Reserves Overbooking: The Problem
We Are Finally Going To Talk About
Grant T. Olsen, W. John Lee, and Thomas A. Blasingame, SPE, Texas A&M University
Summary
Oil and gas reserves estimates that honor disclosure requirements of the US Securities and Exchange Commission (SEC)
are critically important in the international oil and gas industry.
Unfortunately, a number of exploration and production (E&P)
companies have allegedly overstated and subsequently written
down certain reserves volumes in recent years. In some cases, the
consequences have been quite adverse. We document some of these
cases of reserves overstatements and summarize the consequences.
Reserves write downs are of obvious interest to numerous groups
involved in the reserves estimation process and outcome, including estimators, managers, investors, creditors, and regulators.
The magnitude and nature of recent overstatement cases, relative
unfamiliarity with the SEC’s inner workings, and the SEC’s new
reserves-reporting requirements increase the need to examine critically reserves disclosures and reserves overstatements.
Disclaimer
This paper discusses write downs and alleged overstatements of
oil and gas reserves. Information used to write this report has been
obtained from extensive examination of the public record. Overstatements and violations of federal securities laws and actions by a
company or its representatives are only alleged in the public record,
and, unless stated otherwise, any settlements discussed should be
considered as made without admission of guilt. Write downs can
readily happen with even the best of intentions. We authors—and
you readers—are not judge and jury. Our intent is to raise awareness
about write downs, overstatements, and observed consequences,
and to promote the responsible reporting of oil and gas reserves.
Overview of the Reserves Overbooking Issue
A number of E&P companies have, in recent years, allegedly
overstated and subsequently written down certain reserves volumes
reported to the US SEC. Operators including Shell, El Paso, Stone
Energy, and Repsol YPF, among others, have found themselves
in the spotlight—and courtroom—for alleged overstatements of
their oil and gas reserves. Overstatements and write downs have
occurred for a variety of reasons and often have been accompanied
by significant adverse consequences. A stigma and discomfort surrounding overstatements exists within industry, as the topic has
been labeled “the problem no one wants to talk about” (McLane
and Rose 2001).
The SEC has roles, investigative processes, and enforcement
procedures unlike any other organization involved with the oil
and gas industry. However, the SEC’s inner workings are not
frequently discussed or well understood by all of the groups
that these rules affect. The SEC’s Modernization of Oil and Gas
Reporting Requirements has made certain standards more flexible
(e.g., elimination of the “one offset rule” and allowance of “reliable technologies”). Accordingly, engineers must now adjust to
these new guidelines and deal with the possibility of disclosing
previously unrecognized asset value without overstating reserves.
The difficulty of this task, along with the technical “liberalization”
and an enhanced “principles-based” emphasis in the rules, could
Copyright © 2011 Society of Petroleum Engineers
This paper (SPE 134014) was accepted for presentation at the SPE Annual Technical
Conference and Exhibition, Florence, Tuscany, Italy, 20–22 September 2010, and revised
for publication. Original manuscript received for review 24 June 2010. Paper peer approved
23 September 2010.
68
create even greater potential for reserves overstatements than in
the past.
Therefore, the magnitude and nature of recent alleged overstatement cases, relative unfamiliarity with the SEC’s inner workings,
and the SEC’s new reporting requirements together have created
a need to discuss openly reserves disclosures and reserves overstatements. Overstatements are not confined to particular reserves
categories, asset types or locations, or filer size. However, overstatements are most likely to occur within the proved undeveloped
(PUD) category. Reserves write downs can create nearly instantaneous value destruction for shareholders. A study of case histories
indicates that significant corporate and/or individual penalties may
be associated with overstatements, along with the potential for
class-action lawsuits.
Background
By a recent SEC definition, oil and gas reserves “are estimated
remaining quantities of oil and gas and related substances anticipated to be economically producible, as of a given date, by application of development projects to known accumulations” (US
SEC 2008c). Reserves may be subdivided into proved, probable,
and possible categories according to the degree of uncertainty
associated with recovery of the volumes. In addition to being
dependent on the manner in which the term is defined, reserves
are also a function of numerous known and assumed technical
factors including reservoir parameters, project costs, ownership,
and commodity prices.
Reserves volumes and values of publicly traded oil and gas
companies (e.g., on the New York Stock Exchange) are not directly
reported on a company’s balance sheet but are rather attached to
financial statements. Barry (1993) considered it “odd” for reserves
not to be reflected in the balance sheet. Furthermore, he observed
that “the volume of reserves is a corporation’s Black Hole. It exerts
a huge influence on everything else in its orbit, yet emits very little
light.” Because reserves are not part of the balance sheet per se,
they are not subjected to audits by financial or accounting firms.
However, filers commonly elect to have their reserves audited by
third-party engineering firms.
Reserves are of significant importance to a variety of stakeholders including filers, investors, regulators, and politicians.
An E&P company’s financial health depends in large part on its
stated oil and gas reserves. Financial measures such as finding and
development costs, reserves-replacement ratio, reserves life index
and depreciation, depletion, and amortization are all impacted by
a firm’s oil and gas reserves. Furthermore, reserves are a vital
instrument toward gaining access to capital markets: Credit ratings
depend on reserves volumes, and bankers will commonly lend
funds based on reserves as collateral. In his prepared testimony
before the US House Committee on Financial Services on 21 July
2004, Dharan (2004a) stated that reported reserves of oil and gas
represented more than USD 3 trillion worth of value (and more
than 70% of a typical E&P company’s market value). In sum, many
individuals and organizations have a great interest in the reporting
of oil and gas reserves, and the quantities reported have important
financial and geopolitical implications.
The Evolution of Reserves
Given the somewhat disparate users and uses involved with oil
and gas reserves, along with continuous advances in engineering and geological technology, the definition of reserves has
been a moving target. The American Petroleum Institute created
April 2011 SPE Economics & Management
definitions in 1936 as part of its annual studies of US oil reserves,
and the American Gas Association joined these studies in 1946
(Harrell and Gardner 2005). The Society of Petroleum Engineers
(SPE) first adopted definitions for proved reserves in 1964. In
1975, the Energy Policy Conservation Act was passed, which led
to definitions for proved reserves from the SEC in 1978. SPE and
the World Petroleum Council (WPC) published their “Petroleum
Reserves Definitions” in 1997. That document had “seemingly
subtle but often important divergences in interpretation” with the
SEC definitions (Harrell and Gardner 2005). In 2007, the SPE/
WPC/AAPG/SPEE released the Petroleum Resources Management System, which sets forth an international standard for the
definitions, codification, and evaluation of oil and gas reserves
(SPE/WPC/AAPG/SPEE 2007). Although numerous organizations
have weighed in on reserves definitions and filers are free to report
reserves internally as they see fit, the SEC definitions are the
legal standard by which filers must report their proved oil and gas
reserves if they list their securities on US Exchanges.
