SEC doubts companies' ability to book PUDs beyond 5 years

Marc Folladori, Jeff Dobbs, Robin Clarkson
Mayer Brown LLP, Houston

In December 2008, the Securities and Exchange Commission amended its oil and gas disclosure rules for publicly reporting exploration and production companies for the first time in three decades. The new rules in many respects were designed to conform to current industry standards, but after their adoption, questions began to arise regarding the application of the new rules in a number of critical areas. The SEC's Division of Corporation Finance issued compliance and disclosure interpretations (CDIs) in October 2009 in an attempt to clarify the new rules and address the industry's questions and concerns. As of the date of the preparation of this article, none of these CDIs have been supplemented or amended.

In December of 2010, two of the authors published an article in Oil & Gas Financial Journal that summarized their review of 25 E&P companies' annual reports on Form 10-K filed with the SEC during 2010, in order to gain a general understanding of how these companies had interpreted and implemented the new rules.

Two of the most significant changes adopted under the new rules were (i) a "five-year rule" for proved undeveloped reserves (PUDs) and (ii) a broadened authorization that permits companies to prove their reserves by the application of "reliable technology."

• The new rules impose time-based limitations on reserves that a company can classify as PUDs. In order for PUDs to be booked for an undrilled location, there must be a development plan adopted by the company that indicates that the undrilled location is scheduled to be drilled within five years. PUDs that have remained recorded as such on the books for more than five years should be removed from the proved category. The new rules do provide an exception to this hard five-year rule if "special circumstances" are present that justify a longer interval before development will be initiated. The SEC staff identified some examples of types of projects that may, depending on the circumstances, constitute candidates for these "special circumstances." These include development in urban areas, remote or environmentally sensitive locations, and projects that involve the construction of offshore platforms. The oil and gas CDIs indicate that the ability to classify a location as a PUD location where development is scheduled to begin more than five years in the future "should be the exception, not the rule."
• The new rule permitting companies to use "reliable technology" in their determination of proved reserves meant that companies were no longer restricted to the use of flow tests or the observation of actual production. The new rules define reliable technology as technology that has been field tested and demonstrated to provide "reasonably certain" results with consistency and repeatability in the subject formation or in an analogous formation. Broadly defining reliable technology in this manner allows companies the opportunity to use their existing proprietary methods or to develop new methods for determining reserves quantities.

The results of our Form 10-K review indicated that, at least with respect to the companies surveyed:

• The five-year rule forced some companies to remove PUDs that had been previously booked as PUDs; and
• A few companies (particularly those active in shale gas development) were able to increase the amount of PUDs booked by utilizing the new disclosure rules permitting the use of reliable technology to determine PUDs.

This first round of reporting under the new rules in 2010 indicated to investors how E&P companies were applying the new rules and interpretations, and provided the SEC staff an opportunity to analyze whether their application was congruent with the SEC's expectations. The views of the staff on the companies' compliance with the new rules in their SEC filings were expressed in various "comment letters" issued by the staff in 2010 and early 2011.

The comment letters

These comment letters revealed a number of issues that the staff had identified in reviewing E&P companies' disclosures of their reserves estimates and operations with respect to fiscal 2009. The bulk of the issues cited by the staff involved simple failures to address or adequately satisfy the black-letter requirements of the new rules. However, many letters dealt with the extent of companies' compliance with the SEC's more principles-based guidance regarding the five-year rule and what constitutes sufficient support for booking new reserves that were added through the use of reliable technology. Some letters requested expanded disclosures of the specific technology used to establish reasonable certainty for the additions to their reserves estimates. A few letters dealt with companies classifying reserves as proved for which the companies could give no assurance regarding the amount and timing of future production.

Five-year rule. The staff generally took issue with descriptions of PUDs being converted to proved developed reserves at a rate that, mathematically, would take longer than five years. If it did not appear to be possible to convert all existing PUDs to proved developed reserves within five years, the staff asked the companies to explain how they planned to accomplish that. The staff sometimes asked companies to provide the amount and percentage of PUDs that had been converted to proved developed reserves during various years prior to 2009. The staff also took issue with PUDs that had been listed as such for longer than five years and asked those companies to explain why those PUDs remained undeveloped. For some companies that had provided these explanations, the staff wanted to know when the companies planned on drilling and producing from those locations, and emphasized that if those companies were not reasonably certain of developing the wells within the next five years, the reserves estimates attributable to those locations should be removed.

There were numerous comments dealing with insufficient explanations of material changes in PUDs from year to year and the reasons for those changes. Where PUDs attributable to a particular project or property were significant, the staff requested additional information about the development schedule and other factors regarding the project properties (e.g., whether there was one development project or multiple development projects, the terms of the relevant leases, etc.).

