Oil and gas disclosure rules
Part one of a three-part series: 2013-14 SEC staff comments on companies' compliance
Marc Folladori, Attorney-at-Law, Houston
This new installation is the fifth in a series of articles in Oil & Gas Financial Journal that address publicly-held exploration and production (E&P) companies' compliance with amended oil and natural gas disclosure rules adopted by the Securities and Exchange Commission (SEC) in late 2008. Our analysis of these compliance efforts have largely been based upon our review of comment letters issued by the staff of the SEC's Division of Corporation Finance, beginning in 2010. Comment letters to companies reflect the staff's views on whether and to what extent the companies are complying with SEC regulations and accounting rules.
The amended rules first became applicable to disclosures in E&P companies' annual reports for their fiscal years ended December 31, 2009. Comment letters concerning these fiscal 2009 annual reports disclosures for fiscal 2009 began appearing on the SEC's EDGAR website approximately halfway through the 2010 calendar year. SEC guidance provides that comment letters to and responses from a company must be made publicly available, but not sooner than 45 days after staff review of the subject filing is complete.
The most significant topic for comment under the amended rules since 2010 has been the development of companies' proved undeveloped reserves (PUDs) - and in particular, a new "five-year rule" for PUD development. 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. Reserves that have remained booked as PUDs on a company's books for more than five years should be removed from the proved category.
For each of our articles, we analyzed letters (and companies' responses to those letters) made publicly available by the SEC over a roughly 12-month period. For example, the series published in 2014 summarized our review of letters issued by the staff and made publicly available during the second half of 2012 and the first half of 2013. We refer to each of these 12-month periods as a "review period." These approximate 12-month periods are not delineated by any regulatory or other specific timeframe; the authors have used them only as an organizational tool for purposes of analyzing comments from period to period and identifying trends.
This current article covers comment letters and response letters made publicly available during the second half of 2013 and the first half of 2014, which we refer to as the 2013-14 review period. For the most part, these letters and responses generally addressed companies' annual reports for fiscal years ended December 31, 2012, although many concerned disclosures relating to their fiscal 2013 fiscal year.
Highlights from 2013-14 review period
The number of comment letters dealing with oil and gas disclosures appeared to increase during the 2013-14 review period, when compared to prior periods. This greater number of comments may have partially resulted from a greater number of initial public offerings (IPOs) filed by E&P companies that were reviewed by the staff during 2013-14. Perhaps another contributor to the greater number of comments during 2013-14 was that apparently more E&P master limited partnerships (MLPs) were reviewed and received comments.
As was the case with previous periods, the most numerous staff comments issued in the 2013-14 review period dealt with disclosures regarding companies' development of their PUDs.
The fact that many E&P companies have been reporting under the amended rules for multiple reporting periods-some for as many as five years-has enabled the staff to compare the companies' disclosures in their most recent filings to those in prior filings dealing with the same or similar subject matter. In instances where certain data or information disclosed by a company in one period (such as trends in PUD development) appeared to be inconsistent or in conflict with that contained in prior filings, the staff often requested the company to provide clarification or additional information (see Kosmos Energy Ltd. (June 12, 2014); Penn West Petroleum Ltd. (Aug. 23, 2013)). In the same vein, there appeared to be more comments on companies' press release disclosures, website presentations, and presentations at analysts' conferences; these comments sometimes called companies' attention to information that was inconsistent or in conflict with information appearing in their annual reports or other filings (Forest Oil Corp. (Aug. 9, 2014); Linn Energy LLC, Apr. 25, 2013 [made publicly available in June 2014])).
Other notable highlights of the 2013-14 review period included (i) an increase in disclosures of "probable" and "possible" reserve volumes in filings, and (ii) many requests for natural gas liquids (NGLs) reserves and production data to be segregated and shown separately from crude oil reserves and production data. Finally, as in more recent periods, the number of financial and accounting comments continued to rise, with a particular focus during 2013-14 on cost calculations used in determining companies' standardized measure of discounted future net cash flows (standardized measure, or SM) regarding their reserves, and their capitalized costs for purposes of ceiling limitation and impairment tests under full cost and successful efforts accounting methods.
Development of companies' PUDs
Five-Year Rule. The staff continued to scrutinize whether companies' PUDs would be developed within five years (see, e.g., Vanguard Natural Resources LLC (Dec. 24, 2013)). Where a company disclosed in its fiscal 2012 annual report that its US natural gas drilling for 2013 would "be limited to that necessary to hold acreage," the staff asked the company to quantify the extent to which its disclosed 2012 PUDs included dry gas drilling locations and affirm that all those locations would be drilled within five years of their initial disclosure (EOG Resources Inc. (Aug. 29, 2013)). Comments continued to be raised where it appeared that a company's most recent annual rate (e.g., 5%) of converting its PUDs to proved developed reserves (PDs) would not support the company's contention that all of its PUDs would be developed in five years (Goodrich Petroleum Corp. (March 27, 2014); CNOOC Limited (Aug. 29, 2013)).
It appears that during 2013-14, very few North American onshore producers argued that they met the conditions for the "special circumstances" exception from the five-year rule - i.e., that circumstances such as remote or environmentally sensitive locations or substantial infrastructure construction needs, would justify a period of greater than five years before development of PUDs could begin. Where the exception was sought, it was generally denied (Miller Energy Resources (May 23, 2014), relating to its Alaskan prospects).
