While zooming around various SA energy articles and comments, I've noticed that the accounting nuances that go into oil & gas accounting and reporting are often misunderstood. Most notably, I've seen this surrounding the subject of SEC oil & gas reserves ("SEC Reserves"). As a CPA whose career thus far has been focused on oil & gas accounting and finance, I thought it may be helpful to some to provide some insight into the SEC's definition of "proved reserves" as disclosed in an oil & gas company's financial statements. I am not an engineer, so I will stay away from the actual reservoir definitions of what makes a company's reserves proved vs. non-proved.
After the precipitous drop in both oil and gas prices this past year, I've heard it suggested that the SEC Reserves figures reported by public companies appear to be misleading as there is a clear disconnect between the pricing used for the calculation at 12/31/2014 ($95/bbl crude oil and $4.25/mmbtu natural gas) and current spot prices ($50/bbl crude oil and $2.70/mmbtu natural gas). While this might appear to be the case at first glance, I aim to explain why this is not an attempt to mislead the common investor, but rather a product of strict adherence to SEC rules and definitions.
Before delving into the SEC Reserves calculation, I first want to emphasize that the SEC case report is really only used for disclosure purposes and in certain financial reporting calculations for companies that elect to use the SEC's "Full Cost Pool" accounting concepts, which I plan on covering in a future article. Investors focus on the SEC Reserves number because it is the number that is published by companies in their investor reports and financial statements; however, the real impact of the SEC Reserves to a company are limited. Borrowing base redeterminations, acquisition/divestiture decisions, and strategic decisions made by management use current or conservative price decks, contemplate cost escalation or savings, really, anything that the user of the reserve reports would like to see. In practical terms, the SEC Reserve report is just one of many ways to take a look at what an oil & gas company believes it has in the ground.
I want to point out two important principles of the Financial Accounting Standards Board's ("FASB") financial reporting framework: consistency and comparability. While the SEC and FASB are two distinct organizations, the FASB principles are central to being able to make any comparisons between companies and assessing the progress or lack of progress of an oil & gas company over a period of time. Without a standard framework for reporting purposes, oil & gas companies could theoretically incorporate assumptions into their reserve reports that would make it nearly impossible to compare company A to company B. To solve these problems, the SEC has mandated certain assumptions that must be used to report reserves for financial reporting purposes. Though oil & gas companies will have different economics based on their own cost structures and operating basins, the SEC rules ground reporting economics in historical financial results and a standard commodity price. The SEC report is governed by SEC Regulation S-X 4-10. I've included excerpts from the SEC rules below. You can find the full text here.
The SEC's definition of proved reserves is as follows:
"(22) Proved oil and gas reserves. Proved oil and gas reserves are those quantities of oil and gas, which, by analysis of geoscience and engineering data, can be estimated with reasonable certainty to be economically producible - from a given date forward, from known reservoirs, and under existing economic conditions, operating methods, and government regulations - prior to the time at which contracts providing the right to operate expire, unless evidence indicates that renewal is reasonably certain, regardless of whether deterministic or probabilistic methods are used for the estimation. The project to extract the hydrocarbons must have commenced or the operator must be reasonably certain that it will commence the project within a reasonable time"
I highlighted a few relevant items above. We'll start with the ones that do not relate to the definition of pricing.
"Economically producible… under existing economic conditions, operating methods, and government regulations".
"(10) Economically producible. The term economically producible, as it relates to a resource, means a resource which generates revenue that exceeds, or is reasonably expected to exceed, the costs of the operation"
Simply put, if the revenues generated from a potential or existing oil & gas well are not able to cover its costs, you are not able to report those volumes. For an undrilled well, cash inflows must exceed both the cost to drill the well and the cost to operate it. For an already producing well, cash inflows must exceed the costs to operate the lease. This can create a phenomenon where a well can be producing and generating current revenues for a company, but its production cannot be reported in the reserve report. In many cases, only a portion of a well's future production can be recorded as proved reserves, as the last few low producing years a well's life may not generate sufficient revenues to offset costs.