SEC Modernization of 2009
The 1978 SEC definitions came under ever-increasing fire over the
next 3 decades. As Lee (2009) outlined, some of the key changes
that occurred since the 1978 definitions include the following:
• Significant advances in the recovery and characterization of
hydrocarbons
• Growth and improvement of both spot markets and transportation for oil and gas
• Establishment of economic production from nontraditional
resources (e.g., bitumen from oil sands)
Some of the most noteworthy updates resulting from the
Modernization (US SEC 2008a, 2008b, 2008c), along with the
perceived benefits, are presented below:
• While proved reserves must still be reported, probable and
possible reserves may be disclosed at the option of the reporting company. Because companies commonly make investment
and strategic decisions on the basis of 2P reserves, disclosure of
these additional categories should provide more transparency and
relevancy for investors.
• Economically producible nontraditional resources, such as
gas hydrates, synthetic oil and gas mined from coal and oil shale,
and bitumen mined from oil sands, are now reportable as oil and
gas reserves. A greater focus has been placed upon the end product
than on the source of the product, and this will allow a broader
view of a filer’s reserves.
• Instead of requiring year-end pricing to calculate reserves, filers must use an average price that weighs equally the price on the
first day of each of the 12 months of the fiscal year. This change
has the potential to remove some of the effect of the volatility
inherent in product prices and to serve as a more representative
measure of recent oil and gas prices.
• Reserves may also be reported, at the filer’s discretion, as a
function of alternative price forecast(s). Such alternative pricing
scenarios could give insight into the potential resiliency and/or
upside of the filer’s reserves portfolio.
• Reliable technologies may be used to determine reserves
volumes. The regulations do not specify which technologies may
be used, thereby implicitly allowing for the advent of new and
incorporable technologies.
• PUD locations greater than one offset away from a proved
developed producing (PDP) location, provided they meet the reasonable certainty criterion, may now be booked.
Role of Third Party Firms
Third party engineering firms are commonly used throughout the
oil and gas industry to audit reserves estimates made by filers, or
to perform full reserves evaluations. As defined by the Modernization requirements of 2009 (US SEC 2008c), a reserves audit is “the
process of reviewing certain of the pertinent facts interpreted and
assumptions underlying a reserves estimate prepared by another party
and the rendering of an opinion about the appropriateness of the
methodologies employed, the adequacy and quality of the data relied
upon, the depth and thoroughness of the reserves estimation process,
April 2011 SPE Economics & Management
the classification of reserves appropriate to the relevant definitions
used, and the reasonableness of the estimated reserves quantities.”
The Modernization guidelines do not require reserves audits
of E&P companies. Should a filer indicate that a third party conducted an audit, process review, or any valuation of its reserves,
however, the filer must make a number of disclosures regarding
the third-party report. Specifically, the new regulations require “a
brief summary of the third party’s conclusions with respect to the
reserves estimates” (US SEC 2008c). The guidance offered by
SPE’s 2007 Auditing Standards (SPE 2007), which does not have
the force of law but is mentioned in the “Supplementary Information” section of the new SEC rules, states that in rendering an
opinion on the reasonableness of the estimated reserves, quantities
and value “should reflect a quantity and/or value difference of not
more than plus or minus 10%, or the subject reserves information
does not meet minimum recommended audit standards.” This ±
10% variation may be interpreted as the amount by which qualified professionals can reasonably be expected to disagree when
independently estimating reserves using identical information.
Certain companies may elect to contract a third-party firm for
a full evaluation of their oil and gas reserves, wherein the third
party independently calculates the reserves on the basis of data
provided by the filer.
Overstatements and Write Downs
From Proved to Unproved. A reserves write down is a negative
revision to oil and gas reserves estimates. A write down should
occur if and when it is discovered that reserves estimates are too
high. According to Smith and Sheehan (1997), downward revisions
of reserves are made “to reflect new information on existing well
performance and/or changes in economic conditions (i.e., oil and
gas prices, operating cost environment).” Write downs are not necessarily a cause for concern among regulators or shareholders. For
instance, reserves may be subject to a negative revision if product
prices decrease over a given year. Such an occurrence represents
a macroeconomic-level event to which filers are simply subject
and over which they are likely to have little control. Additional
technical data regarding reservoir performance may necessitate a
reserves write down. There are other potentially unavoidable or
uncontrollable factors, both large and small, which may result in
or contribute toward a reserves write down. This paper addresses
reserves write downs and focuses in particular on reserves overstatements, which represent largely avoidable reserves write downs
from the proved category to probable, possible, or subreserve
“contingent resource” status. Overstatements can occur when there
has been an intentional misapplication of or disregard for reserves
booking guidelines.
A Mixed Record in the Industry. Previous articles have commented that reserves volumes for the US have a reputation for
being conservative (Reservations About Reserves 2004), and congressional testimony offered by experts has indicated that reserves
values are “generally stable and are subject to very few downward
adjustments overall” (Dharan 2004b). A 1997 research article
from the Energy Information Administration (EIA) (Morehouse
1997) had encouraging findings regarding audits of US reserves
estimates submitted to the EIA since 1977: “most of the proved
reserves estimates submitted to EIA are more than 90% certain to
be recovered in the future and, in many cases, are more than 95%
certain to be recovered.” Proved reserves data requested by the
EIA is “generally the same information” that filers must submit
to the SEC (Wascak 2004.) However, the EIA data entail grossoperated reserves, while the SEC requires net reserves (operated
and nonoperated). At the individual field level, the EIA believes
that the proved reserves estimate “almost always” falls within the
range of “professional competence,” and that at the aggregate level
for the total volume of proved reserves presented in their annual
reports, companies have a “99.999% probability” of recovering at
least the physical volume that is estimated (Wascak 2004).
On the other hand, reserves overstatements have been acknowledged as “the problem no one wants to talk about” (McLane and
Rose 2001). A previous study by Spear and Lee (1999) indicated
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a high degree of uncertainty for reserves estimates of 106 “leading
oil and gas firms” during 1985–1994. Furthermore, between 2003
and 2008, E&P companies reported negative revisions of more than
9.3 billion net BOE (Hodgin 2009).
“Honest mistakes” in reserves estimation can and do happen.
Furthermore, a handful of alleged overstatements should not cast
doubt upon the reserves estimates of the entire petroleum industry. As
Meyer and Zorn (2004) aptly stated in a 2004 Simmons & Company
International report, “to broadly ascribe significant reserves risk to all
E&P companies simply on the basis of the specific circumstances of a
few is a dangerous game.” However, this same report also states that
“incidences of noncompliance with SEC proved reserves guidelines
are numerous, each with their own specific case history and set of
root causes.” In certain instances of reserves write downs from the
recent past, the SEC and/or shareholder groups believed that the
overstatements were not necessarily attributable to honest mistakes.
