Producers must differentiate between their in-house estimates and financial regulators’ requirements.
Nick Snow, Correspondent, OGFJ
The first indication to many Stone Energy Corp. investors that there was a problem came on Oct. 6, 2005, when the Lafayette, La., independent producer announced that during the third quarter it internally reviewed all of its fields, including hiring an outside engineer to look at several of its largest Gulf of Mexico fields.
Based on the review, Stone estimated its proved reserves as of Sept. 30 were approximately 670 billion cubic feet of natural gas equivalent, including a 161 Bcfe reduction of previous estimates. It said that a full reserve report by third-party engineering firms would be performed at the end of 2005.
On Nov. 8, Stone announced that it would restate financial statements from 2001 through 2004 and for the first six months of 2005 after reviewing whether parts of the Oct. 6 revision should be applied to prior years.
It said that the company and its audit committee were working actively to implement controls and procedures to ensure the integrity of its reserve booking process. These included improved training regarding Securities Exchange Commission guidelines, revisions of documentation procedures and controls, continued use of one or more independent third-party engineering firms, and appointment of a reservoir engineer as vice president of reserves.
Stone said that four days earlier, Davis Polk & Wardwell, in a preliminary report to the audit committee of Stone’s board of directors, “was critical of certain past review estimation and review practices and methodologies.”
Emphasizing that its investigation was not completed, the New York-based law firm told Stone’s audit committee that preliminary findings “indicated inadequate training and understanding of the SEC requirement for booking reserves,” Stone said.
“Davis Polk also reported that in the past, there appears to have been a tone of optimism and aggressiveness set by management regarding reserve booking,” it added.
Informal inquiry
Two days later, Stone reported that the SEC’s staff was conducting an informal inquiry into the reserves revision and intended to cooperate fully. Such inquiries are the earliest stage of an SEC examination and do not always result in full investigations.
On Dec. 5, the company announced the independent review’s findings after receiving Davis Polk’s final report on Nov. 28. The report found that a number of factors contributed to the reserves write-down including a lack of adequate internal guidance or training on the SEC’s standard for estimating proved reserves, “evidence that some former members of Stone management failed to fully grasp the conservatism of the SEC’s ‘reasonable certainty’ standard of booking reserves,” and evidence that there was an optimistic and aggressive “tone from the top” for estimating reserves.
It said that in addition to providing written guidelines and proper training on the SEC’s reserve reporting requirements, Davis Polk said that Stone should “continue to emphasize the difference between [the] SEC’s standard of measuring proved reserves and the criteria that Stone might use in making business decisions.”
After accepting the report, Stone said that its board resolved to promptly implement the recommendations as well as hire outside consulting firms to independently evaluate all of the company’s reserves, a process it expected to complete during 2006.
Following the report’s delivery, D. Peter Canty, who had retired as Stone’s chief executive on April 1, 2004, resigned from the company’s board. Directors also told Stone’s management to request resignations of an officer and a senior manager associated with the reserve estimation process.
Since that time, the company has continued to operate. Its properties continue to produce oil and gas. Its bank group extended waivers until Mar. 31, 2006, and agreed to secure borrowings under its bank credit agreement with a security interest in its oil and gas properties.
But the reduction of officially estimated reserves and the financial results restatement made it a legal target. Between Nov. 30, 2005, and Jan 12, 2006, 16 law firms announced class-action notices against Stone for the period from June 7 to Oct. 6, 2005, when the company first announced it would revise its reserve estimates.
The essential problem
Stone was not the first oil and gas producer to go through this ordeal. It probably won’t be the last. Other publicly traded upstream independents face the same essential problem of differentiating in-house reserve estimates from figures they file with the SEC.
“Without a doubt, since we’ve had some high profile restatements over the last few years, I can’t think of any exploration and production company that hasn’t refocused on this area. They have reviewed the processes because of the negative publicity companies receive when they make downward revisions,” observed Charles R. Swanson, partner, Ernst & Young Americas, and director of its oil, gas, and chemical sector.
“I expect that, across the board, the processes have been strengthened. It’s hard to imagine any audit committee or senior management that didn’t look at its company’s processes,” he said.
At the root is the SEC’s ongoing attempt to get uniform reports so investors can compare producers’ assets. The requirement is predicated on proved reserves, which are determined by established industry-wide procedures that some producers find unnecessarily conservative.
