SEC Issues Final Rule on Modernization of Oil and Gas Reporting
Submitted by Robert S. Ballentine, Daniel M. McClure, Laura Ann Smith (Houston) and Harva R. Dockery (Dallas), Fulbright & Jaworski L.L.P.
On December 31, 2008, the Securities and Exchange Commission (SEC) issued its revised disclosure requirements for oil and gas reserves contained in its Regulation S-K and Regulation S-X under the Securities Act of 1933, the Securities Exchange Act of 1934 and Industry Guide 2. This final rule and interpretation was published in the Federal Register on January 14, 2009 (Final Rule). 74 Fed. Reg. 2157. This article provides a comprehensive analysis of the new rules.
In short, the Final Rule modifies the SEC’s reporting and disclosure rules for oil and gas reserves by, most notably:
Replacement of the Year-End Pricing Assumption. Changing the pricing assumptions from the prior use of single day year-end price to the use of average prices during the 12-month period prior to the ending date of the period covered by the SEC report, calculated as the unweighted arithmetic average of the first-day-of-the-month price for each month within such period, unless prices are defined by contractual arrangements, excluding escalations based upon future conditions.
Permitting Voluntary Disclosure of Probable and Possible Reserves. Permitting the voluntary disclosure of probable and possible reserves, previously prohibited by SEC rules.
Proved Undeveloped Reserves (PUD) Disclosure Standard. Easing the standard for the inclusion of proved undeveloped reserves (PUDs), and requiring disclosure of information indicating any progress toward the development of PUDs.
Defining Reasonable Certainty. Defining "reasonable certainty."
Reliable Technologies. Expanding the range of acceptable technologies used to reliably estimate a company’s reserves.
Reserves Estimators’ and Auditors’ Qualifications. Requiring the disclosure of the qualifications of those persons responsible for a company’s reserves estimates and audits.
Foreign Reserves Disclosure. Requiring disclosure of reserves in each foreign country where more than 15% of a company’s global proved reserves, in barrels of oil equivalent (BOE), are situated.
Expanding Definition of Producing Activities. Defining "oil and gas producing activities" to divert attention away from the extraction technology used and shifting it to the resulting final product.
BACKGROUND
The Final Rule was preceded by the SEC’s Concept Release, issued by on December 12, 2007. See 72 Fed. Reg. 71610 (Dec. 18, 2007), corrected, 73 Fed. Reg. 8836 (Feb. 15, 2008). Encouraged by the many industry participants who had expressed concern that the SEC’s disclosure rules were out of synch with current industry practices, the Concept Release contemplated revisions to the definition of "proved reserves", including the criteria used to assess and quantify resources that can be classified as proved reserves, and expanding the categories of resources that may be disclosed in SEC filings to include resources other than proved reserves. It considered whether revised disclosure rules should be modeled on any particular resource classification framework currently being used within the oil and gas industry, whether any revised disclosure rules could be made flexible enough to address future technological innovation and changes within the oil and gas industry, and whether the SEC should require independent third-party assessments of reserves estimates that a company includes in its filings.
The Concept Release was followed by the SEC’s June 27, 2008 issuance of the proposing release, Release No. 33-8935, et seq., 73 Fed. Reg. 39525 (Jul. 9, 2008), in which it contemplated:
(A) allowing disclosure of probable and possible reserves;
(B) the use of average historical prices to represent existing economic conditions to determine the economic producibility of oil and gas reserves for disclosure purposes while continuing to use a single day year-end price to determine the economic producibility of reserves for accounting purposes;
(C) including bitumen, oil shales, and other resources in the definition of "oil and gas producing activities";
(D) expansion of the types of technology that a company may use to establish reserves estimates and categories;
(E) removing the "certainty" element from the definition of proved undeveloped reserves (PUDs); and
(F) the disclosures required by the proposed definition of “geographic location.”
