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This is a long article on the subject of oil and gas reserves and due diligence.

My purpose is to alert you to the revision of SEC Regulation S-K and Regulation S-X effective January 1, 2010. Concealed in a handful of benign new regs is a financial truck bomb that's going to blow away "proved reserves" as a meaningful metric of oil company assets.

Old definition: Proved Reserves are those quantities which can be estimated with reasonable certainty to be commercially recoverable from known reservoirs under defined economic conditions. Proved quantities are limited by the lowest known hydrocarbon as seen in a well penetration unless otherwise indicated by definitive geoscience, engineering, or performance data. Seismic data alone is not sufficient to define fluid contacts. Undeveloped locations may be classified as Proved in undrilled areas of a reservoir that can be judged with reasonable certainty to be commercially productive.
New definition: Industry is no longer constrained by the criterion of certainty. An operator can book incremental proved reserves from planned enhanced recovery projects (gas injection, acid fracturing) based on a pilot project. Coal seam gas, bitumen, oil shale and other unconventional resources can be booked as Proved Reserves. Estimated reservoir properties in the aggregate is a departure from the old rules. The new SEC definition does not require that an analogous reservoir has to be in the immediate area or in pressure communication. Seismic analysis and reservoir models are sufficient to book Proved Reserves.
Hold on to your shorts, it gets worse.

Under the new SEC rules you don't have to drill a well and actually produce oil. An operator can establish levels of lowest known hydrocarbons and highest known oil through "reliable technology" other than well penetrations. It doesn't have to be 90% reliable or widely accepted by industry peers. It can be AVO bright spots, or a fuzzy patch of seismic that could conceivably be a mud volcano, or the ridiculous Russian hokum of "passive" hydrocarbon indicators. You don't even have to explain exactly what your technology does, if it's proprietary and trade secret.

We [the SEC] proposed to define the term ‘‘reliable technology,’’ expressed in probabilistic terms, as technology that has been proven empirically to lead to correct conclusions in 90% or more of its applications. Several commenters expressed concern that this proposed 90% threshold would be difficult to verify and support on an ongoing basis. We agree that a bright line test would be difficult to apply to a particular technology or mix of technologies to determine their reliability. Therefore, we are not adopting the 90% threshold as part of the definition... The proposal also would have required reliable technology to be ‘‘widely accepted.’’ However, some commenters were concerned that this requirement would exclude proprietary technologies that companies develop internally that have proven to be reliable. We concur with these commenters and have removed the ‘‘widely accepted’’ requirement from the final rule.” [Federal Register Vol. 74, No. 9, p 2166]

Who were the commenters in favor of playing dueces wild? Basically everybody. Oil companies, professional groups like SPE and AAPG, consultants, academics, Wall Street speculators and Bush Administration lawyers.

Why? -- because the Shell (NYSE:RDS.A) reserves fraud made them duck and cover.

Two Plus Two Equals Seven

Under the old SEC rules, "proved reserves" were quantities that geological and engineering information indicated with reasonable certainty could be commercially recovered from known reservoirs. In 1998, the proved reserves outlook was scary. World reserves of conventional crude declined eight percent, from 1.26 trillion in 1997 to 1.07 trillion barrels in 1998.

It was a powerful incentive to start fibbing.

Less than three years after taking over the chairmanship of the Royal Dutch/Shell Group, the world's third-largest oil and gas company, Sir Philip Watts was swept out of office in early 2004 by revelations that the company had overstated its proved reserves by nearly 25 percent. Ousted with Watts was Walter van de Vijver, head of Shell's exploration and production operations. A third top Shell executive, chief financial officer Judy Boynton, was forced from office shortly after the departure of Watts and van de Vijver. It was alleged that Watts, van de Vijver, and Boynton had been aware of the reserves shortfall since early 2002 and had conspired to keep the problem a secret from investors. []

An isolated incident? Nope. On February 17, 2004, El Paso cut its proved reserves 41%. It triggered a Federal class action suit by shareholders. In July 2001, Seven Seas issued $45 million in secured debt tied, in part, to the oil reserves held by the company. Engineering consultants Ryder Scott estimated their oil reserves to be 47.9 million barrels. About a year later, Seven Seas revised its reserves downward to 16.3 million barrels, which led to Chapter 7 bankruptcy, a flood of lawsuits and stiff silence at Ryder Scott, the world's most respected 'competent person' outfit.