A number of reserves write downs have equaled or exceeded 20%
of a company’s previously reported volumes. According to a former
SEC Chief Accountant, “A 20% restatement of proved reserves is a
humungous [sic] error…. not an oversight. It’s an intentional misapplication of the SEC rules” (Macalister 2004).
So in light of the fact that alleged reserves overstatements and
subsequent write downs have occurred on a number of previous
occasions, it is naive to assume that there will not be further
instances in the future. The following anecdote was relayed by an
SEC employee in 1964 (White 1964):
“A rather unusual filing… ascribed nearly 100 million bbl of oil
and nearly 250 billion cu ft of gas to potential production from
horizons ‘not yet discovered.’ This statement was volunteered
in addition to an estimated 8 million bbl of proved undeveloped
reserves which were subsequently reduced to 3 million bbl.
Even this was a forced overestimation to allow for the remotest
of contingencies. There had been only a little over 1 million
bbl of developed reserves involved. After nine years, none of
the ‘potential’ reserves has been discovered. Obviously this was
not one of the better reports.”
Although this comment was made nearly 50 years ago and the case
predates modern regulations, the attitude conveyed is telling and
its tone has echoed through history.
Causes of Overstatements. McLane and Rose (2001) presented
a number of reasons why reserves overbooking may occur. First,
they state that poor estimating practices and ignorance may be
responsible. Such practices of unsound technical work represent
unintentional “errors of omission.” These errors persist, despite
ample availability of technical material covering reserves estimation including comprehensive texts on the subject (Cronquist
2001) and papers which specifically address “recurring mistakes
and errors” in reserves estimation (Harrell et al. 2004; Hodgin and
Harrell 2006). When estimating year-end reserves for SEC reporting purposes, an insufficient understanding or improper application
of SEC definitions would constitute a poor estimating practice and
ignorance. A lack of adequate internal controls within a company
would also be characteristic of shortcomings in this area.
Second, according to McLane and Rose (2001), misguided
incentives and competition for investors may be additional causes of
reserves overbooking. Specifically, regarding misguided incentives,
staff bonuses may set the tone for staff behaviors. If an engineer’s
compensation is dependent on achieving an aggressive level of
reserves volumes, it may be difficult for the engineer to maintain
objectivity during the estimation process. McLane and Rose discuss
the significant pressure on managers to meet the high expectations
of the equities market. McLane and Rose state that pressure exists
“to push the envelope of credibility in efforts to buoy investor confidence and thus increase stock value.” Michael Oxley, then-Chairman of the US House of Representatives Committee on Financial
Services, quoted this same phrase during a Congressional Hearing
on Oil and Gas Reserves in 2004 (Oxley 2004).
Third, McLane and Rose list a number of human biases that
may contribute to reserves overbooking. He describes biases
affecting judgment under uncertainty and also biases affecting risk
70
decisions. Some of the biases affecting judgment under uncertainty
include overconfidence, availability, and anchoring. To be sure,
any reserves estimate should be construed as requiring “judgment
under uncertainty.” Biases affecting risk decisions are focused on
the perception of risk with respect to investment decisions.
Last, according to McLane and Rose, reserves overstatements
may reflect a lack of professionalism. They cite a number of
behaviors, some of which are listed and consolidated below, that
signify and encourage professionalism:
• Being fair and objective
• Accepting accountability for estimates and improving these
estimates
• Disregarding the pressure to intentionally overbook reserves
Consequences of Overstatements and Write Downs. McLane
and Rose (2001) observed that many companies that have used
aggressive reserves booking no longer exist because the temporal
benefits of the practice disappear when the reserves have to be
removed from the books. While the prospect of a company going
out of business as a result of reserves overbooking may sound
severe, our analysis of public records from numerous cases indicates that other penalties may also be significant. Sections that
follow illustrate the significant potential liability for both individuals and corporations. As evidenced by the share price responses to
admissions of substantial write downs, overly aggressive booking
practices can shake marketplace confidence. Reserves overbooking
may lead to sudden and dramatic value destruction for shareholders. Shareholder groups, in turn, have occasionally sought redress
through class action civil lawsuits.
In addition to the “external” costs described in the preceding,
an operating company may feel other consequences. For instance,
McLane and Rose (2001) believe that “overbooking creates stress
and tension within an organization.” Most engineers and geoscientists, if pressured by management to “push the envelope” of technical credibility, would likely harbor or express these sentiments. It
is possible—and in some cases documented—that employees or
managers have left or even, more specifically, have been asked to
leave an organization because of reserves overbooking. Investigation of noteworthy cases even shows that management teams have
been largely reshaped as a result of alleged overbooking.
Enforcement and the Regulatory
Environment
The SEC. According to the SEC’s website, its mission “is to
protect investors, maintain fair, orderly, and efficient markets,
and facilitate capital formation,” and “first and foremost, the SEC
is a law enforcement agency” (US SEC 2010). The agency does
not make claims regarding the preferrability of one investment
over another but rather aims to promote clear and full corporate
disclosure to the investing public.
General Enforcement Process. An investigation by the SEC may
arise for a number of reasons: a routine review of SEC filings, tips
from the public or news stories, referrals from other SEC investigations or government agencies (Larsen et al. 2008). Schaumann
(2002) and Larsen et al. (2008) outlined the typical stages of an
investigation. The investigation begins with an informal inquiry. At
this point, the SEC does not have subpoena power, and witnesses
cooperate voluntarily. On the basis of the informal inquiry, the investigating staff may request authority to conduct a formal investigation.
If granted, the staff may then subpoena witnesses to testify.
The target of the investigation does not have the right to know
that an investigation is being conducted, nor to make a statement.
Typically, however, the target is issued a wells notice, which provides notification of the staff’s intent. The target then has the option
to respond by a wells submission, which may ultimately be used as
evidence. After considering the wells submission, the staff makes
a recommendation to the Commission. If a violation is believed to
have occurred, the five-member Commission may elect to pursue
any or all of these three options:
• File an action in federal court—Seeks an injunction
(either temporary or permanent) or civil penalties, and may bar the
April 2011 SPE Economics & Management
INVESTIGATIONS OPENED
1,000
900
800
700
600
500
400
300
200
100
0
944
890
776
FY07
FY08
FY09
Fig. 1—Investigations opened by the SEC in 2009 are up 20%
from 2007 (adapted from US SEC 2009).
subject from serving as an officer or director of an SEC-regulated
company.
• Begin an administrative proceeding—Held before an administrative law judge (employed by the SEC), who has the discretion to impose an array of sanctions, “ranging from the relatively
innocuous to the severe” (Schaumann 2002). Such administratively
issued sanctions may include a cease-and-desist order, which is
similar to an injunction.
• Request that the Department of Justice (DOJ) bring a criminal action—A DOJ investigation may be conducted in parallel
to that of the SEC and may or may not be because of a referral
from the SEC.