REGULATION S-K
Introduction of New Subpart 1200, Codifying Industry Guide 2
The Final Rule adds a new Subpart 1200 to Regulation S-K for companies engaged in oil and gas producing activities. Subpart 1200 substantially follows Industry Guide 2, but includes certain revisions and enhancements. As explained in the Final Rule, the SEC revised these requirements to make them more current, to provide better clarity regarding the level of geographic area, and other, detail required when a company makes oil and gas disclosures, and to provide the formats for the tabular presentation of oil and gas disclosures. The following new disclosure requirements are contained in Subpart 1200:
(1) disclosure of reserves from non-traditional sources (e.g., bitumen, shale, and coal) as oil and gas reserves;
(2) disclosure of the development of proved undeveloped reserves;
(3) disclosure of technologies used to establish additions to reserves estimates;
(4) disclosure of a company's internal controls over reserves estimation and the qualifications of the business entity or individual preparing or auditing the reserves estimates;
(5) disclosure based on a new definition of the term "by geographic area";
(6) optional disclosure of probable and possible reserves; and
(7) optional disclosure of oil and gas reserves’ sensitivity to price.
General Instructions (Item 1201)
When presenting reserves disclosures by geographic area and seeking to comply with Regulations S-K's Item 103 Instruction 3, oil and gas companies have inconsistently interpreted the level of specificity required, according to the SEC. Currently, some companies organize their reserves by hemisphere or by continent. SFAS 69 requires reserves to be disclosed separately for the company's home country and foreign geographic areas, defining "foreign geographic areas" as "individual countries or groups of countries as appropriate for meaningful disclosure in the circumstances." The operations of oil and gas companies have become much more diversified globally since SFAS 69 was first issued.
The Final Rule’s definition of "by geographic area" is nearly identical to that contained in SFAS 69, except the Final Rule applies specific percentage thresholds. The Final Rule requires disclosure of production in each country or field containing 15% or more of the company’s proved reserves unless prohibited by the country in which the reserves are located and requires field disclosure of production to 15% to make the threshold consistent. Rather than requiring disclosure based on a percentage of the amount of a company’s reserves of an individual product, the Final Rule requires disclosure based on a percentage of a company’s total global oil and gas proved reserves, based on barrels of oil equivalent. For many oil and gas producers in the United States, the majority of their reserves now are located overseas, with material amounts in individual countries and even individual fields or basins.'
Disclosure of Reserves (Item 1202)
Item 1202 was added by the Final Rule which expands on the requirements of Item 102 by specifically permitting the disclosure of probable and possible reserves and permitting the disclosure of reserves from non-traditional sources. The Final Rule no longer distinguishes between types of accumulations, with disclosures of different final products (e.g., oil, gas, synthetic oil, synthetic gas, and other natural resources) sold by a company being disclosed. Item 1202 requires disclosure of reserves estimates in the aggregate and by geographic area using prices and costs under existing economic conditions, for each product type, in the following categories:
Proved developed reserves;
Proved undeveloped reserves;
Total proved reserves;
Probable developed reserves (optional);
Probable undeveloped reserves (optional);
Possible developed reserves (optional); and
Possible undeveloped reserves (optional).
Disclosures of proved developed reserves, proved undeveloped reserves and total proved reserves, made in tabular form, are mandatory. Disclosures of probable developed and undeveloped reserves and possible developed and undeveloped reserves are optional. The disclosures are to be presented by geographic area and for each country containing 15% or more of a company’s overall proved reserves.
At its option, a company may include a reserves sensitivity analysis table in its disclosures. If a company includes such a table, it may choose the different scenarios that it wishes to disclose, but must also disclose the price and cost schedules and assumptions on which the alternate reserves estimates are based. The SEC explained that a company disclosing a reserves sensitivity analysis table should also discuss in its MD&A known trends and uncertainties, including any revisions to prices and costs to the extent they may be used in alternate reserves estimates.
Optional Disclosure of Probable and Possible Reserves
A company may choose, but is not required, to disclose its probable or possible reserves. If a company discloses probable or possible reserves, it must provide the same level of geographic detail it must provide with respect to its proved reserves and must state whether the reserves are developed or undeveloped. Item 1202 also requires a company to disclose the relative uncertainty associated with these classifications of reserves estimations. By permitting disclosure of all three of these classifications of reserves, a company may provide investors with greater insight into the potential reserves base that their managements may use as a basis for considering investment in resource development.
