The oil and gas industry should prepare for, even welcome, public attention likely to focus soon on its accounting methods. After Enron Corp.'s collapse and federal indictment of its auditor, Arthur Andersen LLP, interest is high in accounting in general and energy accounting in particular. Eventually, scrutiny will come anew to the tricky subject of oil and natural gas reserves.
Enron's fatal deceptions and Andersen's carelessness with a document shredder have aroused scandal-seekers in and around the US Congress. They'll think they've found something sinister when they stumble onto financial accounting for oil and gas reserves. First they'll learn that audited financial reports of US producers don't directly account for discoveries. Then they'll encounter the uneasy cohabitation of two different but legal methods for reporting the confusion. Congressional press offices will spew expressions of shock and outrage. Investigations will be announced.
But it's all old news. Accounting authorities have struggled with these problems before. Although the current system probably can be improved, change shouldn't come at the hands of outraged politicians who know nothing about the subject.
Basic dilemma
Reserves accounting involves a basic dilemma. Oil and gas in the subsurface can't be evaluated with the dollars-and-cents precision of financial reports. The Securities and Exchange Commission (SEC) and Financial Accounting Standards Board (FASB) reached this conclusion after experimenting with a system called reserves-recognition accounting in the late 1970s and early 1980s. They decided that the existing system was superior and left it, with some adjustment, in place.
Under it, producers disclose on balance sheets what they can accurately measure about oil and gas reserves: money spent finding and developing them. They treat these expenditures as assets to be reduced over time by charges against production revenue. The process, depletion, is analogous to depreciation of physical assets.
Accounting methods diverge mainly over the handling of drilling costs for unsuccessful exploratory wells. One method, called full-cost accounting, treats them as depletable assets. The other method, successful-efforts accounting, charges them to expense when exploration is determined to have been unsuccessful. Valid cases can be made for both methods.
Before the experiment with reserves-recognition accounting, companies had no obligation to disclose anything about reserves other than what they spent to find and develop them. When the SEC and FASB sensibly decided not to mandate use of the experimental system, they added a requirement for supplementary estimates of reserves volumes and values.
Although not subject to audit, the required reserves disclosures tell investors much about future profitability of oil and gas producers. They are central to what have become evaluation benchmarks, such as reserves-replacement rates, reserves-to-production ratios, and finding costs. In the hands of analysts who understand the uncertainty inherent in reserves estimates, they are useful tools for evaluating producers in the US. Problems arise for production and companies elsewhere.
One problem is the definition of "reserves." The US uses a strict, narrow definition that essentially excludes oil and gas volumes not producible through existing wells. Other accounting regimes allow inclusion of undeveloped and less well-delineated reserves.
Another problem is handling of oil and gas volumes available through contracts with foreign governments. Companies may include in their reserves disclosures volumes available under concessions, production-sharing agreements, and risk-service contracts.
For concessions, the accounting is straightforward: Companies book reserves in proportion to their working interests. The other two—and nowadays more common—types of fiscal arrangement create problems. Companies' working interests in these deals usually differ from their actual economic interests because of contract complexities. But calculating reserves on the basis of economic interest can make volumes inversely proportional to price, which is backwards.
Useful scrutiny
New scrutiny of reserves accounting would be useful if it aimed at standardizing practices in areas such as these and at improving the comparability of companies subject to differing accounting regimes. The scrutiny would do more harm than good, however, if its motivation is politics. Reserves accounting is complex, not scandalous.
Producers should prepare to acknowledge confusion in the financial accounting of oil and gas reserves. They should note that the confusion arises because estimating volumes and values of fluids in the subsurface isn't the same as counting pennies. And they should welcome change. The current system needs it.
