Improved process can cut risk in reserves reporting

US Securities and Exchange Commission (SEC) director John White recently announced the commission’s intentions to hire an Engineering Fellow to evaluate its reserves disclosure rules and determine whether changes need to be made. While the industry awaits the outcome of the SEC’s analysis, Ernst & Young and Ryder Scott Petroleum Consultants offer four steps oil and gas companies can take to improve the reserves estimating process and reduce company risk.

A few years ago, legislators, think tanks, investors, consultants, and representatives from oil and gas companies began scrutinizing rules the companies have been following for 3 decades. There was no shortage of opinions, yet there resulted little consensus as to how the rules should or should not change.

Despite years of public discourse, it appears that no major changes will occur any time soon. While many companies would prefer to see changes in the rules requiring disclosure of oil and gas reserves estimates, most companies seem content to live with the existing rules.

Why this display of patience? Primarily, it stems from the fact that, internally, most oil and gas companies have a very different view of their reserve positions. Within the company, they use oil and gas reserve estimates to make investment and operating decisions that can vary significantly from the reserves that must be disclosed under SEC guidelines.

This raises the question: Who has the better oil and gas information? Right or wrong, the companies believe that they do-a view that tempers any pleas for changes in the SEC’s oil and gas reserve disclosure guidelines. At the same time, financial auditors have neither reason nor the responsibility to push for changes in reserves disclosures. The SEC, as steward for the shareholder, appears to have little motivation for change. It appears to embrace the view that conservatism and comparability are particularly important in this matter.

However, as the discourse continues, the energy professionals at Ernst & Young and Ryder Scott suggest that oil and gas companies continue to shift their focus to the process that governs how the rules are interpreted, taught, applied, and documented in their organizations. The real lesson of the past few years is that many companies have not formalized the process for estimating and reporting reserves, which can greatly increase the risk of restatements and the fallout that they cause.

There are four steps oil and gas companies can take to mitigate this risk and restore confidence in how they report the most important asset they have: hydrocarbons in the ground.

Define

The first step in formalizing a process for reserves estimation and reporting is to define and record clearly how the rules will be interpreted and applied in the company. To some, this may seem counterintuitive. After all, rules are rules, right? In truth, like many other accounting regulations, these rules are often open to interpretation, with a large amount of gray area between the black and the white.

To illustrate this point, consider the SEC, which enforces the accounting and financial reporting standards that it developed along with the Financial Accounting Standards Board (FASB). SEC regularly issues guidance and interpretations of these standards as new questions arise, because standards dealing specifically with oil and gas accounting and financial reporting were issued during 1977-82-before the emergence of new technologies and market dynamics that led to specific questions of interpretation. This is similar to the relationship between the US Constitution and the US Supreme Court, which issues 80-90 formal written opinions each year clarifying how the Constitution applies to modern-day situations that its authors could not have imagined.

The sometimes-subjective nature of the rules, however, does not give companies a license to interpret them to their benefit on a case-by-case basis. Historically, SEC has looked favorably on companies that adopt the most conservative interpretations and stick to them, regardless of how they impact reserves estimates. Companies that opt for conservatism and apply the rules in a consistent manner have already taken a major step in avoiding unexpected downward revision in their oil and gas reserve estimates.

Assign

Ask three oil and gas companies who prepares their reserves estimates and you’re likely to get three different answers-or more, if you ask 2 years in a row. Unlike other key functions in oil and gas companies, there is little consistency in who is responsible for this important function:

• In general, larger companies view reserve estimates as a full-time job with a dedicated staff that spends the majority of its time on this process.
• The smaller the company, the more it is viewed as a part-time, once-a-year endeavor.
• For companies with multiple reservoirs scattered about the globe, the process is often highly decentralized, with asset teams accountable for estimates of their specific properties. The result can be different processes used to evaluate properties within the same company.

Events of the past few years have demonstrated that estimating reserves is a process important enough to warrant a more thoughtful, uniform approach. Indeed, more companies are forming dedicated teams using a consistent, centralized process to prepare estimates for all of the company’s reserves.

This is an encouraging development that more companies should consider.

Oil and gas companies also should examine how much the measurement of company reserves affects the compensation of those responsible for estimating the reserves. Frequently, oil and gas companies base a portion of annual employee bonuses on reserves growth and replacement. While this makes sense because these metrics play a major role in projecting the company’s future cash flows and earnings, it creates an obvious conflict of interest for those charged with estimating this measure. Clearly, it’s not advisable to tie such metrics to compensation.