Resources Not Considered Reserves
Because disclosure of probable and possible reserves is permitted under the Final Rule, Instruction 5 to Item 102 of Regulation S-K has been revised in the Final Rule to continue to prohibit disclosure of estimates of oil or gas resources other than reserves, and any estimated values of such resources, in any document publicly filed with the Commission, unless such information is required to be disclosed in the document by foreign or state law.
Historically the disclosure of resources other than reserves has been prohibited because such resources are too speculative and may lead investors to incorrect conclusions. However, a company may continue to disclose such estimates of non-reserves resources in an SEC filing related to an acquisition, merger, or consolidation if the company previously provided those estimates to a person who is offering to acquire, merge, or consolidate with the company or otherwise to acquire the company's securities.'
Preparation of Reserves Estimates or Reserves Audits
A company must provide a general discussion of the internal controls that it uses to assure objectivity in the reserves estimation process and disclosure of the qualifications of the technical person primarily responsible for preparing the reserves estimates or conducting the reserves audit if the company discloses that such a reserves audit has been performed. This is true regardless of whether the technical person is an employee or an outside third party.
Although the Final Rule does not require an oil and gas company to engage an independent third party to prepare reserves estimates or conduct reserves audits, whether a company prepares its own reserves estimates or engages a third party to conduct an audit, the Final Rule requires disclosure of the qualifications of the chief technical person who oversees the company's overall reserves estimation process. In addition, a company must provide a general discussion of the internal controls it maintains to assure the objectivity of the estimate or audit. The internal controls include technical assessment routines, management and board review and approval processes, internal audit processes, external audit frequency, and qualification standards of typical reserves estimators. If a company represents that its estimates of reserves are based on estimates prepared by a third party or that a third party conducted a reserves audit, the company must file a summary report of the third party as an exhibit to the relevant registration statement or report.
Proved Undeveloped Reserves – PUDs (Item 1203)
The SEC proposed requiring tabular disclosure of the aging of proved undeveloped reserves (PUDs). As proposed, Item 1203 would have required an oil and gas company to prepare a table showing, for each of the last five fiscal years and by product type, proved reserves estimated using current prices and costs in the following categories:'
(1) Proved undeveloped reserves (PUDs) converted to proved developed reserves during the year; and
(2) Net investment required to convert proved undeveloped reserves (PUDs) to proved developed reserves during the year.
Instead of a table, the Final Rule requires a company to disclose the following in a narrative format:
(1) The total quantity of PUDs at year end;
(2) Any material changes in PUDs that occurred during the year, including PUDs converted into proved developed reserves;
(3) Investments and progress made during the year to convert PUDs to proved developed oil and gas reserves; and
(4) An explanation of the reasons why material concentrations of PUDs in individual fields or countries have remained undeveloped for five years or more after disclosure as PUDs.
These disclosures would have been required under the proposal, but much of it would have been presented in tabular format. Rather than requiring forward-looking information about a company’s plans to develop reserves that may lead to exaggeration of a company's capability to actually convert such reserves, the SEC explained that disclosure of a company's verifiable, established track record of converting such reserves, including its ability to obtain financing for such activities, would be a better indication of the likelihood of that company's success in developing reserves in the future. Specific disclosures that are required regarding a company’s failure to develop material concentrations of PUDs for five or more years address concerns that a company may have no intention to develop such reserves.
The SEC proposed requiring a table disclosing for each of the last five years the amount of PUDs converted to proved developed reserves and the net investment in conversion of PUDs into proved developed reserves during the year. The proposing release issued in June 2008, also would have required a discussion of plans to develop PUDs in the future. Under the Final Rule, however, oil and gas companies are only required to include a narrative disclosure of the total quantity of PUDs at year end, any material changes in PUDs during the year (including by conversion to proved developed reserves), and investments and progress made in converting PUDs during the year. A company must also explain why any material concentrations of PUDs in individual fields or countries have remained undeveloped for five years or more after disclosure as PUDs.
Currently, the definition of the term "proved undeveloped reserves" imposes a "reasonable certainty" standard for oil and gas reserves located in drilling units contiguous to a drilling unit containing a producing well and a "certainty" standard for reserves located in drilling units located beyond the contiguous drilling unit. This higher "certainty" standard has prevented companies from booking reserves that are not located in drilling units immediately adjacent to drilling units containing a producing well, so the Final Rule replaces this "certainty" standard with a "reasonable certainty" standard for areas located beyond the contiguous drilling unit. Therefore, a uniform standard becomes applicable to all proved reserves.