Where a company disclosed that it expected to drill 90% of its undrilled locations within the next five years, but there had been no material conversions in 2009, the staff requested expanded disclosures to clarify the company's planned schedule for development of those reserves and the disclosures required by Item 1203(c) of SEC Regulation S-K (the new rule requiring disclosures of "investments and progress" made during the year to convert PUDs to proved developed status, including capital expenditures).

Development. If a company discloses special circumstances to justify why certain PUDs will not be developed until year six or later, the staff may ask for the total proved reserve figures with respect to those particular PUD locations and the conditions that may prevent their initial development within five years of booking. If PUDs are expected to be developed and classified as proved developed reserves within the next five years, the staff may request more detailed explanation on how the booked PUDs will be developed within that timeframe. And, where the company discloses that PUDs will be developed within the next five years as a result of special recovery methods – such as the use of compression techniques – the staff may inquire as to whether the company has made a final investment decision on installing the requisite special recovery equipment and facilities in the field. If it appeared that a company's liquidity to fund development plans was insufficient, the staff asked for additional information explaining how the PUDs could be developed within the timeframe disclosed.

One company had stated that pre-2005 PUDs in one field had remained undrilled primarily due to a lack of access to hydraulic fracturing services, rental equipment (primarily completion rigs) and associated contract services – factors that, according to the company, were largely out of its control. The staff responded by noting that these shortages most likely constituted a known factor at the time of estimation and as a result, this probability should have resulted in the removal from the proved category of those PUD locations that were not scheduled to be drilled within five years of their initial booking.

Also, in cases where additional PUDs had been added and the additions were attributable to a number of different factors, the staff requested disclosure on which portions of the additional reserves had been attributable to (i) drilling, (ii) acquisitions and (iii) revisions. Where newly-booked PUDs were offset by two or more locations from a proved producing well, the staff requested additional information on the number of locations away from the producing well that the company had determined met the definition of proved reserves.

If the 2009 additions to reserves were attributable to a number of different factors under the new rules, and these factors were in addition to the ability to book PUDs more than one location away from a producing well, the staff requested a description of these factors, disclosure of how many reserves were added and an explanation of how those reserves had met the revised SEC definition of proved reserves. The staff noted that since a significant portion of a company's PUD locations were two or more offsets removed from a producing well or wells, the company should disclose statistics of its drilling history for PUDs offset by two or more locations.

Reliable technology. The SEC staff requested specific description of the technologies used to establish the appropriate level of certainty for the disclosed reserves estimates. The level of details required to be disclosed was referred to in separate letters as a description, a general discussion and an explanation of the methods used.

The staff requested companies to expand disclosure on their reliable technology, including the actual technologies used and why the company believed they were reliable "in the geological environment [in which] they were applied." The staff also requested that a company disclose if the company used "any alternative methods and technologies of production flow tests in determining material amounts of proved reserves…and why those methods or technologies are considered reliable in the geological environment [in which] they were used." Because reliable technology must have been field tested and demonstrated to provide "reasonably certain" results with consistency and repeatability in the subject formation, in order to establish the appropriate level of certainty, the staff required an explanation of the actual methods used to establish reasonable certainty, and requested disclosure on how many proved reserves were determined by the alternative methods and technologies. Broad, imprecise descriptions of the technologies relied upon, according to the staff, were found to not meet the "reasonable certainty" threshold.

Where specific technologies were cited, the staff often requested explanation in a greater degree of detail (e.g., with respect to "the microseismic operations and reservoir simulation modeling" employed). Likewise, where only a general reference to technology was made (such as to "the application of reliable technologies"), the staff asked for the company to provide more detail.

Reasonable certainty of production within a stated time. The SEC staff took issue with companies inadequately disclosing the amount or timing of actual production with respect to the volume of proved reserves disclosed. If reasonable certainty on the amount and timing of actual production could not be given, the staff requested that the volume of those proved reserves be removed. In another letter, the staff felt that the use of phrases such as "appears to have enhanced" and "apparently economic" made it unclear if the reasonable certainty threshold had been met. here a company stated that it could give no assurance regarding amount or timing of actual production from underlying properties, the staff noted that under definitions of proved reserves and reasonable certainty in Rule 4-10 of SEC Regulation S-X, the company should have reasonable certainty – from a given date forward, from known reservoirs and under existing operating conditions, operating methods and government regulations – that its volume of reserves stated to be proved would be produced in the timeframe that the company stated they would, assuming conditions remained relatively the same.