Enforcement Trends. The most significant securities regulation laws
since 1934 have been those of the Sarbanes-Oxley Act (SOX) of 2002.
Passed in the aftermath of Enron’s historic collapse in 2001, SOX is
an antifraud measure comprising numerous laws that address financial
reporting by public companies. The act requires that executives take
individual responsibility for the accuracy and completeness of financial statements, requires companies to certify internal controls, and
mandates a triennial SEC review of each company’s financial statements (Dharan 2004a). SOX, however, does not explicitly mention or
discuss oil and gas reserves reporting (Ryder Scott 2003).
The following figures reveal a number of interesting observations regarding SEC enforcement trends. Fig. 1, from the SEC’s
2009 Performance and Accountability Report (US SEC 2009),
100%
90%
7%
16%
70%
7%
8%
9%
60%
50%
40%
3%
11%
5%
7%
8%
40%
8%
9%
14%
12%
16%
16%
20%
40%
Other
Delinquent Filings
21%
17%
40%
Market Manipulation
Insider Trading
10%
13%
40%
40%
16%
12%
40%
33%
24%
6%
6%
10%
13%
29%
14%
8%
5%
15%
10%
3%
40%
11%
30%
Regulation, Documents, and Guidance
Related to Reserves Disclosures
The Energy Policy and Conservation Act of 1975 required the SEC
to “take such steps as may be necessary to assure the development
and observance of accounting practices to be followed in the preparation of accounts by persons engaged, in whole or in part, in the
production of crude oil or natural gas in the United States” (42 USC
Chapter 77 2008). “Rule 4-10” established definitions for “proved
reserves” and other terms of interest used in the oil and gas industry.
In 1978, Accounting Series Release Number 253 and Statement
of Financial Accounting Standards 19, Financial Accounting and
Reporting by Oil and Gas Reporting Companies, were released by
the SEC and the Financial Accounting Standards Board (FASB),
respectively. FASB published SFAS 69, Disclosures about Oil and
Gas Producing Activities—an Amendment of FASB Statements 19,
25, 33, and 39, in 1982 (Statement of Financial Accounting Standards No. 69 1982). Other noteworthy documents include Industry
Guide 2, SEC Staff Accounting Bulletin Topic 12 (1997), SEC
Clarification of Oil and Gas Reserve Definitions and Requirements
(2001), and SEC Exemption to Production Testing in Deep Water
Gulf of Mexico (2004) (Etherington 2009).
Under powers granted by the 1934 Exchange Act, the SEC
has the authority to establish financial reporting and accounting standards. Since 1973, the SEC has designated the FASB
as being responsible for establishing such standards (Financial
Accounting Standards Board 2010b). Through June 2009, FASB
17%
16%
80%
shows that the number of investigations opened by the SEC has
increased steadily since 2007.
Fig. 2 displays that while enforcement cases brought by the
SEC are distributed among a number of different areas, there is
a historical concentration in the area of financial disclosure cases
(US SEC 2009). (Statements pertaining to reserves constitute an
example of “financial disclosure.”)
Fig. 3, which should be of particular importance to reserves
evaluators and executives who vouch for the legitimacy of publicly disclosed financial information, provides an indication of
the frequency of individual and/or corporate SEC settlements for
“misstatement cases” (Larsen et al. 2009). The data show postSOX SEC settlements have included an individual component
more often than not.
In summary, the authority and investigation count of the SEC
are increasing, financial disclosure cases are the most common
type brought by the SEC, and settlements are frequently made
between the SEC and individuals.
23%
22%
Securities Offerings
Broker-Dealers
Investment Advisors and
Investment Companies
Financial Disclosure
40%
0%
FY05
FY06
FY07
FY08
FY09
PLAN
FY09
ACTUAL
Fig. 2—Financial disclosure cases are the most common type brought by the SEC (adapted from US SEC 2009).
April 2011 SPE Economics & Management
71
Only
Individuals
99
Companies and
Individuals
192
Only
Companies
62
Fig. 3—SEC settlements for post-SOX misstatement cases
most commonly include settlement with individuals (adapted
from Larsen et al. 2009).
communicated accounting standards to all industries by issuing a
number of “Pronouncements,” including statements of financial
accounting standards, interpretations, staff positions, and technical bulletins (such as those, just mentioned). As of July 2009,
FASB has streamlined its communications with the Accounting
Standards Codification, and any (previous) accounting literature
outside of the Codification is nonauthoritative (FASB Accounting
Standards Codification 2009). Oil and gas accounting guidelines
were set forth in “Extractive Activities—Oil and Gas (Topic 932).”
In January 2010, FASB revised the topic to be aligned with the
SEC’s Modernization of the Oil and Gas Reporting Requirements
(FASB Accounting Standards Update 2010a).
Oil and gas reserves volumes for US-based companies are disclosed annually to the SEC and investors in conjunction with a Form
10-K. (Foreign issuers file a comparable document entitled Form
20-F.) Most companies are also required to file a quarterly report
known as Form 10-Q. Certain intraquarter material events call for a
Form 8-K to make the important information public to shareholders.
If there are certain intraquarter material events, a Form 8-K (“current report”) is filed to make public the important information to
shareholders. Form 8-K filings are relatively common and may be
necessitated by a variety of different events, but the information
disclosed may have the potential to alter a corporation’s share price
significantly. The expectation or specifics of a reserves write down
may be communicated by means of Form 8-K.
Potential “Triggers” for Reserves Inquiries. Although a previous
section mentioned briefly some potential causes for an SEC investigation, the following is a more comprehensive list compiled from
multiple sources (Hodgin 2009; Roesle 2007; Schaumann 2002)
that gives insight into items that may serve—independently or in
concert—as the impetus for a reserves inquiry or investigation:
• History of negative reserves revisions
• Partner activity, press release, or revision
• History of SEC infractions (e.g., in other, “nonreserves”
areas)
• Potentially questionable press release issued by filer
• Annual reports that do not conform to press releases
• Negative publicity
• Mandatory triennial SOX review
• Self-reported problems
• Unusual stock volume or movement
• Whistleblowers
• Response to an SEC comment letter
The SEC currently employs two petroleum engineers who are
responsible for monitoring compliance to the SEC’s standards for
reserves disclosures (Meyer and Zorn 2004).
Comment Letters. The SEC regularly issues comment letters in
response to issuer filings. Any number of topics may be addressed
in a comment letter, such as financial and accounting details,
72
controls and procedures, executive compensation, legal proceedings, and reserves volumes. The comment letter requests a response
to the questions raised by the SEC. Certain comment letters and
response letters pertaining to disclosures made after 1 August
2004 are made public through the Electronic Data Gathering,
Analysis, and Retrieval (EDGAR) system. (Other forms, including a company’s 10-K, must be filed through EDGAR and are in
turn also publicly available through the system.) However, if a
company requests confidentiality, they may submit a redacted version—without the confidential information—to be made available
publicly in addition to their unfiltered response to the Commission
(US SEC 2004a).