The SEC originally proposed to impose a five-year general limitation on maintaining undeveloped reserves, but in recognition of the fact that certain projects take more than five years to develop, the Final Rule allows reserves that have remained undeveloped for more than five years to be included when specific circumstances warrant their inclusion, provided those circumstances are disclosed as well. The Final Rule also requires a company to provide additional disclosures regarding the aging of and any material changes in its proved undeveloped reserves.
Oil and Gas Production (Item 1204)
The Final Rule codifies the SEC's current Industry Guide 2 disclosure item with several revisions. Consistent with Industry Guide 2 disclosures, Item 1204 requires, for each of the prior three fiscal years, disclosure of a company's production of oil, gas, and other products by final product sold. For the same period of time, a company must also disclose, by geographical area:
(1) average sales price (including transfers) per unit of oil, gas and other products produced; and
(2) average production cost, not including ad valorem and severance taxes, per unit of production.
Unlike Industry Guide 2's disclosure item, however, this disclosure must be made by geographical area and for each country and field containing 15% or more of the registrant's proved reserves, expressed on an oil-equivalent-barrels basis. The instructions codified from Industry Guide 2 include:
(1) net production should include only production that is owned by the registrant and produced to its interest, less royalties and production due others, but in special situations (e.g., foreign production), net production before any royalties may be provided, if more appropriate. If "net before royalty" production figures are furnished, the change from the usage of "net production" should be noted.
(2) production of natural gas should include only marketable production of natural gas on an "as sold" basis and production will include dry, residue, and wet gas, depending on whether liquids have been extracted before the registrant transfers title. Flared gas, injected gas, and gas consumed in operations should be omitted. Recovered gas-lift gas and reproduced gas should not be included until sold. Synthetic gas, when marketed as such, should be included in natural gas sales.
(3) the transfer price of oil and gas (natural and synthetic) produced should be determined in accordance with SFAS 69.
(4) the average production cost per unit of production, including products from unconventional sources, should be computed using production costs disclosed pursuant to SFAS 69, and units of production should be expressed in common units of production with oil, gas, and other products converted to a common unit of measure on the basis used in computing amortization.
Another instruction, which is not contained in the Industry Guide 2 (which only requires separate disclosure based on whether the end product was oil or gas), permits the disclosure of reserves of other end products such as bitumen:
(5) if any product, such as bitumen, is sold or custody is transferred prior to conversion to synthetic oil or gas, the product’s production, transfer prices, and production costs should be disclosed separately from all other products.
Drilling and Other Exploratory and Development Activities (Item 1205)
The SEC's Industry Guide 2 disclosure item regarding drilling activities has been codified in the Final Rule as Item 1205 of Regulation S-K, with revisions that include the application of a new definition of the term "geographic area" and the addition of extension wells and suspended wells.
Under the Final Rule, drilling activities must be disclosed as provided in Industry Guide 2, without requiring tabular disclosure. However, because oil and gas resources extracted by mining techniques are encompassed by the Final Rule's definition of "oil and gas producing activities," a company must discuss its exploratory and development activities regarding those resources.
Present Activities (Item 1206)
Item 1206 of Regulation S-K codifies the required disclosure of a company's present activities, including the number of wells it is in the process of drilling (including wells temporarily suspended), waterfloods it is in the process of installing, any pressure maintenance operations, and any other related activities of material importance.
Delivery Commitments (Item 1207)
Item 1207 of Regulation S-K requires disclosure of arrangements under which a company is required to deliver specified amounts of oil or gas and how the company intends to meet such commitments.
Oil and Gas Properties, Wells, Operations, and Acreage (Item 1208)
Item 1208 of Regulation S-K codifies the existing Industry Guide 2 disclosure, defining "gross well or acre", "net well or acre", "productive wells", "undeveloped acreage" and calling for disclosure of (a) the total gross and net productive wells, as of a reasonably current date or as of the end of the fiscal year, expressed separately for oil and gas (including synthetic oil and gas produced through wells) and the total gross and net developed acreage (i.e., acreage assignable to productive wells) by geographic area and (b) the amount of undeveloped acreage, both leases and concessions, if any, expressed in both gross and net acres by geographic area, as of a reasonably current date or as of the end of the fiscal year, together with an indication of acreage concentrations and, if material, the minimum remaining terms of leases and concessions.