Uncertainties. A number of comments issued during 2013-14 revealed an increasing staff focus on whether certain factors or uncertainties created concerns about the ultimate recovery of a company's proved reserves. Paragraph 932-235-50-10 of Financial Accounting Standards Board Accounting Standards Codification Topic 932 (FASB ASC 932-235-50-10) states that if important economic factors or significant uncertainties affect particular components of a company's proved reserves, the company must provide an explanation of those factors or uncertainties. Examples of such factors or uncertainties are expected unusually high development or lifting costs, or the need to build a pipeline or other major facilities before production of reserves can begin.
For example, an independent engineers' report filed as an exhibit to a fiscal 2012 annual report stated that the estimates of the company's PUDs contained in the report included PUDs attributable to certain locations that would generate positive future net revenue, but had negative present worth discounted at 10% based on constant prices and costs as of December 31, 2012. Citing the requirements of FASB ASC paragraph 932-235-50-10, the staff asked that the company's disclosures be expanded to include the total number of locations and net quantities of hydrocarbons attributable to the locations having negative present worth valuation (Rex Energy Inc. (December 30, 2013)). The company responded, indicating that there were 28 such proved undeveloped locations that had a negative present worth valuation. The staff replied, noting that the PUDs attributed to those locations appeared to represent a material portion of the company's total proved reserves as of year-end 2012, and asked the company to expand further its disclosures regarding those PUDs and locations (Rex Energy Inc., (February 11, 2014); see also Halcon Resources Corp. (Feb. 7, 2014)).
The Southwestern Energy Co. (May 13, 2014) letter involved a similar fact situation to that in Rex Energy. The independent engineering firm's audit report stated that the company had included estimates of PUDs as of December 31, 2013 for certain locations that would generate positive future net revenue, but had negative present worth based on a 10% discount based on year-end constant prices and costs. The staff requested quantification of the number of locations and their associated net quantities of proved reserves, along with the company's affirmation that it was committed to drilling all such PUD locations. After the company's reply, the staff expressed its views that the estimated reserves attributed to those locations were material, which triggered the expanded disclosures required under FASB ASC 932-235-50-10 (Southwestern Energy Co. (July 10, 2014)). In its response to the staff dated August 5, 2014, the company stated that wherever applicable as to its future filings, it would disclose that its "year-end proved reserves quantities included XXX bcfe of PUDs from YY locations that had a positive present value on an undiscounted basis in compliance with proved reserve requirements, but did not have a positive present value when discounted at 10% (i.e., a negative $ZZ million)."
Another company disclosed that some of its wells had been drilled in locations that were not then serviced by gathering and transportation pipelines having sufficient capacity to transport additional production. The staff asked the company for information (i) clarifying the geographic area(s) where the company's production could be impacted by this lack of adequate infrastructure, (ii) stating the volumes impacted and (iii) addressing the impact that the lack of such sufficient infrastructure could have on the development of its existing PUD locations (Linn Energy LLC (Apr. 25, 2014)). Where a company disclosed it could give no assurances as to whether its proposed field development plan would be approved by Ghana's Ministry of Energy, the staff asked the company to explain the extent to which any PUDs disclosed as of December 31, 2013 were subject to the plan's approval (Kosmos Energy Ltd. (June 12, 2014)).
Disclosures of changes in companies' development plans also drew comments. WPX Energy Inc. disclosed in its annual report for fiscal 2012 that it had determined to reduce its quantity of PUDs it planned to develop during 2013 from an estimated 70 bcfe to 31 bcfe. The staff asked the company (WPX Energy Inc. (January 7, 2014)) to address the progress it had made in converting its PUDs during 2013, including (i) providing an updated schedule for the remaining undrilled 2013 PUDs, (ii) describing the impact that the delay in 2013 drilling would have on the company's overall schedule to develop its entire quantity of PUDs and (iii) addressing the extent to which the company had either drilled the subject wells according to its updated schedule or elected to remove any of those locations from its proved reserves.
Where there were wide differences between a company's historical unit development costs for its fiscal 2012 (ranging from approximately $35 per boe to $29 per boe) and the estimated future unit development costs it was employing for purposes of calculating its SM (approximately $18 per boe), the staff asked for clarification and an explanation (RSP Permian Inc. (Dec. 4, 2013)).
Acreage expiration dates
Another popular topic in recent years has been near-term expiration dates of companies' leases, concessions and other mineral rights that cover a significant portion of their undeveloped acreage relating to future development of their PUDs. In those instances, the staff has often requested companies to quantify the amounts of their PUDs attributable to locations scheduled to be drilled after the expiration dates of their subject leases or concessions. Comments have also requested data about companies' development plans with respect to their soon-to-expire undeveloped acreage, and the progress to date converting PUDs associated with locations on the expiring acreage. Where it appeared that significant quantities of a company's PUDs were scheduled to be drilled after the subject leases' expiration dates, the company was asked to disclose details on how it planned to extend the term of its legal rights to that acreage (EPL Oil & Gas Inc. (Dec. 19, 2013)). Companies were asked whether delay rentals were available with respect to their expiring undeveloped acreage, and whether the related dollar amounts of those delay rentals, if available, were material (Devon Energy Corp. (Dec. 11, 2013)). Companies having substantial operations in shale formations were often the targets of comments where it appeared that significant concentrations of their undeveloped acreage were scheduled to expire in a couple of years (see Halcon Resources Corp. (Feb. 7, 2014)).
About the author
Marc Folladori has been a merger and acquisition and securities attorney in Texas since 1974, and has had extensive experience representing energy companies and firms engaged in energy investment and finance. He recently retired from Mayer Brown LLP, where he served as the head of the firm's Global Energy Practice from 2007 until his retirement in 2014. The author wishes to acknowledge the research and other contributions in connection with this article made by Amelia Xu while she was an associate at Mayer Brown LLP during 2014.