Confidence, Credibility At Stake
WASHINGTON, D.C., February 23, 2005 - The 27-year-old U.S. system for measuring and reporting oil and gas reserves has failed to keep pace with a changing, increasingly global industry and, as a result, falls short of accurately describing industry and individual companies' values, performance and strategies, according to the findings of a six- month study released today by Cambridge Energy Research Associates (CERA).
"The system of reserve reporting in force in the United States is in urgent need of modernization," said CERA Chairman Daniel Yergin, one of the authors of the report, In Search of Reasonable Certainty: Oil and Gas Reserves Disclosures. "It is increasingly at odds with the realities of the oil and gas industry in the 21st century and, as a result, it does not properly inform investors about values and prospects of companies."
"With as much as a 60% increase in worldwide oil production needed to meet growing demand in the next 25 years, and an expected doubling in natural gas demand, $4 trillion to $6 trillion in new exploration and production (E&P) investment will be required. Reserves are at the heart of the confidence and credibility necessary to insure the industry has access to those funds and the capability to meet those huge needs," according to the report.
1978 System
According to the CERA study, the SEC's Congressionally mandated reporting system, described as the "1978 System," should be modernized through a joint governmental, industry, accounting, legal and investor consultative process that establishes a principles-based regulatory framework, avoids undue optimism or conservatism, achieves cost benefits, and protects registrants' confidentiality and competitive positions.
"The 1978 System was really made for an oil industry whose map was centered in what might be called 'Texlahoma' -- a conceptual composite of Texas, Louisiana, and Oklahoma that describes the heart of the conventional US oil patch," said study project leader and CERA's Director of E&P Strategy David Hobbs. "Since the 1978 System was established, among oil and gas companies that are registered with the SEC, the proportion that North American reserves comprise of their global totals has declined from more than 65% to just 17%," Hobbs noted.
In Search of Reasonable Certainty identifies six primary areas of modernization that should be evaluated by the SEC with the assistance and input of industry experts:
- Reflect the way in which companies view their assets and make their decisions. This would involve the use of industry accepted methods and technologies upon which companies rely when investing billions of dollars.
- Encourage an open dialogue on industry developments by creating some separation between the functions of making rules and monitoring compliance.
- Assure transparency by making the process for obtaining the regulator's view on best practices and interpretation of the regulatory regime's principles open and visible to all participants and the public.
- Adapt to industry changes including: fiscal terms (e.g., royalty/tax, PSA, service contracts), operating regimes (e.g., "Texlahoma", deep water, Arctic,), commercial arrangements (e.g., liberalizing global gas markets), and technical capabilities (e.g., 3D seismic, inferred water contacts).
- Help users of reserves disclosures to recognize inherent uncertainty in reserves estimates. E&P companies recognize that there is uncertainty in a reserve calculation, and they communicate this effectively within their organizations. By contrast, disclosure regulations that create a focus on a single number can prevent this uncertainty from being properly conveyed to and understood by investors and other stakeholders.
- Disclose the basis of assurance that companies use in preparing and disclosing their reserves estimates. Some E&P companies choose to rely on the established competence of their internal estimators. Others prefer to reinforce their internal process by retaining well-respected consultants to evaluate their reserves or publish an opinion of the company's reserves and/or its methods.
Outmoded
Four critical developments in the E&P industry have left the rules increasingly "stranded in time," according to In Search of Reasonable Certainty:
- Globalization of the industry and capital markets - Less than 20% of SEC registrants' reserves are located in the U.S. today, compared with more than 65% when the reserves reporting system was established in 1978. A good part of the critical resources outside the U.S. that are central to companies' strategies and future growth are excluded from public reporting because significant discoveries awaiting development approvals cannot be recognized as proved under SEC standards. In addition, differences in foreign fiscal regimes (royalty tax regimes, production-sharing agreements, buyback and service agreements) reduce the comparability of SEC-based disclosures covering domestic and international reserves.
- Technological advances - With technological innovation transforming noncommercial resources into future reserves, the current SEC system remains rooted in the technology of the 1970s, without any consultative forum to address technological change in reserves reporting. Advanced techniques are used by companies to support investment decisions costing billions of dollars, but the SEC does not yet or only partially sanctions their use.