Reserves volumes are commonly questioned in comment letters
to oil and gas companies. A search for reserves-related comments
on EDGAR clearly illustrates that the SEC is indeed actively
examining the reserves data provided by issuers. Questions posed
by the SEC can be general (e.g., a request for a company’s detailed
reserves report) to very specific (e.g., requests about particular
assets or wells). Company responses can yield further questions
and requests for clarification. Two examples of reserves-related
inquiries from SEC comment letters are presented in the next
paragraph. These are only two brief examples of many that pertain
to reserves volumes.
In a comment letter to American Oil and Gas regarding filings from 2005–2006, the SEC required further commentary on
reserves revisions (Feiten 2007): “We note significant oil reserve
revisions in 2004 and significant gas reserve revisions in 2005.
Please provide us with the reasons for these revisions.”
Regarding Cabot Oil and Gas Corporation’s 2006 Form 10-K,
the SEC wrote a comment letter and sought additional details
regarding Canadian PDP reserves (Schroeder 2008): “Please provide us with a graph over time of production through the latest
month the data is available for each your wells in Canada. Include
on each graph your forecast of future production and reserves as
of December 31, 2006.”
Types of Write Downs. Comment letters may result in a reserves
write down. Roesle (2007) identified two different types of negative
revisions: a debooking and a restatement. A debooking “typically
results from [an] SEC request to remove certain reserves from the
next annual filing” and is “rather common.” A restatement “is a much
more serious result, particularly under SOX, as it requires the issuer
to retroactively ‘correct’ past reserves disclosures and recalculate
earnings.” In the event of a reserves restatement, the DOJ will likely
open an investigation into the matter. The DOJ can issue both civil
and criminal charges (Labaton and Gerth 2004). Additionally, corporate penalties may be triggered under SOX (Hodgin 2009).
Corporate and Individual Liability. The SEC’s Division of Corporation Finance has issued reminders about individual liability that
have been directed specifically to those involved with the reserves
estimation process (US SEC CF Accounting Staff 2001):
The SEC staff reminds professionals engaged in the practice
of reserve estimating and evaluation that the Securities Act
of 1933 subjects to potential civil liability every expert who,
with his or her consent, has been named as having prepared or
certified any part of the registration statement, or as having
prepared or certified any report or valuation used in connection
with the registration statement. These experts include accountants, attorneys, engineers or appraisers.
Schaumann (2002) provides details on the legal liability associated with securities disclosures. Information that is said to
rely on subjective analysis and judgment is referred to as “soft”
information. Because of the potential of soft information to mislead investors, the SEC established safe harbor rules in 1979 for
forward-looking statements containing soft information. These
statements are to be made “in good faith,” and the company has
a duty to provide updates as new information becomes available.
Further legislation brought an additional safe harbor act, the 1995
Private Securities Litigation Reform Act. Under this act, protection is afforded according to two alternative means: a plaintiff
cannot “prove that the forward looking statement was made with
April 2011 SPE Economics & Management
Transportation
and Utilities
2009
Producer
Manufacturing
Process Industries
2008
Retail Trade
2007
Miscellaneous
Health and Technology
Services
2006
Finance
Communications
Energy and
“Nonenergy” Minerals
Consumer and
Distribution Services
Electronic Technology and
Technology Services
Consumer Durables
and “Nondurables”
Commercial, Industrial,
and Other Services
Percentage of Filings by Sector and Year
(01 January 2005 – 30 June 2009)
2005
65%
60
55
50
45
40
35
30
25
20
15
10
5
0
Fig. 4—Preponderance of energy-related class action lawsuits is decreasing but is historically high compared to those filed in
other sectors (Plancich and Starykh 2009).
actual knowledge that it was false or materially incomplete”; and
adequate cautionary statements made by the defendant.
According to Larsen et al. (2008), 88% of individual settlements made with the SEC include a disgorgement payment. As
previously mentioned, the SEC may also seek an injunction,
which is “awarded for the purpose of requiring a party to refrain
from doing or continuing to do a particular act or activity….The
injunction is a preventative measure which guards against future
injuries rather than affording a remedy for past injuries” (Gifis
1996). Certain parties in the El Paso reserves overstatement case,
for instance, were enjoined in the 2008 SEC complaint.
Shareholder Lawsuits
Class Action Trends. In light of the fact that reserves overstatements have been a principal or contributing factor in a number of
class action lawsuits, it is necessary to make a few brief comments
regarding their unique nature. A class action is defined as “a lawsuit
brought by a representative member(s) of a large group of persons
on behalf of all the members of the group” (Gifis 1996). McArthur
(1996) has written extensively on class action lawsuits in the petroleum industry and commented that “the oilfield is no stranger to
class actions.” He claims that class actions have been used in drilling fund and partnership fraud cases, stock cases, and royalty cases.
The “archetypal” class action involving securities entails stock price
inflation by means of a misrepresentation or omission.
Recent documentation from the National Economic Research
Associates (NERA), presented in Fig. 4, shows that class action lawsuits have been relatively common in the energy industry when compared to filings in other industries (Plancich and Starykh 2009).
Furthermore, the same NERA research indicates that for class
action settlement values in 2008, the median was USD 8.0 million
and the average was USD 43 million. Settlement values have, on
average, increased significantly since the passage of SOX. Investor losses are said to be the most influential factor in determining
settlement amounts. Another interesting finding, again courtesy
of NERA (Plancich and Starykh 2009), is presented in Fig. 5,
which shows that investors commonly arrive at settlements that
are a mere fraction of their losses. Additionally, the data indicate
a nonlinear relationship between losses and settlements. Investors
who suffer higher losses will likely settle for a disproportionately
lower amount relative to those suffering lower losses.
April 2011 SPE Economics & Management
Case Studies
Royal Dutch Shell Group (Shell). Shell’s international recognition
and the magnitude of its 2004 reserves write down make it likely
the best-known alleged reserves overstatement case. The company
announced a 3.9 billion BOE reduction in proved reserves on a 9
January 2004 conference call (Shell/Fair Disclosure 2004a). The
Group Chairman was not on the conference call in which the
reserves write downs (or “recategorizations”) were communicated
to analysts, and he received criticism as a result (Davis 2004). The
E&P Chief Executive Officer (CEO) was also absent from this call.
Company representatives acknowledged that reserves audits were
completed internally, with the aid of a contract reservoir engineer,
and the write down was associated with a review prompted by “part
of our normal stewardship of the assets.” Furthermore, representatives stated “there is no material effect on financial statements for
any year up to and including 2003,” and that “most of the reserves
will be rebooked in the proved category over time” (Shell Transport and Trading Company 2004a). The value of Shell Transport’s
American Depository Receipts dropped 6.9% on 9 January 2004 as
a result of the announcement (Pennsylvania Employees Retirement
System v. Royal Dutch/Shell Transport 2005).
