Marc Folladori, Mayer Brown LLP, Houston
Jeff Dobbs, Mayer Brown LLP, Houston
In late December of 2008, the Securities and Exchange Commission (SEC) modified the oil and gas disclosure rules for the first time in three decades. Given their greater similarity to industry standards than under the old rules, the changes were initially heralded as modernizing and liberating, but questions quickly began to develop regarding the lack of clarity for some critical provisions.
The SEC's Division of Corporation Finance issued Compliance & Disclosure Interpretations (CDI) in October 2009 in an attempt to clarify the new rules and address the industry's questions and concerns. For details of the modified disclosure rules, please reference the Mayer Brown article dated Mar. 2, 2009 (http://www.mayerbrown.com/publications/article.asp?id=6212&nid=6).
The completion of the first round of reporting under the new rules in 2010 provides an opportunity to examine how companies applied the rules and analyze whether their application was congruent with the SEC's expectations. The initial returns were not favorable, at least in the SEC's eyes. In April 2010, H. Roger Schwall, assistant director in the SEC's division of corporation finance, stated at a financial reporting session of the United Nations Economic Commission for Europe in Geneva that the SEC wanted more detail in year-end petroleum reserves disclosures and that it may issue additional guidance in 2010.
Under the new disclosure rules regarding the use of reliable technology to determine "proved undeveloped reserves" (PUDs), some companies were able to increase the amount of PUDs booked, especially companies having large reserves of shale gas. The new five-year limitation rule forced other companies to remove PUDs that had been previously booked as PUDs. Generally, the change in pricing assumptions to 12-month average prices and the significantly depressed oil and natural gas prices early in 2009 negatively impacted the economic calculations for determining reserves.
A survey conducted by Ryder Scott found that less than 2% of public companies in US markets booked material reserves additions for year-end 2009 based on the use of "reliable technology" as defined by the SEC. Of the 111 surveyed 10-K filers, 20 companies provided statements on the impact of technology on the estimation of their proved reserves as of Dec. 31, 2009. Of those 20, 15 companies, without disclosing magnitudes, stated that reliable technology had no or minimal effects. Three companies reported 2% or less increases in proved reserves. Two filers disclosed material proved reserves additions.
Mayer Brown examined the annual reports on Form 10-K of 25 public oil and gas companies in a non-scientific sampling to gain a general understanding of how these companies were affected by the rules and how the rules were interpreted and implemented. Mayer Brown's examination yielded results similar to the Ryder Scott survey in finding that only a minority of companies increased PUDs in 2009 based on the use of reliable technology.
Reliable technologyUsed to calculate PUDs
The implementation of the new rules ushered in new disclosures of methods used to calculate PUDs. Companies are no longer restricted to the use of actual production or flow tests, but instead can prove reserves through the use of "reliable technology." The SEC was intentionally vague when defining reliable technology as technology that has been field tested and demonstrated to provide "reasonably certain" results with consistency and repeatability. Defining reliable technology in this manner allows companies the opportunity to develop new methods for determining reserves or to use existing proprietary methods.
Petrohawk Energy Corp. reported an approximate 200% increase over the previous year's total reported PUDs, including additional PUDs totaling 1,771 Mbbls of oil and 1,115,334 MMcf of natural gas resulting from the application of reliable technologies in determining reserves. The company stated that the calculations of new PUDs were based on analogy to producing wells within the same area exhibiting similar geologic and reservoir characteristics, combined with volumetric methods. The volumetric estimates were based on geologic maps and rock and fluid properties derived from well logs, core data, pressure measurements, and fluid samples. Proved undeveloped locations were limited to areas of uniformly high-quality reservoir properties between existing commercial producers.
EOG Resources Inc. increased PUDs by about 135% from 2008 to 2009 but did not disclose how much of the increase was based on the use of reliable technology. The company did provide an explanation of the technology used to calculate PUDs, which suggests that some portion of the increase was related to the use of reliable technology. EOG reported that studies were conducted employing numerous data elements and analysis techniques, including a combination of seismic data and interpretation, as well as comprehensive sets of wireline logs and/or core data and transient analysis techniques applied to pressure and production data from existing producing wells. The company found these studies to be proven effective based on application in analogous reservoirs.