- Changed anatomies of major projects - Non-traditional projects, which are drawing an increasing proportion of E&P expenditures, are not adequately accommodated in the present system of reserve accounting. Production from non-traditional sources, including oil sands, gas-to-liquids projects, and the deep water is forecast to grow to 10% of global supply by 2010, up from under 1% in 1990. In North America, their impact is even greater, and expected to account 45% of North American liquids capacity by 2010. This creates a conundrum for companies reporting under current SEC regulations, particularly if they need to raise external equity or debt to fund their development expenditures.
- Globalization and commoditization of oil & gas markets - The development of deregulated gas markets in Europe and North America, with third-party access regulations and the emergence of wholesalers, means neither buyers nor sellers of gas are compelled to enter into long-term contracts any longer. Although the SEC recognizes this reality, its application has yet to be fully tested against scenarios for the larger, commodity-driven LNG business that will be critical to future U.S. natural gas supplies.
Despite the volatility of year-end pricing and its arbitrariness, the SEC continues to require that year-end pricing be used to estimate the value of companies' proven reserves. The price at year-end is a volatile number that can be affected by seasonal factors or market anomalies. By contrast, reserves are a measure of the long-term prospects and strategies of a company that should be more closely linked to longer-term assessments of oil and gas prices than to the vagaries of the market price on a particular day.
"The 1978 System's insistence on using the year-end price to calculate oil and gas reserves is not meaningful and creates confusing distortions for investors," according to Hobbs. "The price at the end of the day at the end of the year is no sure guide either to what happened over the previous year or to what will happen in the coming year - or indeed even to what happened on that particular day."
Crucial Misunderstanding
"It is a crucial misunderstanding to think of oil and gas reserves as being similar to inventory or a company's cash balances," said Yergin. "They are not a fixed quantity capable of physical inspection or exact enumeration. Reserve auditors cannot enter the underground warehouse, that is the pore space in a reservoir, and check off the barrels. They cannot correlate and add up reserves to a second decimal place, as they can with revenues and net income."
The study describes reserves as an approximation -- estimates derived from a complex combination of direct evidence, expert interpretation, a variety of scientific methodologies and experience-based assumptions about the future, often stated in terms of probabilities. For the purposes of internal investment decision-making, companies may use probabilistic methods - alongside single-point deterministic estimates -- to categorize reserves as either proven (90% chance of ultimate recovery), proven plus probable (50% probability), or possible (10% chance of recovery).
However, the study notes, the 1978 System focuses on proved reserves as defined by a standard of "reasonable certainty" pegged to "direct contact" with an existing well. The report described this measure as suitable for reserves forecasts of individual producing wells, but unsuited to an increasing proportion of the modern oil and gas industry, particularly to larger offshore projects. In practice, according to the study, the SEC also appears to have shifted beyond the "reasonable certainty" principle toward an "absolute certainty," rule-based approach, without the transparency and discussion the SEC typically utilizes for other kinds of rule-making. The result can be to disconnect many companies' official reserves disclosures from the reality of their plans, strategies and actual activities.
In comparison to the SEC approach, definitions promulgated by the Society of Petroleum Engineers (SPE), the World Petroleum Congress (WPC), and the American Association of Petroleum Geologists (AAPG), the most prominent technical organizations operating in this arena, incorporate the changes that have occurred in the industry during the past two decades. These standards recommend the use of all available data that companies use for internal investment programming.
In the course of conducting the research and analysis to produce In Search of Reasonable Certainty, CERA organized a consortium that included 30 oil and gas, accounting, reservoir consultants and law firms to support the research, consulted with more than 150 people knowledgeable about the subject in multiple workshops in Washington, Houston, New York, London and Moscow. CERA's study team included ten of the firm's researchers, as well as Prof. Joseph Pratt, Cullen Professor of History and Business at the University of Houston. CERA is solely responsible for the report and its contents.
Cambridge Energy Research Associates (CERA), a subsidiary of IHS Inc., is a leading advisor to international energy companies, governments, financial institutions, and technology providers. CERA (www.cera.com) delivers strategic knowledge and independent analysis on energy markets, geopolitics, industry trends, and strategy. CERA is based in Cambridge, Massachusetts, and has offices in Beijing; Calgary; Mexico City; Moscow; Oakland, California; Oslo; Paris; São Paolo; and Washington, DC.
© 2005, Cambridge Energy Research Associates, Inc. All rights reserved. CERA and the CERA logo are registered trademarks of Cambridge Energy Research Associates, Inc. All other trademarks or trade names are properties of their respective owners.
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