On 5 February 2004, Fourth Quarter 2003 results and additional
write down details were presented in a conference call (Shell
Transport and Trading Company 2004b). As part of this call,
the Group Chairman apologized for his absence on the previous
month’s conference call and it was disclosed that the Group was
“on credit watch,” that class action shareholder lawsuits had been
filed, and that it would be necessary to revise previously filed
financial statements. Regarding the recategorizations, the group
chairman stated, “As soon as that came to my attention, it was
a matter of all hands on deck, and I remember writing down the
words ‘get the facts and do the right thing….’” Later in the call,
an analyst asked the Shell team if it would be appropriate for the
Group Chairman to resign.
At the time of the alleged overstatement, the company allegedly had a “Byzantine dual holding structure,” in which Royal
Dutch Petroleum Company was based in the Hague, and Shell
Transport and Trading Company was headquartered in London.
Some observers believed this structure led to lax oversight
(Mouawad 2009). These parent companies owned shares in holding companies (“the group”) that engaged in operational activities
73
Investor Losses USD 1,000 million
Expected Settlement: USD 11.5 million (1.2%)
Predicted Settlement, million USD
12
10
8
Investor Losses USD 300 million
Expected Settlement: USD 7.5 million (2.5%)
6
Investor Losses USD 100 million
Expected Settlement: USD 5.1 million (5.1%)
4
2
0
0
100
200
300
400
500
600
700
800
900
1,000
Investor Losses, million USD
Fig. 5—Class action settlements increase nonlinearly with investor losses (Plancich and Starykh 2009).
(SEC v. Royal Dutch Petroleum Co. et al. 2004). Early reports,
including one from Meyer and Zorn (2004), stated that the write
down resulted in large part from the fact that projects booked as
proved undeveloped between 1996 and 2002 in areas such as Australia and Nigeria had not, in fact, “progressed to their expected
technical and commercial maturity.” Reportedly, Shell and its
partners had yet to receive government approval for a natural-gas
development, known as Gorgon, in Australia. (ChevronTexaco, a
partner in this project, did not include Gorgon estimates as part of
its proved reserves.) Additionally, securities analyst Fadel Gheit
commented that companies with operations in Nigeria were likely
under pressure from that nation’s government to inflate reserves.
Because production quotas are assigned to Organization of the
Petroleum Exporting Countries (OPEC) member countries on the
basis of proved reserves, “it is in an OPEC country’s best interest
to put pressure on filers to motivate them to book more reserves”
(Kopytoff 2004).
Ultimately, the alleged overstatement would prove to be 4.47
billion BOE, or approximately 23% of the company’s total. A joint
investigation was conducted by the SEC and Financial Services
Authority, and Shell settled claims with the regulators for USD
120 million and BP 17 million (or USD 28 million), respectively,
without admitting to or denying the findings of the SEC. The SEC
alleged that Shell’s overstatement stemmed from:
• “Its desire to create and maintain the appearance of a strong
Reserve Replacement Ratio.”
• “The failure of its internal reserves estimation and reporting
guidelines to conform to applicable regulations.”
• “The lack of effective internal controls over the reserves
estimation and reporting processes.”
The SEC complaint stated that Shell had internal “excessively
permissive” guidelines that did not adhere to those of securities
regulators. Furthermore, Shell did not maintain adequate internal
controls and did not ensure that its employees were well trained
regarding SEC disclosure requirements. The complaint also alleges
that Shell did not ensure timely compliance with Rule 4-10 by
lowering proved reserves estimates despite internal events and
relevant signals dating back to January 2002.
Furthermore, the SEC complaint shed light on the areas that
constituted the majority of the recategorization:
• Australia—Shell carried reserves on the Gorgon project dating back to 1997, despite the lack of a market, development plan,
and firm commitment to invest in the project.
• Nigeria—Reserves did not acknowledge license expiration,
and estimates were not made according to “existing conditions”
as defined in Rule 4-10.
74
• Oman—Petroleum Development of Oman, partly owned by
Shell, lacked a development plan on which to base reserves volumes;
certain volumes were “not supported by any identified projects.”
After settling with the Shell Group, an SEC official vowed,
“As our investigation continues, we intend to focus on, among
other things, the people responsible for Shell’s failures” (US SEC
2004b). Furthermore, it was reported in March 2004 that the US
DOJ opened an investigation into whether Shell executives violated
any laws (Labaton and Gerth 2004). In June 2005, the DOJ investigation was closed and no action was taken against Shell. Then,
in August 2006, it was announced that the SEC would not pursue
charges against the (former) Group Chairman (Robertson 2006).
A number of lawsuits in the US followed the recategorization
announcement. The reference class action complaint alleges a
number of shocking details (Pennsylvania Employees Retirement
System v. Royal Dutch/Shell Transport 2005). In October 2002,
an email from the E&P CEO to the group chairman stated that “I
must admit that I become sick and tired about arguing about the
hard facts and also cannot perform miracles given where we are
today….If I was interpreting the disclosure requirements literally
(Sorbanes [sic]-Oxley Act etc) we would have a real problem.” The
E&P CEO wrote the Group Chairman in November 2003 that he
was “becoming sick and tired about lying about the extent of our
reserves issues and the downward revisions that need to be done
because of far too aggressive/optimistic bookings.” In December
2003, a “script” was prepared that discussed the need to disclose
noncompliant reserves volumes. The E&P CEO replied that “this
is absolute dynamite, not at all what I expected and needs to be
destroyed.” The Group Chairman, Chief Financial Officer (CFO),
and E&P CEO left the company soon after the reserves revelations
(Shell settles case for $150 M 2004).
The class action lawsuit named and aligned claims against
certain defendant groups: “Shell Group Defendants” Royal Dutch,
Shell Transport, the former Group Chairman, the former E&P
CEO, and former CFO; “Individual Defendants” former Group
Chairman, former E&P CEO, and former CFO; and financial
auditors PwC UK and KPMG International. The first two counts,
against the Shell Group Defendants and financial auditors, respectively, alleged violations of Section 10(b) of the 1934 Securities
Exchange Act and Rule 10b-5 Promulgated Thereunder. The third
count was against the individual defendants for Violations of Section 20(a) of the 1934 Securities Exchange Act.
Certain analysts had believed that Shell would need to merge
with another company by the end of 2004 as a result of the scandal
(Mouawad 2009), although this did not come to pass. Reserves
booking procedures of other major integrated oil companies were
April 2011 SPE Economics & Management
questioned by the SEC in the wake of the Shell overstatement (Kopytoff 2004). Analyst J.J. Traynor of Deutsche Bank commented, “We
remain convinced that reserves bookings are a sector-wide issue,
albeit amplified at Shell” (Shell difficulties ‘could spread’ 2004).