Chesapeake Energy Corp. reported about a 50% increase in PUDs from 2008 to 2009, which was partially attributable to the company's use of reliable technologies, and reported that it had utilized both public and proprietary data in its calculations. The technologies included seismic data and interpretations, open hole log information, and petrophysical analysis of the log data, mud logs, gas sample analysis, drill cutting samples, measurements of total organic content, thermal maturity, sidewall cores, whole cores and data measured from internal core analysis facilities. The analysis required data from a statistically significant number of producing wells within the defined geologic area. This data was then tested for confidence by insuring that the variance in results over time, area and distance was evaluated.
Pioneer Natural Resource Co. disclosed that it recorded four proved undeveloped locations and 2 MMboe of PUDs in the United States that would not have been recorded under the old rules. The company used reliable technologies to establish additions to its reserve estimates, including a combination of seismic data and interpretation, wireline formation tests, geophysical logs and core data.
The increases in PUDs discussed above contrast with some larger-cap reporting companies. BP plc, Anadarko Petroleum Corp. and Royal Dutch Shell plc all reported increases of approximately 1% or less of proved reserves based on reliable technology.
Overall, approximately one-third of the companies examined disclosed that they had utilized reliable technologies under the new rules to increase PUDs. Of the companies surveyed that disclosed that they had utilized reliable technologies under the new rules, the average increase was approximately 16%, which led to an aggregate average increase of approximately 9.4% for total PUDs examined.
Used to prove development spacing locations more than one development spacing location away from economic producers
The SEC also adopted revisions that permit a company to claim proved reserves beyond those development spacing locations that are immediately adjacent to developed spacing locations if the company can establish with reasonable certainty that these reserves are economically producible. Several companies reported PUD increases within such spacing locations by calculating the PUDs using reliable technology.
Bill Barrett Corp. added 170.0 bcfe of PUDs in the Gibson Gulch area of the Piceance Basin at Dec. 31, 2009, of which 86.3 bcfe was attributed to the addition of second offsetting spacing locations from economic producers. The company reported that its decision to report increased reserves was supported by geologic, engineering and economic data in addition to well productivity across the area and the basin. Chesapeake Energy stated that it utilized and developed reliable geologic and engineering technology to book PUD reserves more than one location offsetting production locations in the Barnett Shale and Fayetteville Shale without disclosing the specific technology employed. CNX Gas Corp. disclosed that "[e]xtensions and discoveries also include 120,933 MMcfe [approximately 13.9% of PUDs as of Dec. 31, 2009] as a result of initially applying the amendments of [accounting guidance on mineral rights conveyances and related transactions] related to capturing proved undeveloped locations more than one location away if reliable technology can be demonstrated." However, the company did not describe in detail the reliable technology it utilized.
Greater detail required by SEC in reporting use of reliable technology
A challenge facing companies and the SEC in the reporting of reliable technologies utilized concerns the disclosure of proprietary and confidential technological information of companies. While the SEC allows companies to utilize proprietary methods, and companies may be eager to do so, they are reluctant to report those technologies in public documents.
This reluctance creates a predicament for the SEC because one impetus in developing the new rules was to allow companies to use their technological developments to determine reserves. However, full and complete financial reporting disclosures require an understanding of the technology employed to calculate the reported reserves.
Generally, the companies examined by Mayer Brown simply listed different technologies without discussing how those technologies were utilized for each area or how they were used in the calculations. The SEC has not indicated whether this type of reporting requires more detail or whether the need for greater detail is in response to reporting similar to that of Northern Oil & Gas Inc., which disclosed that, as of Dec. 31, 2009, about 60% of its total reported reserves calculated in accordance with the SEC pricing assumptions were PUDs. The company did not discuss the calculation procedures for deriving those figures, the length of time the PUDs had been booked or the use of reliable technology. Further guidance is necessary to determine whether this type of disclosure is sufficient for the SEC's purposes.
