SEC Changes the Rules on Oil Reserves

The Securities and Exchange Commission yesterday announced that it has approved new rules to "modernize its oil and gas company reporting requirements." Well, modernization, like beauty, is in the eye of the beholder.

The SEC did not publish the new rules yet, but a 172-page draft was published in June that described the proposed changes. Here are some of the more general changes:

* Allows using new technology (3-D/4-D seismic) to calculate proved reserves, if the new technologies "have been demonstrated empirically" to accurately estimate reserve volumes.

* Allows companies to disclose probable and possible reserves to investors. Currently, only proved reserves are required to be disclosed.

* Allows companies to include resources such as oil sands as oil and gas reserves. Previously, these were counted as mining reserves.

* Requires valuation of the oil and gas reserves using an average price for the previous 12-months. Currently, reserves are valued at the market price on the last day of the reporting period.

The SEC indicated in its press release that the use of new technology to determine reserves has been adopted, as has the reporting of probable and possible reserves. Average pricing will replace end-of-year spot pricing to determine reserves valuation. The announcement does not indicate whether or not oil sands will be classified as oil and gas reserves, but it’s hard to believe that the SEC didn’t approve that change. The changes take effect on January 1, 2010.

Does any of this matter to investors? It should, and it does. The biggest impact will come from valuing reserves at an annual average rather than a spot price. Oil is likely to close 2008 at around $35/barrel. The 12-month average is certain to be much higher than that. This change alone could add billions to an oil company’s balance sheet.

Allowing companies to use new technology to determine proved reserves also benefits producers. Proved reserves are those which have a 90% chance of being produced economically. The key word here is "economically." At a price of $35/b for crude, it becomes uneconomic to produce many proved reserves. New 3-D/4-D technology is far cheaper than drilling to determine the extent of new reserves.

Producers will be able to report probable (50% chance of economic recovery) and possible (10% chance of economic recovery) reserves. This could be a good thing or a bad thing. Investors will need to pay close attention to movement among the reserves classes.

The addition of non-traditional reserves, such as oil sands, also needs to be watched closely. If the reserves are reported by type, then the new rule will add substantially to transparency. If, however, oil sands and shales can be lumped together with more traditional reserves, the new information is much less useful because the recovery techniques can be so different in both kind and cost.

Through its new rules, the SEC is moving toward a "principles-based" approach to accounting for reserves rather than a "rules-based" approach. This move parallels the current plan for the US to adopt the principles-based financial accounting practices currently followed in the European Union. Principles are tricky though, and one man’s principles could turn out to be another man’s poison.

Paul Ausick