In September 2008, a settlement with US investors was
approved in which Shell paid more than USD 80 million to
shareholders (Egoy 2008). In 2009, an Amsterdam court declared
binding a USD 352.6 million settlement with non-US shareholders
(Stichting Shell Reserves Compensation Foundation 2009).
El Paso Corporation. El Paso’s reserves data attracted much attention after the publication of a November 2002 Houston Business
Journal article (Perin 2002). In this article, a veteran reservoir
engineer with the Houston-based company stated that after El
Paso acquired Coastal Corporation, engineers at the company were
asked to “clean up the books” and remove reserves volumes that
did not meet SEC criteria. However, the engineer reported that
“management interfered with engineering decisions” and issued an
order to return the reserves to the proved category. The company,
according to the engineer, was in some cases attributing reserves
to projects that would not be developed for 10 years. A second
engineer claimed that El Paso had recently been questioned by
the SEC regarding proved undeveloped locations greater than one
offset location away from proved developed locations.
On 17 February 2004, the company disclosed a write down of 1.8
Tcf, or approximately 40% of its previously reported proved reserves.
The organization’s new CEO announced that in October 2003, after
performing a number of field reviews, he believed that it was necessary to have a “fresh set of independent eyes” recalculate reserves
volumes for the end of the year (El Paso to Review Reserve Revisions Conference Call 2004a). The majority of the negative revision
involved proved undeveloped locations that no longer met key technical and commercial hurdles (Meyer and Zorn 2004). The company
later restated earnings for a number of prior years, resulting in a USD
1.7 billion decrease in stockholders’ equity (US SEC 2008d).
Alleged details emerged from a SEC complaint that was filed
more than 4 years later against El Paso Corporation, two of its
subsidiaries, and five former employees of El Paso Exploration
and Production Company (EPEP) (SEC v. El Paso 2008). The
complaint stated that a former EPEP President and former Senior
Vice President “aggressively sought to maximize oil and gas
reserves….The three Divisional vice presidents, in response to
the pressure to maximize reserves, overstated reserves totals” in
the following ways:
• Recording proved reserves to unproved reservoirs
• Assigning reserves despite a lack of sufficient engineering
and geological data
• Failing to reduce reserves volumes on the basis of performance
Furthermore, the company failed to maintain adequate internal
controls. Financial statements dating back to 1999 were restated.
Details on the degree to which certain assets were affected can be
gleaned from the SEC complaint and preliminary data announced
in the February 2004 conference call. Selected highlights are
presented below:
• South Texas—The largest revision, in which Vicksburg
sands for PDP and PUD reserves were adjusted to account for
smaller drainage areas in low-permeability sands and well interference owing to larger drainage areas in high-permeability sands.
Reserves data for PUD reserves were not immediately adjusted to
account for post-drill expected ultimate recoveries, which indicated
that the company would recover only 67% (subsequently lowered
to 39%) of predrill estimates for particular locations. 25% of the
South Texas write down was because of the company using an
outdated study on a single field to justify a 7% minimum decline
rate when a 12 to 13% minimum decline rate was more accurate.
• Rocky Mountains/Coalbed Methane—In part because of
Raton Basin locations found to be draining only 80 acres (as
opposed to historical bookings at 160 acres). Also, to create viable
locations, did not use current economic, operating, and cost conditions in accordance with Rule 4-10. Booked 150 PUD locations on
the basis of three test locations and two producing wells.
April 2011 SPE Economics & Management
• Gulf of Mexico—Mechanical failures, performance, and
revised geologic interpretation. (Not cited in SEC complaint.)
• Brazil—Lack of gas sales agreement for Camamu basin. (Not
cited in SEC complaint.)
By the end of June 2004, EPEP had “a new leadership team
not only at the top, but at least two levels down” and seven new
members on the El Paso Corporation’s Board of Directors (El Paso
Corp. to Review Plan for Production Business Conference Call
2004b). The five EPEP executives named in the SEC complaint
settled with the Commission for either USD 75,000 (EPEP President) or USD 40,000 (EPEP Senior Vice President (VP) and three
divisional VPs) (Plourd 2008). Despite settling for USD 235,000
with the five employees (who did not admit guilt), the SEC did not
fine the company (Gold 2008). El Paso and each of the executives
did, however, agree to injunctions against future violations of the
securities laws at issue. (US SEC 2008d).
Beginning in 2002, approximately 1½ years before the reserves
write down, a number of class action lawsuits were filed against
El Paso (and related parties) for various securities law violations (Wyatt v. El Paso Corporation, et al. 2006). The reserves
write down resulted in additional lawsuits, which were ultimately
consolidated. The suit claims that El Paso’s share price dropped
approximately 18% in response to the reserves announcement in
February 2004. El Paso agreed to pay USD 273 million to settle
the case (Wyatt v. El Paso Corporation, et al. 2006).
Stone Energy Corporation. Stone Energy Corporation, based in
Lafayette, Louisiana, and with assets concentrated in the Gulf of
Mexico, Rocky Mountains, and Williston basin, announced on
6 October 2005 that the company had recently retained services
of a third-party firm to perform a reserves review of all its fields
(Stone Energy Corporation 2005a). The company stated that it
would need to revise previous estimates by 171 Bcf equivalent, or
approximately 20% of its reported total at year-end 2004.
A press release issued on 8 November 2005 announced that
certain financial statements dating back to 2001 would need to be
restated (Stone Energy Corporation 2005b). Another press release,
issued just 2 days later, announced that the company had received
notice that the reserves revision would be the subject of an informal
investigation by the SEC (Stone Energy Corporation 2005c). In
December, Stone detailed the preliminary findings of an independent
review on the reserves revision (Stone Energy Corporation 2005d).
The negative revision resulted from a number of factors, including
• Lack of “adequate internal guidance or training on the SEC
standard for estimating proved reserves.”
• “Some former members of Stone management failed to fully
grasp the conservatism of the SEC’s ‘reasonable certainty’ standard of booking reserves.”
• “There was an optimistic and aggressive ‘tone from the top’
with the respect to estimating reserves. Some on the Stone technical staff felt pressure to interpret the geological and engineering
data in an aggressive manner.…”
Subsequently, Stone’s former CEO left the company’s Board of
Directors. Furthermore, management was advised by the board of
directors to request resignations of two other individuals involved
with the write down (Snow 2006). No fewer than 16 law firms
announced class action lawsuits in the months following the negative reserves revision. A consolidated class action complaint was
filed in June 2006 in US District Court for the Western District
of Louisiana (El Paso Fireman and Policeman’s Pension Fund v.
Stone Energy Corporation 2006). Along with Stone, it also named
the former and subsequent CEOs and CFOs as defendants. The
complaint stated that the company overstated its reserves for 4½
years despite using the services of a third-party firm, and that the
former CEO
• “Redrew geological maps of oil and gas reservoirs to manufacture false reserves numbers.”
