SEC delivers transparency and reliability to investors
On Dec. 29, 2008, the Securities and Exchange Commission unanimously approved revisions to modernize oil and gas reporting requirements and allow more comprehensive disclosure of probable and possible reserves. These new rules will be effective as of Jan. 1, 2010. The SEC’s first attempt in more than 30 years to revise financial reporting disclosures for publicly-traded exploration and production (E&P) companies can be summarized in two words: transparency and reliability.
Reserves then and now
Finding, developing, and producing oil and gas reserves is the objective of all upstream energy companies. The elusive, viscous, subterranean oceans underlying this oversimplified assessment of the oil business are what it is really all about. That’s right, reserves.
Investors primarily value E&P companies based on how efficiently their cash flows generate reserves. This creation of value has historically been translated into the stock price of publicly-traded E&P companies. This value, however, has been entirely based on the value of proved reserves.
Management, lending institutions, and private equity investors have long considered the complete economic kaleidoscope of oil and gas reserves in their risk management and value assessment processes. Due to SEC disclosure limitations, however, investors in publicly-traded E&P companies have been limited to making investment decisions based solely on the economic potential of proved reserves.
It would seem the SEC has drawn back the competitive veil between public and private E&P investment opportunities. The revisions to the disclosure reporting requirements will allow publicly-traded E&P companies to disclose both their probable and possible reserves in the footnotes to the financial statements, allowing investors to incorporate all known and potential reserves in their investment decisions.
During the most recent boom in the E&P business, E&P companies were able to monetize reserves with significant consideration given for proved undeveloped, probable, and possible reserves, which clearly established market demand and value attribution for such reserves. This recognition of value by the markets was interpreted by the SEC as a deficiency in the existing disclosure rules, prompting an appraisal of the need for further transparency in reserve disclosures.
The new requirements
The preparation of reserve estimates is a rigorous, time-consuming undertaking requiring the analysis of a tremendous amount of data and the use of professional judgment to evaluate vast reservoirs of hydrocarbons investors cannot see. Short of blind faith, how do investors know the disclosures are accurate?
While the transparency provided by the revised disclosure rules offers greater insight into the value of publicly-traded E&P companies, transparency is only as meaningful as the associated information is accurate. The SEC has recognized and addressed this concept by increasing the disclosure requirements regarding the independence and qualifications of firms who prepare the reserve reports that serve as the basis for the reserve disclosures. The SEC is also requiring publicly-traded E&P companies to file reports when a third party is relied upon to prepare reserve estimates or conduct reserves audits.
Increasing disclosure reliability
The new disclosure rules will allow current and potential investors to evaluate the credentials of the reserve estimate preparer when evaluating the quality of the reserve disclosures, further increasing the reliability of the disclosures.
The quality of the information will be further enhanced by the disclosure of the independence standing of reserve report preparers, a long-time requirement of the auditors of the financial statements of the same companies. Accordingly, investors can make their own judgments as to whether reserve estimate preparers are influenced by any direct financial interests or other independence-related associations with their clients.
The disclosure of the reports when third parties are used in the reserve estimation process will alert current and potential shareholders to consider the benefits afforded by the new qualification and independence disclosures required for reserve estimate preparers. These new disclosures should yield higher quality valuation assessments as investors perceive greater reliability in the reserve disclosures; no need for blind faith.
Eliminating year-end pricing
The final revision to the oil and gas disclosure rules by the SEC requires incorporating the historical pricing experience of publicly-traded E&P companies in their reserve disclosures. That revision eliminates the use of year-end pricing, which some believe limited the comparability of reserve estimates due to potential valuation distortions caused by the volatile nature of energy commodities.
Publicly-traded E&P companies will now be required to use the average price realized by the company during the fiscal year to attribute value to their reserves. This should provide additional transparency into the quality of the reserves; given the prices realized by the registrant should be indicative of the quality of the hydrocarbons being produced. Further, the overall qualitative mix of the reserves will be evident in the average price determination.
Given the global economic roller coaster holding investors hostage, these new disclosure requirements could not have come at a better time. Investors are looking for opportunistic buys, as well as reassurance of the value of current investments. Even prior to the current economic environment, more and more emphasis was being placed on value.
The recent proliferation of accounting rules, releases, and clarifications regarding the determination of value for financial accounting purposes provide evidence of that emphasis. Those new rules and guidance closely mirror the valuation methods employed by sophisticated investment bankers, hedge fund managers, and management teams of Fortune 500 companies.
Allowing investors better insight into the reserves of publicly-traded E&P companies, the historical pricing experienced by these companies and the qualifications and independence of those responsible for making the reserve estimations should serve to make the reserve values more transparent and reliable. After all, shouldn’t the value of oil and gas companies be based on the value of their oil and gas?
About the author
Melvin F. “Trey” Hunt III, CPA, is an audit senior manager at Weaver and Tidwell LLP. With offices in Houston, Dallas, Fort Worth, and San Antonio, Weaver and Tidwell is ranked the largest independent certified public accounting firm in the Southwest by Practical Accountant.