Deficiencies in disclosures of principles or standards followed in estimating reserves. The staff took issue with disclosures indicating that estimates of proved reserves had been prepared by third party petroleum engineering firms "in accordance with generally accepted petroleum engineering and evaluation principles," or words to that effect. The staff often addressed this disclosure deficiency by saying "[w]hile we understand that there are fundamentals of physics, mathematics and economics that are applied in the estimation of reserves, we are not aware of an official industry compilation of generally accepted petroleum engineering and evaluation principles."

The staff asked for the basis upon which the petroleum engineers concluded that an industry standard exists. One company sent a response letter to the staff, asserting that a compilation of generally accepted principles was unavailable, but that its estimates had been prepared "using generally accepted principles and methods as promulgated by the [Society of Petroleum Engineers] in the SPE 2007 Standards" and set forth in petroleum engineering textbooks. The staff nonetheless felt that without an actual compilation of principles, reference to any such principles was not appropriate. Most companies and engineers resolved the comment by simply agreeing to make reference instead to the SPE Standards. Regardless of whether the reference was included in a third-party engineers' report or the companies' reference to their internal controls applicable to their reserves estimation process, the staff noted the lack of an official industry compilation of practices that would constitute "generally accepted petroleum engineering principles." Failures to discuss the specific internal controls that companies used to ensure objectivity in their reserve estimation processes were also highlighted by the staff.

Disclosure deficiencies in third-party petroleum engineering reports. Many third-party petroleum engineering firm reports on reserves estimates (or reserves audits) were found lacking in compliance with Item 1202(a)(8) of SEC Regulation S-K, which governs the contents of these reports. Where the terms used by three petroleum engineering firms in their separate reports filed with a company's 10-K were inconsistent (i.e., "reviewed"; "reserve audit"; "evaluation"), the staff requested explanation on how a review or evaluation was distinguished from a reserve audit, as provided in Regulation S-K Item 1202(a)(9).

Inconsistencies between third-party petroleum engineering reports and company estimates. Where reserves totals estimated by the company differed from those estimated by the third-party engineering firms, the staff required reconciliation of the differences. The staff also took issue with a statement that a company's internal estimates may differ from an independent engineering firm's estimates, given the SEC requirement that proved reserves be "reasonably certain" regardless of the estimation process used. Where the company disclosed only that there had been a "difference" between the company's and the engineering firm's estimated totals, quantification of the percentage difference between the two was required to be disclosed.

Natural gas liquids. Where proved oil reserves included natural gas liquids (NGLs) that were evidenced in sufficient quantities, the staff asked for the company to either separate and disclose the two product types or explain why they should be grouped together.

Qualifications of technical persons. Multiple letters requested disclosure, or more detailed disclosure, of the qualifications of the technical person at the company primarily responsible for overseeing or accepting the reserves estimates (or audit) from the third party engineering firm as required under the new rules.

Failure to record proved reserves attributable to a significant discovery. Where a company had disclosed that (i) a significant prospect was under development, (ii) the first production from this prospect was expected in 2012 and (iii) the company had signed a 17-year agreement to sell natural gas from the prospect field in the fourth quarter of 2009, the staff requested information on why volumes of proved reserves for the field had not been recorded at year-end 2009.

Significant changes in proved reserves. Whenever material additions to previous reserves estimates are disclosed, the new rules require that those disclosures be accompanied by a discussion of the technologies used to establish the appropriate level of certainty for the reserve estimates from the company's material properties. Where a company's proved reserves had increased by 11.12% during 2009, the staff requested that the company provide the disclosures required by this new rule, or else explain why the rule was not applicable. Accounting rules may also require enhanced disclosures regarding significant changes in net quantities of a company's proved reserves during the year.

Where there had been a year-over-year doubling of the crude oil reserves estimates, and the estimated gas reserves had increased by 33.3% through revisions, extensions and discoveries, the staff asked for an explanation of these changes in future filings that complied with ASC Topic 932, paragraph 50-5. If revisions in estimates are due to both pricing and performance changes, the disclosures should quantify separately the amount of reserve changes attributable to (i) the price changes and (ii) the changes in performance.

Conclusion

There were many other disclosure shortcomings addressed by the staff in its comment letters to E&P companies. And, of course, the companies that were the subject of the published comment letters referenced in this article constituted only a percentage of the total SEC-reporting E&P companies. Future staff reviews of other E&P companies will no doubt deal with the same problem areas, but will also raise new issues and areas of concern given the fact that no two E&P companies are alike. However, in the authors' views, the two most significant truths to be gleaned from the comment letters to date with respect to fiscal 2009 are that (i) the staff's presumption against companies' ability to book PUDs for more than five years appears to be a stronger than many expected, and (ii) a substantial level of explanatory support will be required in order for a company to be able to establish the "reasonable certainty" required to justify adding proved reserves by the application of "reliable technology."

About the authors