By Joaquin M. Sena

Oil and gas companies use outside consultants and internal advisory committees to verify their oil and gas reserve estimates. Internal disagreements are inevitable about the amount of estimated reserves and how to classify the reserves. When this happens, at least two questions are in the back of everyone’s mind: What do we do, and will we have to restate the financials?

The answer to the first question is to determine whether an error has been made and whether it materially affects the company’s financial statements.

If an error was made and it materially affects the company’s financial statements, then the financials must be restated.

The author served for 12 years in the enforcement division of the US Securities and Exchange Commission, most recently as assistant chief litigation counsel in the division’s trial unit.

To determine whether an error was made, begin by listing where the experts disagree. Determine whether the differences can be reconciled. Is the problem that the experts disagree about the quantity of reserves or how to classify them? As discussed below, discrepancies in quantity estimation may result from the use of different methods of estimation. Discrepancies in reserve classification may be attributed to different opinions about the reasonable certainty of recoverability.

A clear case for restatement is one where the financials contain a material misstatement due to an error in either quantity estimation or classification of oil reserves. A more complicated situation arises when none of the differing opinions is necessarily wrong. In this latter situation, the best approach would be to confer with the SEC staff or else err on the side of full disclosure and include a footnote in the financials that explains the difference in opinion and the magnitude of the difference. If the financials have already been filed, then the explanation can be included in an SEC Form 8-K.

Why Care?

The booking of oil and gas reserves has taken on increased significance as a result of both new legislation and new regulatory policies.

The new developments that are playing a role include the Sarbanes-Oxley Act in 2002, the decision by the SEC enforcement division to scrutinize the oil and gas industry, and the ambiguities in SEC Rule 4-10(a), which defines how oil and gas reserves should be classified. Both officers and directors of oil and gas companies are finding themselves under increasing regulatory and prosecutorial scrutiny and are potentially exposed to liability. This has led them, in turn, to seek the opinions of independent advisers and audit committees to confirm their estimates of reserves and the accounting for them. Unfortunately, the likelihood of disagreement rises along with the number of opinions sought.

Sections 302 and 404 of the Sarbanes–Oxley Act impose new responsibilities upon chief executives, chief financial officers and upper management. They require certification of the companies’ periodic reports to the SEC and the filing of internal control reports along with the companies’ annual reports.

The SEC requires that both the CEO and the CFO of a company certify for every report the company filed with the SEC that they have reviewed the report, it does not contain any material misrepresentations or omissions, the financial statements fairly present the financial condition and results of the company, they are responsible for establishing and maintaining disclosure controls and procedures and internal controls over financial reporting for the company, and they have disclosed any fraud and all significant deficiencies concerning the internal controls.

The SEC also requires management to provide an “internal control report” that contains a statement about the quality of the company’s internal controls. Management must confirm that it has responsibility for maintaining adequate internal controls over financial reporting. It must describe how it evaluates the effectiveness of the internal controls. It must give its assessment about whether the internal controls work. And it must state that the company’s auditor attested that the internal controls that the company has in place work. In sum, sections 302 and 404 of the Sarbanes-Oxley Act require public energy companies and their executives to stand by the financial statements of the company, ensure they are correct by implementing strong internal controls, and explain what those internal controls are and how effective they are.

The SEC increased its scrutiny of oil company reserves following the recent announcement by Shell Oil that it was restating its reserves. Officials from the SEC enforcement division said at an “SEC Speaks seminar” in Washington in early March that one of the enforcement practices to be expected in coming years is for the staff to examine several companies within an industry when the agency finds problems at just one company within the industry.

When to Restate

Unfortunately, the SEC has not explained how to estimate reserves. Not all companies or independent estimators use the same methods. Technology advances also contribute to differences in methods. Thus, there is room for a wide variety of conflicting opinions about reserve estimates.

However, SEC rules do explain how reserves should be classified. Classification of reserves involves determining whether a company’s oil and gas reserve estimates can be categorized as “proved oil and gas reserves,” and if so, whether they are developed or undeveloped. The definitions for these classifications are set out in what is referred to as SEC Rule 4-10(a).

Rule 4-10(a) defines “proved oil and gas reserves” as “the estimated quantities of crude oil, natural gas, and natural gas liquids which geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions, i.e., prices and costs as of the date the estimate is made.”

“Reasonable certainty” of recoverability is subjective and can easily be an area of disagreement among advisers. In 2001, the SEC staff attempted to explain what constitutes “reasonable certainty” by issuing an “interpretation and guidance” essentially stating that, in order for there to be reasonable certainty, there must be geological and engineering data supporting the amount of estimated proven reserves. Accordingly, more supporting data justifies classifying more reserves as proven, and less data requires a more conservative approach, whereby fewer estimated reserves are classified as proven. More recently, a member of the SEC staff defined “reasonable certainty” as situations where there is little doubt that the reserves could be higher.

In speeches to industry groups, SEC staff members have provided fairly objective examples of when reasonably certainty does not exist. Such certainty does not exist in a number of situations. One is where the assumptions are at odds with current economic and operating conditions. Another is where a company defers the same project year after year and appears unwilling or unable to proceed with production. A third is where management has not made a substantial financial commitment, does not have sufficient funds to make such a commitment, or lacks requisite legal permits or concessions to pursue the project.

In 2001, in a case called In re Triton Energy Ltd. Securities Litigation, a federal district court in Texas acknowledged similar indicia of a lack of reasonable certainty and refused to dismiss a civil compliant alleging that an oil company materially misstated its proved reserves. The facts that the court found significant were a lack of facilities to process and transport reserves to market, no commitment to install such facilities, no definitive contract, no success in obtaining a definitive contract despite repeated attempts, and no capital to overcome contingencies to obtaining a definitive contract.

Any company that is faced with different opinions about its reserve classifications should review the classifications in light of each of the factors listed above. This would go a long way toward determining whether sufficient “reasonable certainty” of recoverability exists in order to classify the reserves as “proven,” and would probably resolve most points upon which the advisers differ.

Conclusion

To sum up, differences in opinion concerning oil and gas reserve estimates and classification may result from errors or from the use of different methods, economic assumptions or geological and engineering data. These differences may be resolved through a review of the supporting methodologies, assumptions and data. If differences in estimation of proven reserves cannot be reconciled in this way, then they may be addressed by conferring with the SEC staff engineers responsible for oil and gas issues or by disclosing an explanation of the difference in either a note to the company’s financials or a Form 8-K. If a review reveals an error in the estimation of proven reserves, and that error materially affects the company’s financial statements, then they must be restated.