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What Do the New SEC Reserves Reporting Requirements Mean for E&P Companies and Their Investors?

June 28, 2012

In December 2008, the United States Securities and Exchange Commission (the “SEC”) adopted new rules that amend its oil and gas reporting requirements.  Their motivation for making these changes was three-fold.  First, the SEC had to acknowledge the new technological capabilities available to estimate and extract minerals from a variety of new formations including oil sands.  Second, the United States reporting requirements were woefully behind international standards creating a competitive disadvantage for US based oil and gas companies.  Finally, more detailed, standardized, and improved disclosures would give investors a better view into valuations for exploration and production (“E&P”) companies.  These new standards took effect for the 2009 filing period which gave most companies until April 2010 to fully comply in their annual reports filings.

Companies and their accounting firms had to adapt to several new changes.  Calculating the future value of reserves used to be based on the prices of oil or gas on a single day at the end of the previous year.  This caused wide fluctuations on a year to year basis and the rule was changed to average the price over the prior 12 months.  Fair enough, a simple change.  Next, the SEC now allows companies to calculate and include the value of probable and possible reserves to their proven reserves and report both together thereby increasing their overall reserves. Related to adding probable reserves was expanding the allowable production and the definition of “Proven Undeveloped Reserves” from non-traditional sources such as oil sands.  This simple change reflected technological advances in extracting minerals but also served to almost triple the reserves reported by US companies with leases in Canada.  To better estimate both probable and proven reserves with “reasonable certainty”, the SEC allows the use of other reliable technologies and broadens the geographic area that these technologies can be used to estimate reserves around a producing well.  Companies must also disclose their internal controls and the process by which these estimates are calculated and reported, and companies must now file a report from an engineering firm with the SEC based on standards adopted by the Society of Petroleum Evaluation Engineers (“SPEE”).

The benefits to US companies who can get these engineering reports properly filed are significant.  Being allowed to book reserves from non-traditional sources is a huge benefit to companies working in shale and heavier oil sands.  Clearly expanding reporting around probable and possible reserves gives investors some insight into the future prospects of a company as their proven reserves are depleted by production.  Leveling the playing field with international reporting standards allows US companies to raise capital in a more

consistent way, enhancing domestic drilling and production.  The competitive disadvantage because of the limited reporting of reserves that some US companies faced when raising capital is now removed.

These standards have now been in place for two reporting years and many companies have spent the time, energy, and resources to generate an engineering report and file it with the SEC.  Public companies who have completed this requirement have now achieved the new gold standard and have given themselves and their investors an advantage over public companies who do not have the resources to comply or private companies who do not have any requirement to comply.  These smaller public companies and most private companies face significant challenges when raising capital for drilling or acquiring prospects.  Of course any company could voluntarily comply with the SEC requirement but most do not have the capital or the time to get the reports done by an engineering firm and are thus at a severe disadvantage that potentially stifles US domestic development and production.

So have we simply placed tremendous power into the hands of engineering firms?  Certainly some of the largest firms hold many cards and with their reputations at stake will tend to be as conservative as possible.  Since investors will be relying on their reports for comfort and another layer of due diligence, it is in the engineering firm’s best interest to be conservative when estimating reserves that are thousands of feet below ground level.   However, smaller engineering firms may need the E&P companies more than the companies need them.  Investors need to remain cautious about reserves reporting no matter how technologically advanced our engineering methods have become.

Since engineering firms and E&P company investors are being conservative and cautious, does this potential “under reporting” lead to a risk of insider trading violations for management and boards of E&P companies? Could investors be disadvantaged in this case?  Undoubtedly it is better practice to conservatively report than it is to have a constant march of reduced reserves estimates in the future.

Overall, the SEC changes have been embraced by the oil and gas industry as the metrics for valuation are on a level playing field with other international competitors.  Recognition by the SEC that 25 years of technological advances in estimated reserves and extracting them has improved the flow of capital to develop and produce more domestic oil.  US domestic production has risen steadily since the adoption of these SEC amendments.   However, these new standards may leave small and/or private E&P companies at a disadvantage when raising capital until they can meet the new gold standard SEC reporting requirements.

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