Five-year ruleEffects of the new rule
The new disclosure rules restrict the reserves that a company can classify as PUDs. In order for reserves to be booked as PUDs, an undrilled location must have a development plan adopted and it must be scheduled to be drilled within five years of the date booked.
The application of the new rule resulted in a decrease of 2.7% in total PUDs reported of the companies examined. Abraxas Petroleum Corp. reclassified 4,954 Mboe (about 44.8% of its 11,052 Mboe of PUDs as of Dec. 31, 2009) to the probable and possible categories as a result of the reserves having been included as PUDs for more than five years. Pioneer Natural Resource Co. disclosed that as of Dec. 31, 2009, the company had 4,582 proved undeveloped well locations (all of which were expected to be developed within the five years ended December 31, 2014), representing a decrease of 395 proved undeveloped locations (8%) since December 31, 2008. The company disclosed that its 4,582 proved undeveloped locations as of December 31, 2009 included 1,675 locations that had remained undeveloped for five years or more, but did not explain why these 1,675 locations continued to be included.
The new rule did not affect all companies as severely. Bill Barrett Corp. removed only 7 bcfe in total PUDs reported (1.4% of its 484.6 bcfe of PUDs as of December 31, 2009) for exceeding the five-year limit. Noble Energy Inc. removed 18 MMboe in total PUDs reported (6.7% of its 270 MMboe of PUDs as of December 31, 2009) that were not scheduled to be developed within five years.
Overall, approximately one-third of the companies examined reported removing PUDs based on the five-year rule. While only a low percentage of companies examined were affected, on average, companies that removed PUDs based on the five-year rule removed about 14.1% of their PUDs formerly booked.
Exception to the rule
The rules contain an exception to the five-year rule if "special circumstances" justify a longer interval before development will be initiated. The SEC has identified several "special circumstances," including developments involving construction of offshore platforms and development in urban areas, remote locations or environmentally sensitive locations. The CDI states that classifying a location as having PUDs where the location's development is scheduled to extend more than five years in the future should be the exception, not the rule.
The CDI gives some guidance on the factors a registrant should consider before classifying a reserve as a PUD beyond the five-year rule. Such factors include:
- the company's history of completing development of comparable long-term projects;
- the company's level of ongoing significant development activities in the area to be developed;
- the amount of time in which the company has booked the reserves without significant development activities;
- the extent to which the company has followed a previously adopted development plan; and
- the extent to which delays in development are caused by external factors related to the physical operating environment (e.g., land use restrictions), rather than by the company's internal factors (e.g., developing properties having higher priority).
Several companies reported PUDs with development periods exceeding five years. Of the 6,604 Mboe of PUDs disclosed by Energy Partners Ltd. as of Dec. 31, 2009, 4,178 Mboe (63.3%) had been booked for longer than five years. The company explained that its PUDs "were associated with infill exploitation reserves in proven reservoirs which generally are up-dip reserves and/or reserves where the existing wellbore is not mechanically viable, requiring a new or replacement wellbore to enable production." The company estimates that these PUDs will be classified as proved developed within five years. The company noted in a risk factor that the SEC has released only limited interpretive guidance regarding the reporting of reserve estimates under the new rules, and that while the company's estimates of proved reserves at Dec. 31, 2009 were prepared based on what it believed to be reasonable interpretations of the new SEC rules, those estimates could differ materially from any estimates applying more specific SEC interpretive guidance.
Anadarko Petroleum also reported a substantial portion of PUDs booked beyond five years. The company reported 680 MMboe of PUDs, of which 136 MMboe (20.0%) had been booked prior to 2005. The company stated that 54% of the PUDs booked prior to 2005 are in Algeria and being developed according to an Algerian government-approved plan. Another 20% of the pre-2005 PUDs are associated with various phases of the Salt Creek enhanced oil recovery phased development program in the company's Rocky Mountain properties located in Colorado, Utah, and Wyoming, where the company has invested $20 to $145 million per year to develop six different Salt Creek phase areas. Another 8% of the pre-2005 PUDs are associated with Gulf of Mexico sidetrack opportunities where platform well slots were not available as of the reporting date. The remaining PUDs booked prior to 2005 are scheduled for conversion by 2015.