Matt Simmons tells an interesting tale about discovery of Ormen Lange gas field in Norway and how partners booked vastly different proved reserves based on data from two wildcat wells:

In 2003, the five owners of Ormen Lange all decided that they had enough knowledge to go ahead and begin booking that as proved reserves... BP, who had a 10.3% share, booked 83.7% of their reserves. Norsk Hydro, who had an 18% share, booked 79.6% of their reserves. Shell booked 64.3%. Exxon Mobil booked 32.9% and Statoil booked 25%.

Q: No eyebrows were raised?

No, they couldn’t have been raised because no one knew this data. This was all comingled within the total reserves companies report. Companies don’t break out field by field. Well, then after Shell shocked the world with their 20% reserve reclassification, the board gets nervous and asks Ryder Scott to come in and do an audit. And two months after the big reserve write-down, they do an embarrassing write-down #2. Write-down #2 I think involved a couple of other areas, but the big area was Ormen Lange. They now only report 22.6% versus 64.3%. And also, guess why Statoil booked 25% and their neighbor Norsk Hydro booked 80%? Statoil had DeGolyer McNaughton as their third party engineering report and they reminded them that to be technically correct, the maximum you could book was 25%. [Global Public Media]

First gas at Ormen Lange came in July 2007. Everything went swell until April 2009, when production of those "proved reserves" didn't happen as booked:

Ormen Lange gas field's reserves in the Norwegian Sea could be less than previously estimated. Disappointing drilling results in the north of the field made it possible that official reserve estimates of 382 billion cubic meters of recoverable gas could be 100 billion cubic meters too high. []

The Tragedy of 21 Darts

When an entire industry goes haywire, like the "toxic asset" meltdown that almost killed commercial banking and made rating agencies look like sell-side hookers, investors want to know: What the hell went so horribly wrong?

The answer is straightforward. Statistical rocket science wrongly predicted a AAA happy meal from diseased meat, lean tails, and worthless guarantees. Something similar is happening now (very quietly, almost stealthily) in the energy sector.

Math Wiz: If you throw 21 darts at Africa, you have a 95% chance of finding oil.
Q: Regardless of basins or known prospectivity?
Math Wiz: It has nothing to do with geology. It's a statistical fact. If you drill 21 wells anywhere in Africa, there's a 95% probability of making a discovery.
Q: What if your first three wells are dry holes?
Math Wiz: That increases the odds of finding oil in the next well. After a dozen or so, it becomes almost 99% probable that the next random location will be highly successful, enough to justify the entire drilling program.

When the Bush Administration SEC succumbed to regulatory capture by Big Oil and discarded the proof in "proved reserves," they opened the door to reporting P1, P2, and P3 capital assets. These are not geological terms. They are probabilities derived from an aptly-named statistical software engine called Monte Carlo.

To cook a Monte Carlo black box project, you input whatever seismic data and well logs you happen to have, ask a petrophysicist to guess a range of porosities and permeabilities, push a button in Petrel, and get a snappy false-color reservoir model suitable for PowerPoint presentation to investors.

The Petrel polygons and a range of possible hydrocarbons (low case, high case) are ported via Excel to Monte Carlo, which runs a couple thousand iterations of probability and spews out P1 (90%) P2 (50%) P3 (10%). Investment decisions are usually made on P2 "more probable than not" estimated reserves. The process is seldom if ever led by rigorous science. Monte Carlo can't process fault picks or coarsening-and-fining facies transitions. Well data is crunched by computer, and assumptions are plugged in concerning production. Reservoir engineers ponder flow assurance and water flooding to maintain pressure. More assumptions (low case, high case). Make a guesstimate of WTI five years from now -- and presto!

