Reserves Overbooking: The Problem We Are Finally Going To Talk About Grant T. Olsen, W. John Lee, and Thomas A. Blasingame, SPE, Texas A&M University Summary create even greater potential for reserves overstatements than in Oil and gas reserves estimates that honor disclosure require- the past. ments of the US Securities and Exchange Commission (SEC) Therefore, the magnitude and nature of recent alleged overstate- are critically important in the international oil and gas industry. ment cases, relative unfamiliarity with the SEC’s inner workings, Unfortunately, a number of exploration and production (E&P) and the SEC’s new reporting requirements together have created companies have allegedly overstated and subsequently written a need to discuss openly reserves disclosures and reserves over- down certain reserves volumes in recent years. In some cases, the statements. Overstatements are not confined to particular reserves consequences have been quite adverse. We document some of these categories, asset types or locations, or filer size. However, over- cases of reserves overstatements and summarize the consequences. statements are most likely to occur within the proved undeveloped Reserves write downs are of obvious interest to numerous groups (PUD) category. Reserves write downs can create nearly instanta- involved in the reserves estimation process and outcome, includ- neous value destruction for shareholders. A study of case histories ing estimators, managers, investors, creditors, and regulators. indicates that significant corporate and/or individual penalties may The magnitude and nature of recent overstatement cases, relative be associated with overstatements, along with the potential for unfamiliarity with the SEC’s inner workings, and the SEC’s new class-action lawsuits. reserves-reporting requirements increase the need to examine criti- Background cally reserves disclosures and reserves overstatements. By a recent SEC definition, oil and gas reserves “are estimated Disclaimer remaining quantities of oil and gas and related substances antici- This paper discusses write downs and alleged overstatements of pated to be economically producible, as of a given date, by appli- oil and gas reserves. Information used to write this report has been cation of development projects to known accumulations” (US obtained from extensive examination of the public record. Over- SEC 2008c). Reserves may be subdivided into proved, probable, statements and violations of federal securities laws and actions by a and possible categories according to the degree of uncertainty company or its representatives are only alleged in the public record, associated with recovery of the volumes. In addition to being and, unless stated otherwise, any settlements discussed should be dependent on the manner in which the term is defined, reserves considered as made without admission of guilt. Write downs can are also a function of numerous known and assumed technical readily happen with even the best of intentions. We authors—and factors including reservoir parameters, project costs, ownership, you readers—are not judge and jury. Our intent is to raise awareness and commodity prices. about write downs, overstatements, and observed consequences, Reserves volumes and values of publicly traded oil and gas and to promote the responsible reporting of oil and gas reserves. companies (e.g., on the New York Stock Exchange) are not directly reported on a company’s balance sheet but are rather attached to Overview of the Reserves Overbooking Issue financial statements. Barry (1993) considered it “odd” for reserves not to be reflected in the balance sheet. Furthermore, he observed A number of E&P companies have, in recent years, allegedly that “the volume of reserves is a corporation’s Black Hole. It exerts overstated and subsequently written down certain reserves volumes a huge influence on everything else in its orbit, yet emits very little reported to the US SEC. Operators including Shell, El Paso, Stone light.” Because reserves are not part of the balance sheet per se, Energy, and Repsol YPF, among others, have found themselves they are not subjected to audits by financial or accounting firms. in the spotlight—and courtroom—for alleged overstatements of However, filers commonly elect to have their reserves audited by their oil and gas reserves. Overstatements and write downs have third-party engineering firms. occurred for a variety of reasons and often have been accompanied Reserves are of significant importance to a variety of stake- by significant adverse consequences. A stigma and discomfort sur- holders including filers, investors, regulators, and politicians. rounding overstatements exists within industry, as the topic has An E&P company’s financial health depends in large part on its been labeled “the problem no one wants to talk about” (McLane stated oil and gas reserves. Financial measures such as finding and and Rose 2001). development costs, reserves-replacement ratio, reserves life index The SEC has roles, investigative processes, and enforcement and depreciation, depletion, and amortization are all impacted by procedures unlike any other organization involved with the oil a firm’s oil and gas reserves. Furthermore, reserves are a vital and gas industry. However, the SEC’s inner workings are not instrument toward gaining access to capital markets: Credit ratings frequently discussed or well understood by all of the groups depend on reserves volumes, and bankers will commonly lend that these rules affect. The SEC’s Modernization of Oil and Gas funds based on reserves as collateral. In his prepared testimony Reporting Requirements has made certain standards more flexible before the US House Committee on Financial Services on 21 July (e.g., elimination of the “one offset rule” and allowance of “reli- 2004, Dharan (2004a) stated that reported reserves of oil and gas able technologies”). Accordingly, engineers must now adjust to represented more than USD 3 trillion worth of value (and more these new guidelines and deal with the possibility of disclosing than 70% of a typical E&P company’s market value). In sum, many previously unrecognized asset value without overstating reserves. individuals and organizations have a great interest in the reporting The difficulty of this task, along with the technical “liberalization” of oil and gas reserves, and the quantities reported have important and an enhanced “principles-based” emphasis in the rules, could financial and geopolitical implications. The Evolution of Reserves Copyright © 2011 Society of Petroleum Engineers Given the somewhat disparate users and uses involved with oil This paper (SPE 134014) was accepted for presentation at the SPE Annual Technical and gas reserves, along with continuous advances in engineer- Conference and Exhibition, Florence, Tuscany, Italy, 20–22 September 2010, and revised ing and geological technology, the definition of reserves has for publication. Original manuscript received for review 24 June 2010. Paper peer approved 23 September 2010. been a moving target. The American Petroleum Institute created 68 April 2011 SPE Economics & Management definitions in 1936 as part of its annual studies of US oil reserves, the classification of reserves appropriate to the relevant definitions and the American Gas Association joined these studies in 1946 used, and the reasonableness of the estimated reserves quantities.” (Harrell and Gardner 2005). The Society of Petroleum Engineers The Modernization guidelines do not require reserves audits (SPE) first adopted definitions for proved reserves in 1964. In of E&P companies. Should a filer indicate that a third party con- 1975, the Energy Policy Conservation Act was passed, which led ducted an audit, process review, or any valuation of its reserves, to definitions for proved reserves from the SEC in 1978. SPE and however, the filer must make a number of disclosures regarding the World Petroleum Council (WPC) published their “Petroleum the third-party report. Specifically, the new regulations require “a Reserves Definitions” in 1997. That document had “seemingly brief summary of the third party’s conclusions with respect to the subtle but often important divergences in interpretation” with the reserves estimates” (US SEC 2008c). The guidance offered by SEC definitions (Harrell and Gardner 2005). In 2007, the SPE/ SPE’s 2007 Auditing Standards (SPE 2007), which does not have WPC/AAPG/SPEE released the Petroleum Resources Manage- the force of law but is mentioned in the “Supplementary Informa- ment System, which sets forth an international standard for the tion” section of the new SEC rules, states that in rendering an definitions, codification, and evaluation of oil and gas reserves opinion on the reasonableness of the estimated reserves, quantities (SPE/WPC/AAPG/SPEE 2007). Although numerous organizations and value “should reflect a quantity and/or value difference of not have weighed in on reserves definitions and filers are free to report more than plus or minus 10%, or the subject reserves information reserves internally as they see fit, the SEC definitions are the does not meet minimum recommended audit standards.” This ± legal standard by which filers must report their proved oil and gas 10% variation may be interpreted as the amount by which quali- reserves if they list their securities on US Exchanges. fied professionals can reasonably be expected to disagree when independently estimating reserves using identical information. SEC Modernization