Several companies kept PUDs related to mining operations recorded even though they exceeded the five-year rule. Cabot Oil & Gas Corp. kept 14,029 MMcfe (approximately 1.9% of PUDs as of Dec. 31, 2009) booked that had not yet been developed based on coal mining operations. CNX Gas Corp. included in its PUDs calculation approximately 120,000 MMcfe (approximately 13.8% of its PUDs as of Dec. 31, 2009) that have been reported for more than five years that relate specifically to CONSOL Energy's Buchanan Mine. The reserves will be developed in order to de-gas the mine ahead of longwall mining. Currently, the SEC has not provided any guidance regarding exceptions for PUDs related to mining operations.
Some of the companies examined did not specifically disclose the amount of PUDs booked that exceeded the five-year rule. Harvest Natural Resources Inc., in discussing its subsidiary Petrodelta's PUDs, stated that "all PUD locations are scheduled to be drilled by 2014. However, there are some PUD locations [amount not disclosed] that are scheduled to be drilled in the sixth year after the PUD locations were first identified."
The company stated that it had a proven track record of developing its PUDs and that the delay could be accounted for by special circumstances related to production targets and quotas set by the Venezuelan government and the Organization of the Petroleum Exporting Countries and difficulty in retaining contractors. Pioneer Natural Resource Co. stated that 36.6% of its PUD well locations have remained undeveloped for five years or more; however, the company did not specifically disclose what percentage of total PUD reserves reported are contained in those well locations. The company also did not explain why the reserves were being reported beyond the five-year rule.
For surveyed companies reporting PUDs beyond the five-year rule, on average the PUDs exceeding the rule accounted for approximately 20.9% of a company's total PUDs. In the aggregate, PUDs exceeding the five-year rule accounted for approximately 4.4% of all PUDs reported by the companies examined. With the staff's emphasis that PUDs allowed to exceed the five-year rule should be the exception rather than the rule, it is unclear whether this 4.4% of the total reported amount will surpass the staff's expectations for permitted exceptions.
Average pricingThe new rule affecting the largest percentage of companies examined is the change in calculating reserves using a 12-month first-day average price as opposed to the traditional end-of-the-year spot price. Of the companies examined, 60% reported being affected by the change.
If traditional year-end prices were used, 2009 calculations would be based on $75.75 per barrel of oil and $5.79 per MMbtu of natural gas for the Henry Hub spot price, versus the $57.65 per barrel and $3.87 per MMbtu that were based on the 12-month first-day average prices. Due to the prevailing lower natural gas prices during most of 2009, and the low prices for crude oil in early 2009, all of the companies examined except two were negatively affected by the change. Even though more surveyed companies were affected by this rule change than any other, PUDs only decreased on average by approximately 4.0% for the surveyed companies affected by the rule change, compared to an average decrease of approximately 2.3% for all of the companies surveyed.
The percentage related to the average decrease by companies affected by this rule change was skewed by a single company, Tengasco Inc. In 2008, Tengasco's oil price used for valuation was $33.96 per barrel, low enough to cause the company to remove all previously booked PUDs. The change to average pricing in 2009 raised its oil price used for valuation to $53.81 per barrel, allowing the rebooking of all PUDs removed in 2008. Excluding Tengasco's figures, the average decrease for companies affected by the rule change was 11.2% of PUDs booked.
Conclusion
As with most regulation changes, it will take time for companies and the SEC staff to reach a common understanding on how these changes in the reserves disclosure rules will operate. This process may be shortened if the SEC can provide specific guidance before the next reporting period. Since more guidance is necessary, companies should provide full and complete disclosure when reporting PUDs calculated by using reliable technology or PUDs exceeding the five-year rule and explain the factors used in making their determinations. OGFJ
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