Certainly, the estimate of an oil and gas company’s most valuable asset should be subject to stringent review. Once it’s determined who is charged with estimating reserves, it’s equally important to assign someone to review and approve the initial estimates.

Whether a second opinion is rendered by an outside reserves engineer or a group within the company is less important than the reviewers’ qualifications and independence. In a recently published survey by John S. Herold, 82% of producers that identified sources of reserves estimates said they use third-party consultants.

Because of the increased awareness by investors and others of the serious consequences of faulty estimates, it’s likely that more companies will turn to outsiders either to prepare initial estimates, review the findings of internal teams, or resolve internal disagreements. Doing so is an excellent way to mitigate the risks inherent in this highly technical-and often highly subjective-evaluation of geological, engineering, and economic data.

Train

Assigning the important task of estimating oil and gas reserves is only half of the human resources equation. The other is equipping personnel to do the job properly.

Currently, there are no statutory requirements in the US relating to the qualifications of employees preparing oil and gas reserves estimates for public companies. Additionally, the relatively few state-licensed engineers who may be involved in this work are not required to sign the reserves reports that are filed with the SEC.

One can argue that the engineers and geoscientists charged with preparing reserves estimates for their employers or clients have a professional responsibility to seek competent training within their companies or through other industry training sources. Unfortunately, this is not always the case.

Regulators, investors, and others who use reserves information assume that companies have established internal standards and requisite training. As a result, they have nothing more than a company’s word that those estimating its oil and gas reserves have been properly trained. For some companies, particularly larger ones, that’s a safe assumption, as they have developed rigorous and thorough educational and training standards. For many smaller organizations, however, qualifications may be lacking.

Failure to have properly trained and experienced personnel is unfair to the employees and to investors, and is an enormous risk that no company can afford. At the minimum, companies should require formal education in the appropriate technical field (petroleum engineering, geophysics, or geology), a minimum number of years of industry experience, and a certain amount of training specific to reserves evaluation. This training can be based on an internally developed curriculum, courses offered by consultants or professional and industry organizations, or a combination thereof.

Despite the presence of excellent training programs at a limited number of companies, training within many E&P companies and consulting firms can be inconsistent and may not be suitably substantial in terms of the depth of its content and reach within the company. The industry’s failure to maintain sufficient in-depth training of qualified individuals, in order to consistently produce reserves estimates that meet the needs of investors and regulators, has led some to call for an industry-wide certification program. This is an idea whose time has come and would be another step forward in minimizing the risk associated with estimating oil and gas reserves.

Document

It’s apparent through our work with oil and gas companies that failure to document the steps taken in estimating reserves is often at the root of related problems.

For example, it’s not uncommon for an organization to produce reliable reserves estimates by highly qualified people but fail to keep a record of how the estimates were produced. Then, when faced with an inquiry into the foundation of the estimates, management embarks on a mad scramble to recreate months of labor because the original work product lies scattered across the organization on hard drives, in e-mails, on the back of a napkin, or in someone’s head.

Failure to document reserves estimates can also cause problems when key personnel involved in the process leave the organization, taking with them significant amounts of institutional knowledge, and making their replacements’ jobs unnecessarily difficult.

Perhaps it’s best to remember and follow the advice of high school algebra teachers: “Show your work!” Collect all oil and gas reserve estimation data in a central repository, and back it up with paper and electronic copies.

Documenting all work is also the first step in developing a process that mitigates risk and makes reserves-estimating more efficient. Only by documenting how tasks are accomplished now can management construct a vision of how they should be accomplished in the future. It’s similar to using a map to reach your destination. The first step is identifying where you are. If you’re unable to do that, it will be impossible to get where you want to be.

By necessity, public companies have recently gained much experience documenting and developing processes through implementation of the requirements of Sarbanes-Oxley Section 404. While many companies may still be catching their breath from meeting recent compliance deadlines and likely are not eager to rush back into a 404-like documentation process, doing so would solve many problems.

The lessons learned from documenting, testing, and evaluating internal controls and procedures for financial reporting are ideally suited for transfer to operational processes. Failure to transfer this knowledge would be a missed opportunity to strengthen and improve a process that recent headlines would suggest is in significant need of attention.

The authors