Problems begin when a financial value has to be assigned to the estimated reserves. Some producers also have complained about the commission’s requiring that an engineer’s reserves estimate use a specific date, usually Dec. 31, in the report.
Nevertheless, the SEC does not consider the reserve estimates it receives sufficiently precise to be a prominent part of a producer’s financial statement, despite reserves usually representing most of an E&P company’s assets. They usually appear as attachments or footnotes instead.
“Contrary to the common language use of the term, ‘reserves’ of oil and gas are not quantities neatly held in ‘storage’ and available to bring to the market in the near term,” observed Peter J. Newman, managing partner of Deloitte Services LP’s global oil and gas group.
“The estimates that are made underlying the ‘reserves’ as disclosed are essentially forward-looking projections of future production of oil and gas, often over many years into the future,” he said.
In a different context, the general public thinks of reserves in the context of grain or another readily accessible commodity. That contrasts with oil and gas, which are not readily accessible. “A lot of the furor in 2004 and 2005 was because the man in the street thought reserves had been lost,” Newman said.
Other measurements
Managements also use other measurements, such as potential and possible reserves, to reach operating decisions. “Any company uses a probabilistic method to determine its reserves as opposed to the SEC’s more conservative approach,” said Swanson. “If you look at the many technical tools that are available for geologists and engineers, different companies use different tools to different degrees and, understandably, reach different conclusions.”
But the additional information is vital in the buying and selling of property and reserves. “You would expect that whatever reserve quantities a company would put on a property it was trying to sell would be consistent with its operating standards. A purchasing company would have its own evaluation process that it would apply in a data room to determine if it agrees with the seller,” the Ernst & Young official said.
Newman suggested that disclosing the expected timing of production from both proved and probable reserves would be valuable to investors. Such disclosures could be in addition to, and not in place of, the standardized procedure that the SEC requires.
He also recommended putting such information within the management’s narrative instead of the financial statements in the annual report because of reserve disclosures’ forward-looking nature. “Indeed, most management teams already provide important commentary on their oil and gas reserves within the management discussion and analysis in the US and the operating and financial review in the UK,” he said.
Producers can have problems for nearly as many reasons as there are methods for estimating reserves. They can range from a simple breakdown of internal controls, where amounts are not accurately recorded, to pressure from members of upper management to make the numbers look good. The latter can occur when reserve growth or stock price improvement are linked to executive compensation.
More investors also need to understand that a reduction of reserves reported to the SEC is not as big an event as it might appear. It certainly does not necessarily mean that any of a producer’s oil and gas has disappeared.
“The fact that these reserve revisions have essentially transferred estimated quantities from the ‘proved’ category to the ‘probable’ category has not been well understood by the public at large. Clearly, more knowledgeable investors and industry professionals understand that the reality, while a serious concern, is far less dramatic,” said Deloitte’s Newman.
“The fact is that some gas reserves that have been taken out of the proved category come back into it when contracts are established,” he added.
Within the industry, engineers, management, and other professionals routinely combine estimates of proved and probable reserves to make decisions about investments, to plan infrastructure, to manage portfolios, to lend against projects, and to establish commercial valuations, he continued.
“Some investors give weight to possible reserves at the end of the spectrum - but relatively little weight,” Newman said.
No one expects the SEC’s reserve reporting requirement to change soon, however. “There’s no proposal before the five commissioners to change the rules. We’re aware that people have opinions. The commission’s staff is contacted regularly. We listen to their input and value their comments,” a spokesman said.
“We’ve sought responses, directly and indirectly, from the SEC about the points we’ve made,” said Newman. “It’s fair to say that it has not indicated that it plans to take up the issue of oil and gas compliance reporting very soon. It is small relative to its other responsibilities.”
While he stopped well short of suggesting that US reserve reporting regulations have become an excessive burden, he added, “There’s been a substantial amount of capital formation in Canada and the UK, in contrast to the United States. We have found that Canada has the most enlightened market in terms of disclosing information to investors. Certainly, its regulators’ actions have not damaged the ability of companies to go to market and raise meaningful capital.”
“Any major overhaul would be difficult. The SEC’s resources were stretched filling its day-to-day duties before the Sarbanes-Oxley law took effect. Overhauling reserve reporting now would stretch them too far,” he added.OGFJ
