New oil and gas reporting rules enhance data for M&A activity

The largest hurdle for oil and gas companies seeking to merge with or acquire a competitor is estimating the true value of their target’s resources and potential reserves – a process made more difficult by recent advances in technology and the emergence of non-conventional hydrocarbons.

When considering a merger or acquisition of a potential target, the value of hard assets, such as pipelines or research facilities, can be easily assessed prior to the due diligence process. And it is possible to identify intangible benefits that can be important, such as the technical expertise of a target company’s workforce. But until recently, US accounting rules limited disclosure to proved reserves (with specific guidelines for determining what is proved), making it challenging to understand an exploration and production company’s full holdings.

For example, new technology can make it possible to extract hydrocarbons from reservoirs previously considered unreachable. Or rising market prices can make it economically feasible to produce non-conventional resources. These types of shifts can have a tremendous impact on long-term revenue streams. However, without an accurate picture of a target company’s untapped assets underground and with no due diligence process, it is difficult to make a merger and acquisition decision.

As 2008 drew to a close, the US Securities and Exchange Commission announced unanimous approval of new reserves reporting rules for the first time in three decades. The new rules are designed to create a more transparent and comparable reporting structure, making it easier for companies to apply a better market value to M&A transactions. When enacted, the SEC’s rules could lead to a new wave of M&A activity in the oil and gas sector.

Detailed disclosure helps investors

One primary rationale behind the changes is to aid investors – both sophisticated industry analysts and individuals seeking to compare different companies – by requiring a more detailed disclosure of reserve estimates. But the SEC’s proposal goes beyond what the industry and investors had hoped or feared for; it provides a framework that allows for the release of significantly more detailed data on reserves and how they are valued. And better information typically means more activity.

Three of the rules changes could have a measurable impact on M&A activity. These rules:

• give companies the option of disclosing probable, possible, and proved reserves,
• permit use of new technologies to determine proved reserves if those technologies have been demonstrated empirically to lead to reliable conclusions about reserves volumes, and
• allow non-conventional hydrocarbon sources such as oil sands, oil shale and bitumen, which are growing in importance in many companies’ portfolios, to be classified as reserves.

The increased transparency allowed by these changes would create a consistent standard for investors, allowing for more comparability and accuracy in analyses of future earnings. They would also more closely align US-based reporting rules with those used globally and potentially increase the number of cross-border transactions.

But for companies seeking merger or acquisition targets, these rules provide a much clearer picture of a target company’s resources and potential reserves, allowing for a more realistic determination of market value and, in turn, a more credible offer price. Also, they make it possible for acquiring companies to more easily understand how a target company’s assets might fit with their own portfolio of reserves.

In other words, the transparency created by the new SEC rules is likely to embolden aggressive companies, which can be more confident that a merger or acquisition will provide sufficient return on capital in the coming years.

Putting some companies at risk

Of course, the more information that is in the public domain – and the more confidence that aggressive companies have in the long-term payoff of M&A activity – the more vulnerable some companies will be. By releasing more data about probable and possible reserves and their lease holdings related to non-conventional hydrocarbons, smaller companies may find themselves more accurately valued by the marketplace and potentially more attractive to acquirers.

Another point of consideration is the extra burden this will place on project teams who, in most cases, will be tasked with creating the extra data required by the new rules. From the perspective of many companies, these rules have been drafted in favor of the demands of investors, and certain companies, particularly smaller ones, will struggle with the extra burden placed on their staffs. This leaves some to question whether the benefits will outweigh the cost and effort involved.

There is also some concern that the new rules go too far in requiring disclosure. For example, one requirement would force companies to break down their reserves by geographic region if any one country or field accounts for more than 15% of their overall proved reserves. Is this level of disclosure forcing companies to give away confidential information that can hurt them competitively? In addition, lack of clarity in some of the technical aspects of the proposed changes may lead to more, rather than less, confusion. Time will tell.

There is another potential impact of more detailed disclosure. The current strict definition of proved reserves often leads to an undervaluing of E&P companies because there is no public disclosure of their probable and possible or non-conventional reserves. This market undervaluing can encourage prescient competitors to make an acquisition bid, lower than one which is fully reflective of the target’s long-term prospects. Under the new rules, a more realistic valuation of the target company might discourage bidders seeking a bargain deal.

Buyers, sellers benefit

For the most part, the impact of more detailed disclosure of potential reserves and resources will help companies looking to merge or be acquired, as well as those doing the acquiring. In many ways, management’s job has been hindered by the old reporting rules, which make it difficult to tell the company’s full story as it relates to reserves. That could end when the SEC’s new rules are enacted.

Companies seeking to be acquired could have the opportunity to make themselves look as attractive as possible by including all possible reserves categories allowed under the new rules.

Companies seeking acquisition targets could have a more sophisticated view of a competitor’s real value and a deeper understanding of the potential upside following a merger or takeover.

And companies that believe they are undervalued relative to real assets can provide investors with a detailed look at how management sees the company. Because one of the new rules changes the valuation method used to an average 12-month price rather than a single end-of-year price – and allows management to explain in detail the impact of pricing sensitivities on their reserves analysis – companies can provide more transparency around their market value.

Change for a changing industry

The bottom line is that disclosing the basis of reserves and resources and key financial accounting estimates is fundamental. The SEC’s new rules enhance disclosure and assist in the global convergence of financial reporting.

Even with these changes, the nature of reserves and resources will continue to be highly subjective, relying on assumptions and estimates. But by giving companies more freedom to communicate their holdings, the SEC is bringing much-needed transparency to an industry that has changed dramatically in the past 30 years – and promises to change even more in the years to come.

About the author

Michael Lynch-Bell is global oil and gas transactions leader at Ernst & Young. The views expressed herein are those of the author and do not necessarily reflect the views of Ernst & Young LLP.