Knowledge Problem

Michael Giberson

On December 23, 2008, I posted on “The forthcoming dramatic fall of reported oil reserves.” Now, as predicted, reports are showing up like this one from Warren Resources, Inc.:

Independent reserve engineers’ estimates of Warren’s proved oil and gas reserves as of December 31, 2008, were 129.3 Bcfe, compared to 356.4 Bcfe as of December 31, 2007, which represented a 64% decline. … This decrease in estimated proved reserves is largely due to the steep decline in year-end oil and gas prices.

(I don’t know anything in particular about Warren Resources, it just happened that they recently issued a news release with year-end results and it was readily found in a Google News search)

As the December 23 post noted, because SEC requirements required reserve estimates to be based upon single-day end-of-year prices, reserve estimates can be dramatically affected by price volatility. The Warren Resources post illustrates the point nicely.

SEC’s reserve reporting requirements were controversial, in part because they departed from industry standard approaches to reserve estimation. And, as mentioned in a December 30 follow up post, the SEC is changing its rules for reporting reserves. The SEC justifies revising their requirements “to help investors evaluate the value of their investments in these companies.”

But will the change help investors?

Richard Miller, a former president of the Society of Petroleum Evaluation Engineers (SPEE), addressed this question in a presentation at last year’s SPEE annual meeting. His article based on that presentation is contained in the new Journal of the Society of Petroleum Evaluation Engineers (pp. 32-39). He said:

Before expending time and effort to revise the SEC reserves reporting rules, perhaps it might be useful for the SEC, reporting companies, and energy company investors to consider this question:

Does the effort to report oil and gas reserves under the current or revised definitions provide information that is useful to investors? Put another way; is the oil and gas reserves information reported in SEC Form 10-K and 10-Q of real value to investors and, if so, what is the value of that information?

In short, Miller finds no support for the idea that the SEC-required reports are valuable to investors.

Miller takes two separate approaches to examine the issue. First he looks at whether stock prices and trading volumes appear to be affected by information announcements (both disclosures of SEC-required reserve reports, and other, more informal information releases). Second, he surveyed oil and gas industry analysis at major financial advisory firms. Neither approach suggested there was much value in the information.

His result is not too surprising. A number of energy industry companies devote significant effort to tracking petroleum reserves, constantly acquiring and digesting information more subtle and more substantial than that required by the SEC. By the time the official version of reserves estimates is issued it is old news. While it may be good for the SEC to revise its rules for other reasons, it won’t provide much in the way of “help to investors.”

Michael Giberson

A week ago I wrote, “The forthcoming dramatic fall of reported oil reserves is due to falling prices and reporting requirements, not ‘peak oil’ or the manipulations of greedy industry executives.” However, as this Associated Press story reports, yesterday the Securities and Exchange Commission adopted proposed changes to reporting requirements that will have the effect of reducing the effects of price volatility on reserves reported.

An SEC press release is available, but as of Tuesday morning the full text of the new regulations were not available on the SEC website.

According to the AP article the new rules will:

• Allow companies to use new technologies to determine proven oil and gas reserves provided the technologies have been shown to lead to reliable assessments.
• Allow companies to disclose their probable and possible reserves to investors. Until now, SEC rules limited disclosure only to proved reserves.
• Require companies to report oil and natural gas reserves using an average price based on the prior 12-month period rather than year-end prices.
• Require companies to certify the independence of petroleum auditors that audit their assessments of reserves.

The third item is the key to reducing the effects of price volatility on officially reported reserves.

The effect of price volatility on reserves can be reduced, but not eliminated, because the price of oil is one factor that determines how much of the oil in the ground will likely be economically producible (cost of production being the other main factor).  A prior twelve-month average of prices is not necessarily the best estimate for a company to use in its own internal evaluation of expected reserves – the company may have reasons to believe it can do better in pulling oil from the ground (or will do worse) than the amount indicated by using the twelve-month average price. But for financial reporting purposes it is important to have a standard and not too volatile measure.