Auditing of Oil and Gas Reserves Called Impractical

Opening up the cloistered, arcane world of oil and gas reserves to outside auditors is impractical and would open a can of worms for other reserve-based industries, accountants say.

The Securities and Exchange Commission is considering a new requirement that would force independent auditors to review the reserves of energy companies. But some see problems with the idea, citing the technical nature of estimating reserves and the effect on other industries that track reserves, such as mining, timber and waste.

The SEC's proposal comes in the wake of an ongoing accounting scandal at Royal Dutch/Shell Group, which was recently fined $150 million for overstating its tally of energy reserves. In an 11-page memo issued in late July, the SEC invoked the language of Sarbanes-Oxley, with the statement that "internal controls" at oil companies may have been inadequate.

The statement asked how auditors can effectively sign off on that holistic set of checks and balances known as internal controls when they don't have access to reserves data.

Politics are also involved; Rep. John Dingell of Michigan, a ranking Democrat on the House Committee on Financial Services and a senior member of the House Energy and Commerce Committee has said the SEC isn't going far enough, and has called on regulators to immediately revise the rules.

The PCAOB and the SEC declined further comment on whether they were considering new rules for oil and gas, or would consider new regulations for other industries.

The Challenge Of Standardization

Accountants say that imposing such rules won't be easy. The process of estimating reserves is complex and requires skilled judgments on geological, geophysical, engineering and economic data.

"We've always relied on reserve engineers for that data," said Lee Graul, national director and head of SEC practice at auditor BDO Seidman. "The question is, how do you judge an estimation that's based on material a couple thousand feet beneath the crust of the earth? It's kind of difficult to get your arms and mind around."

Graul said his firm gets data from acoustic sounding studies done by reserve engineers, but doesn't audit that information. Measures auditors currently take to gauge the reliability of a reserve engineer's data include looking at their credentials and past auditing work, Graul said.

But, "If you're doing sono-tests to figure out what's under the ground, we would literally have to hire a third-party engineer to audit the reports," Graul said.

Bala G. Dharan, a professor of accounting at Rice University who testified on "Improving the Relevance and Reliability of Oil and Gas Reserves Disclosures," to the House Financial Services Committee July 21, 2004, said that an external review of reserves isn't necessarily impossible.

"At the very least, you can professionalize the people who give the reserves calculations," said Dharan.

Currently, reserve engineers have no certified method or professional association that enforces a universal standard. Dharan noted that professional association the Society of Petroleum Engineers, or SPE, has discussed the viability of establishing such a standard.

A spokesman from the SPE said there is a technical committee that's working on standards for reserves auditing, but the spokesman said he couldn't comment further on the reserves issue as it's a matter of public policy. Auditors and engineers also need to become more familiar with the SEC's definition of crude reserves, Dharan said.

Aside from the difficulty of grasping the scope of liquid assets miles under the earth, creating an international standard could also be problematic.

"American companies don't want to be the only ones doing it. Our energy supply is dominated by other countries, and companies or divisions in the Middle East or Nigeria may not get cooperation from local jurisdictions to participate in the implementation of standards," said Dharan.

The Ripple Effect

Aside from challenges within the oil and gas industry, regulators also face the hurdle of a possible ripple effect from regulatory changes to reserves estimation.

"Any requirement to audit non-financial information would have implications for other industries with non-financial information. That's certainly the issue," said Mike Starr, Grant Thornton's US managing partner of professional excellence.

"If the decision is that oil and gas reserves should be audited it logically follows that other similar industries would need to be audited," he added.

The mining industry bears the greatest resemblance to oil and gas in its reliance on reserves. "As an auditor you wouldn't know whether a sample taken of the core represents the right amount of trace elements to generate an effective estimate of what the minerals are down there," BDO Seidman's Graul said.

Jean-Michel Rendu, a retired vice president of Newmont Mining Corp and now part of a working group on SEC reserve issues for the Society for Mining, Metallurgy, and Exploration Inc., said his group has been evaluating various national standards and working to hammer out a more specific set of standards in the U.S.

"The U.S. regulations on the mining side are more than 20 years old and they haven't kept up to speed on what has been agreed upon in the rest of the world," said Rendu.

While South Africa, Canada and Australia all have various standards about reserve auditing, they all vary slightly, and coming up with a set of standards for the U.S. isn't easy, he added.

Dharan said industries like mining, gold and timber may disclose even less than the oil industry does at this point, as FASB standardized oil and gas reserve reporting to some extend in the mid '80s.

"You could also say there's a similar problem in scrap inventory, used paper, used steel, or other metals to be recycled," said Graul. The implications for more detailed understanding of internal controls don't stop with tangible materials.

"If you open up the annual report of Citigroup, you have page after page of derivatives and VAR (Value at Risk) data," said Dharan. In almost every industry there's a level of detail too arcane for most auditors to understand, he added.

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