None of this has any relation to the job of oil and gas production. It's a smooth curve of rocket science black box probability. Most of the input values are type averages.
Hey, so what? -- everybody uses P1, P2, P3, and P4 "original-oil-in-place." There's an SPE industry standard Petroleum Resource Management System that defines proved, probable, possible and contingent reserves. What's wrong with PRMS?

A research report from analysts at Credit Suisse in New York stated that U.S. E&P companies are booking “new era,” lower-quality proved undeveloped [PUD] reserves for year-end 2006... “PUD locations are being booked simply in conjunction with ‘on-trend’ acreage acquisitions, often with no wells having yet been drilled and without specific capital budget allocations,” the report stated. “This acreage-driven booking process poses obvious questions regarding reserve quality.” The analysts noted that rising PUD ratios have been a familiar trend over the past eight years and are poised to increase an average of 35 percent, up from 30 percent the prior year and 23 percent in 1995. [Ryder Scott Reservoir Solutions, Vol 10 No 1, Mar-May 2007]

"Proved undeveloped" acquisitions, huh? Let's look at a notorious reserves player, who booked proved undeveloped reserves of 300 Bcfe plus 9,800 P3 undeveloped acres, 1400 square miles of 3-D seismic, and 12 producing fields in 1998.

If we are unable to obtain further concessions from our lenders and creditors, we would continue to be in default ... and would be subject to the exercise of remedies by our lenders and creditors on account of such defaults. The exercise of such remedies could result in the Company seeking protection under federal bankruptcy laws. [TMR 8-K, 9/10/09]

In 2006, TMR founder CEO and Chairman Joe Reeves was paid $1.855 million in salary and bonus -- earning more than the CEOs at Halliburton, FMC, El Paso and Smith International. He controls two million shares of TMR, still sits on the board of directors, and Reuters seems to think his fiscal year compensation was $6.69 million recently. TMR proved reserves have been cut to 80Bcfe.
The SPE Petroleum Resource Management System is a license to print money and steal from banks and shareholders. Hocus-pocus of Monte Carlo probability means nothing, unless you have an actual oil or gas discovery and conclusive geoscience that proves the areal extent of reserves.

Our shop is one of over 100 independent "competent person" outfits that certifies reserves. We don't use PRMS or Monte Carlo. Instead, we make subsurface maps and pick drilling locations. We sign off on reserves volumes if there's enough well data, core analysis, petrophysics, geochemistry, paleontology, and production to justify it. Period. We don't like sell-side. We work for exploration managers.

Typical bedtime reading:

The deposition model starts in the deepest water zone with dark coloured, crinoidal beds and abundant carbonate mud and argillaceous material (mudstone in the deepest zone facies F1 and wackestone F2). The biostromal zone is mainly built by stromatopoids. [Sedimentary Geology 214]

On a recent assignment, our client griped about his in-house team, saying "There's been too much button-pushing and not enough critical thinking." The new SEC rules are a joke and professional explorationists know it. Very few will speak out about it, because there was a wave of computer automation and black box software to cover up and gloss over the shortage of experienced oil & gas geoscientists.

The industry has been shedding geologists and engineers for the past two decades. “As an aging generation of workers retires, industry experts say the resulting shortfall in skilled labor could lead to an increase in delays and problems on mega oil and gas projects… Over the next decade, a wave of retirements will strip the industry of its most skilled project managers, just as some of the most complex operations ever attempted are supposed to come on stream.” [Rigzone]

For three decades, oil downsized its people and rarely hired. Focus on staying “lean and mean” trumped any concern that we missed three decades of new employees. [Matt Simmons]

The latest quarterly report from Hays indicates exploration professionals, in particular geoscientists and senior reservoir engineers are amongst the most sought after in Australia. [E&P]

The situation is not improved by shopping for the most complaisant mouse jockey you can find to goose the parameters and certify bigger "more probable than not" reserves.

I've seen it too many times. Promoters shop around and there are plenty of sell-side whores who exaggerate blue sky hand-waving on skimpy data.

Source: The Oil Casino: SEC Heading for Monte Carlo, Part I