• “Violated SEC requirements for booking proved reserves”
• “Intimidated and verbally abused Stone employees for calculating proved reserves that were lower than [the CEO] wanted”
According to the complaint, Stone’s Senior VP for exploitation and its reservoir-engineering manager aided the former CEO
75
in orchestrating the overstatement. Also, it states that “company
insiders with knowledge of the fraud were selling their personal
holdings of Stone common stock at prices they knew were artificially inflated by the proved reserves overstatement,” and that
shares dropped 30% as a series of announcements revealing the
truth about Stone’s reserves were made between 6 October 2005
and 10 March 2006.
Stone received notice from the SEC in April 2007 that it would not
pursue an enforcement action in connection with the alleged reserves
overstatement (Stone Energy Corporation 2007). Class action claims
against two of the individual defendants were dismissed in August
2007 (Stone Energy Corporation 2008). In January 2010, a class
action settlement was preliminarily approved for USD 10.5 million
(Stone Energy Corporation Securities Litigation 2010).
Repsol YPF. Repsol YPF, based in Madrid, Spain, announced
in January 2006 that reserves volumes for year-end 2005 would
be reduced by 1.25 million BOE, or approximately 25% of the
volume reported at year-end 2004 (Repsol YPF S.A. 2006). Most
revisions were in Bolivia (659,000 BOE) and Argentina (509,000
BOE). When disclosing the revision, the company cited “changes
in legal and contractual framework (New Hydrocarbon Law in
Bolivia)” and “field performance and new data yielding a deeper
understanding of the affected reservoirs” as the two main reasons
for the write down. Projected economics deteriorated for certain
Bolivian opportunities as a result of the new hydrocarbon law,
and estimates in various Argentinian fields were reduced. After
the announcement, Spain’s securities regulator, the Comisión
Nacional del Mercado de Valores, opened an investigation into
the overstatement.
A consolidated class action complaint filed with the US District
Court for the Southern District of New York alleged securities law
violations against the company, its CEO, and former CFO (Reynolds v. Repsol YPF 2006). According to the lawsuit, an internal
investigation by the company found
• “The process for determining reserves…was flawed from
1999 to 2004.”
• “A lack of proper understanding of and training on the
requirements of the SEC for booking proved reserves.”
• “An unwillingness to accept personal responsibility for reporting internally adverse facts regarding reserves.”
• “Undue optimism regarding the technical performance of the
fields and (for Bolivia) commercialization.”
• “Systemic flaws in the company’s internal control structures.”
The consolidated class action alleged per-share price decreases
of 7% (USD 2.12) and 4.79% (USD 1.34) on the day of and day
following the revision announcement, respectively. A settlement of
USD 8 million was reached with shareholders in 2007.
Analysis of Cases. Arguably, the most important factor regarding some alleged reserves overstatement cases is that they were
entirely avoidable. Through more education on SEC regulations,
stronger internal controls, and/or a greater emphasis on ethics,
many of these overstatements would not have occurred. The write
down or recategorization of certain volumes rapidly destroyed
significant shareholder value as few events can. Allegedly, overstatements have, in certain cases, erased as much as 30% of share
prices. Although not discussed at length here, legal expenses and
attorney’s fees can be significant in class action litigation and are
further costs ultimately borne by shareholders. In light of this
value destruction, shareholders with a sizable position in an E&P
company are concentrating their risk for reserves overstatement.
Implications of Modernization
The reserves booking guidelines under the modernized SEC rules
are more flexible than the previous standards. For example, filers
may now book PUD locations that are greater than one well spacing away from a producing well. Additionally, the requirements
make allowance for using “reliable” technologies. The new regulations are, in effect, more “principles based” than those previously
employed by the SEC.
76
More disclosure is required as a result of this enhanced flexibility. For example, reliable technology must be disclosed, at least
in general ways. Additionally, information is required regarding
the concentrated geopolitical political risk facing a filer. Subpart
229.1200 (Items 1201 through 1208) of Regulation S-K is new
under the Modernization and focuses entirely on reserves-related
disclosures. PUD locations are limited to a 5-year development
time frame. Certain filers may have PUD locations that will need
to be debooked at the end of 2009.
However, the new regulations do not address certain issues or
solve problems that were alleged to have been key factors in certain
overstatement cases we have highlighted, such as a disregard for
the rules, weak internal controls, or human biases. No matter the
definitions, the principles of the industry and its members will ultimately determine how “level” the playing field is. Companies may
ignore the rules, just as they have allegedly done in the past. They
may do so in particular with the new flexibilities afforded under the
PUD booking and reliable technology guidelines just mentioned.
Furthermore, the reliable technology principle may inadvertently
lead to the incorporation of technologies (into reserves calculations) before those technologies are genuinely understood by certain engineers. Probable and possible reserves represent additional
areas of disclosure that may be reported too aggressively and
without using proper evaluation procedures.
For these reasons, some believe that the risk of reserves write
down may increase under the new regulations. According to Darbonne (2009a, 2009b), Geoff Roberts of the Oil and Gas Asset
Clearinghouse believes that “the [modernization] regime opens
the company-reporting process to serious potential for misuse or
abuse by aggressive public companies.” It is now, of course, too
soon to gather any empirical evidence to support or refute such
intuitive claims.
Regardless of the requirements in place, estimating reserves
will likely always be an inexact and subjective science. Authors
have acknowledged that “The mere physical attributes of the asset
class—miles below the surface, significant natural variability
within the oil and gas reservoir—make conventional engineering
precision an impossible standard to achieve…. The lack of precise definitional and engineering standards can naturally lead to a
range of interpretive outcomes, both conservative and aggressive”
(Meyer and Zorn 2004).
Conclusions
We draw the following conclusions from this study:
• Reserves overstatements have occurred on a number of occasions, and for a variety of reasons, in the oil and gas industry.
• There is potential for significant corporate and/or employee
penalties for cases of reserves overstatements, along with the
possibility of class action shareholder lawsuits.
• There may be a greater risk for reserves write downs as a result of
the 2009 Modernization of Oil and Gas Reporting Requirements.
• Accurate reserves reporting should be an ethical and corporate
mandate because doing otherwise can destroy the credibility of
management teams and produce significant civil penalties for
both corporations and employees.
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Grant Olsen completed BS and MS degrees in petroleum
engineering from Texas A&M University, where he was president of the SPE student chapter. He has been active in volunteer causes to help disadvantaged young people. John Lee
is Regents Professor and Peterson Endowed Chair in petroleum engineering at Texas A&M University. His current interests
include reserves and unconventional resources. Lee’s SPE
activities include textbook preparation and past SPE board of
directors. Tom Blasingame is a professor and Whiting Endowed
Professorship in petroleum engineering at Texas A&M University.
His current interests include production data analysis in unconventional reservoirs. Blasingame has been particularly active
recently in SPE program committees.
April 2011 SPE Economics & Management
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