extracted from coal and shale, may be included in disclosure of oil and gas reserves.
"Optional disclosure of probable and possible reserves will be permitted.
"Conforming changes to Form 20-F will impose the same oil and gas disclosure requirements on foreign private issuers, resulting in a significant expansion of the required disclosures for non-U.S. oil and gas companies."
The SEC's disclosure review relates to the issue of the five-year time frame for the development of reserves in order to be included in a company's estimate. The Sullivan & Cromwell report addressed this issue in the following paragraphs, which highlight how the determination of oil and gas reserves has been liberalized from the way they were determined prior to the new rules.
"Definition of 'Undeveloped Oil and Gas Reserves'
"The new rules allow the inclusion of undeveloped reserves if there is reasonable certainty of economic producibility, regardless of whether the reserves are located in development spacing areas immediately adjacent to the development spacing area containing a producing well, or at a greater distance from productive units. This represents a significant change from the current approach, which imposes a 'reasonable certainty' standard for reserves in drilling units immediately adjacent to the drilling unit containing a producing well, and a 'certainty' standard for reserves in drilling units beyond the immediately adjacent drilling units.
"Under the proposed rules, a company would have been prohibited from assigning proved status to undrilled locations if a development plan had not been adopted indicating that the locations are scheduled to be drilled within five years, unless it disclosed unusual circumstances that justify a longer time. Several commenters objected that large, complex or remote projects commonly require more than five years to develop. In response to those comments, under the adopted rules undrilled locations may be classified as having undeveloped reserves even where drilling is not scheduled to begin within five years, if specific (not necessarily 'unusual') circumstances justify a longer time."
In light of the decline in natural gas prices, the SEC is questioning what impact there has been on the intent of producers to develop these reserves and whether any change or potential for a change in plans has been accurately described to investors. It should be noted that in the Sullivan & Cromwell discussion they note that producers can include reserves that won't be drilled within the five-year time frame as long as the circumstances that limit their development are "specific" and not "unusual." A sharp decline in commodity prices that impacts the economics of the development of reserves is not an acceptable excuse for non-development, regardless of how painful the action of writing down the value of the previously claimed reserves may be.
With natural gas spot prices about to fall through the $2 per thousand cubic feet threshold, investors and analysts are questioning when producers will be forced to acknowledge the changed economics and have to write down already-booked reserves, and just how painful it will be for the companies and their share prices. The shift in price determination from the prior single–point to a 12-month average alters that determination, especially in cases where gas is sold with contractual prices substantially higher than spot prices. However, the longer this low-priced condition extends, the greater the pressure will be for producers to reflect the current pricing environment in their reserve calculations. All of this has the SEC concerned that its liberalization of the proved reserves calculations may have led to abuse by certain producers, which means that their reserve value disclosures did not adequately warn investors of the potential inflated value in the company's assets.
According to Ms. Van Tassel, oil and gas producers who received SEC comment letters regarding their annual report disclosures were four-times more likely to have had included a comment about the text of their reserve disclosure. We suspect this reserve disclosure issue will receive greater focus as the year progresses given the level of natural gas prices and the deteriorating financial condition of producers. If you raised money since the revisions to the reserve disclosure, the regulatory risk may be elevated.
G. Allen Brooks works as the Managing Director at PPHB LP. Reprinted with permission of PPHB.
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