Oil & gas revenues are at the mercy of the prevailing commodity price environment, so it should be expected that the value of oil & gas reserves should fluctuate with changes in the underlying commodity. Economics can also be improved through realized cost reductions, thus improving margins and economics on the expense side. We have seen both of these take place in the past few months as service companies have reduced rig and operating rates to keep business flowing, while the E&P industry suffers from reduced cash flow means.
This concept is particularly challenging for a high cost shale producer in the current pricing environment. Areas that may look passable at $95/bbl, such as the Tuscaloosa Marine Shale ("TMS"), may not ever be able to cover their drilling and operating costs and thus will not be able to be reported under $50/bbl pricing. This, however, assumes the current operating cost environment. The TMS may again become an attractive exploration hub if a prolonged commodity price downturn substantially reduces drilling costs and technological advances can sufficiently increase the amount of oil & gas recoverable from the reservoir. However, the SEC definition above mandates "existing economic conditions", meaning recent historical operating data, so future systemic cost reductions and technological advances are not generally contemplated within an SEC report.
"Within "a reasonable time"
"(31) (ii) Undrilled locations can be classified as having undeveloped reserves only if a development plan has been adopted indicating that they are scheduled to be drilled within five years, unless the specific circumstances, justify a longer time."
This is often referred to as the "SEC five-year rule" and means that the clock starts from the time a company reports an undrilled location in an area with proved reserves (referred to as Proved Undeveloped locations or "PUD"s). Notwithstanding certain exceptions, a company has five years to drill and develop a reported PUD location or it must remove those reserves from its SEC report. On an internal decision making basis, this will put an operational emphasis on "PUD age" which may drive a company to drill a well with a "PUD age" of 4 years over an equivalent well with a "PUD age" of 1 year.
This is also relevant in the current environment because not only does the company have 5 years to drill the well, it also needs to possess the ability to drill those wells within the noted time frame. If a highly leveraged shale player has a depressed stock price (limiting equity financing), a highly drawn credit facility (limiting debt financing and increasing sensitivity to borrowing base redeterminations), and low cash flows from low commodity prices, there may be substantial doubt that company can find financing to drill its PUD locations within the SEC's 5-year rule. If this doubt exists, that company may be required to remove those reserves from their SEC Reserve report. This may be a very real situation if prices stay around current levels going into 2016.
The SEC Price
"(22.V) Existing economic conditions include price and costs at which economic producibility from a reservoir is to be determined. The price shall be the average price during the 12-month period prior to the ending date of the period covered by the report, determined as an unweighted arithmetic average of the first-day-of-the-month price for each month within such period, unless prices are defined by contractual arrangements, excluding escalations based upon future conditions."
The definition is silent as to what day should be used when the first of the month falls on a date when the market is closed. In practice, I have seen the next closest trading day used in the calculation, therefore I have used this methodology in the calculation below. The information below was obtained from EIA.gov. Other calculations may vary based on the "next closest day" selected and data source. Note that each data point is not a monthly average, but the price at closing of the first day of each month. This is a simple arithmetic 12-month average.
As you can see, the SEC price has remained relatively flat for the past few years, so up until the recent downturn the topic of the SEC price has not been that interesting. If current prices hold over the next year, I expect we will see dramatic effects on the SEC oil & gas reserves disclosure, which will be denoted under a line marked "revisions" in companies' reserve rollforward disclosures. Note that the price utilized in the SEC Reserve report still has to be adjusted for regional transportation and pricing differentials, which will vary by each company's focus of operations (e.g., could be -$10/bbl in the Bakken vs. -$2/bbl in the Permian). The key point is that every company must use the same starting point for reporting their SEC case reserves.
It is certainly true that the SEC Reserves formula makes oil & gas disclosures look better than reality in a decreasing price environment. However, it can do just the opposite in an increasing price environment. If 2016 shows the price recovery some are expecting, you will see SEC Reserve economics artificially depressed by the SEC's formula. Commodity prices are very volatile. That said, the SEC has mandated a focus on historical results and YE 2014 reserves are a product of this focus. If you want to have a better feel for what proved reserves look like under the prevailing pricing environment, I would look towards reported results of the spring and fall 2015 borrowing base redeterminations. If you see borrowing bases being determined downward with no asset sales or other events, it may call into question the quality of that company's underlying oil & gas reserves at today's prices.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.