Management’s Discussion and Analysis (MD&A) (Proposed Item 1209)
Item 1209 of Regulation S-K – which identified topics that a company should address in either its "Management's Discussion and Analysis of Financial Condition and Results of Operations" (MD&A) or a separate section – was proposed but not codified in the Final Rule. Choosing to describe Item 1209 as a guidance, rather than a specific disclosure Item, the SEC indentifies several topics that an oil and gas company should consider discussing in its MD&A, if material, including:
(1) changes in reserves and the sources of such changes, such as price changes, technical revisions and changes in the status of any concessions;
(2) technologies used to establish the appropriate level of certainty for any material additions or increases in reserves, including those that are the result of the adoption of the final rules;
(3) prices and costs, including the impact on depreciation, depletion and amortization and the full-cost ceiling test;
(4) performance of currently producing wells, including water production from such wells and the need to use enhanced recovery techniques to maintain production;
(5) a company's recent ability to convert PUDs to proved developed reserves, and, if disclosed, probable reserves to proved reserves and possible reserves to probable and proved reserves;
(6) the minimum remaining terms of leases and concessions;
(7) material changes to any line item in its tabular disclosures under the final rules; and
(8) geopolitical risks that apply to material concentrations of reserves.
Foreign Private Issuers – Conforming Changes to Form 20-F
Form 20-F is the form on which foreign private issuers file their annual reports and Exchange Act registration statements. Form 20-F currently contains instructions that are similar to those in Item 102 of Regulation S-K. However, Form 20-F contains its own "Appendix A to Item 4.D – Oil and Gas" (Appendix A) that provides guidance for oil and gas disclosures for foreign private issuers. Appendix A is significantly shorter, and provides far less guidance regarding disclosures, than Subpart 1200 or Industry Guide 2.
Subpart 1200 would be appropriate disclosure for all public companies engaged in oil and gas producing activities, including foreign private issuers, according to the Final Rule. The added guidance contained in Subpart 1200 promotes more consistent and comparable disclosures among oil and gas companies. The SEC understood that many larger foreign private issuers already provide disclosure in their filings with the SEC comparable to the disclosure provided by domestic companies. Thus, the SEC has revised Form 20-F to incorporate Subpart 1200 with respect to oil and gas disclosures and deleted Appendix A to Item 4.D.
A foreign private issuer may be required to prepare two different reserves estimates if the rules in its home jurisdiction specify a different pricing standard than the 12-month average adopted in the Final Rule. However, the SEC believes the same conflict would have existed under its previous rule to the extent the SEC's pricing method differed from the foreign private issuer’s home jurisdiction's method.
The new disclosures would not apply to foreign private issuers under the Multi-Jurisdictional Disclosure System (MJDS) using Form 40-F that comply with NI 51-101 in Canada because those rules already are broadly consistent with PRMS. Thus, the Final Rule does not require those issuers to provide disclosures beyond those required in Canada.
Change in Accounting Principle or Estimate – No Retroactive Revisions Required
The Final Rule does not require retroactive revision of past reserves estimates. According to the Final Rule, the change from mining treatment to oil and gas treatment for those resources formerly considered mining activities is regarded as a change in accounting principle that is inseparable from a change in accounting estimate, which does not require a retroactive revision.
In the Final Rule, the SEC indicates that it will continue to work with the FASB on the issue of whether the FASB should revise Statement of Financial Accounting Standard No. 19 (SFAS 19) to include unconventional resources currently accounted for as mining activities, and provide guidance that no retroactive revisions are required for those resources.
Capitalization Thresholds for Mining Activities vs. Oil and Gas Producing Activities
Under the Final Rule, the extraction of products such as bitumen are considered oil and gas producing activities rather than mining activities. Under current United States accounting guidance, the costs associated with proven plus probable mining reserves may be capitalized for operations extracting products through mining methods, like bitumen. The Final Rule treats bitumen extraction and operations that produce oil or gas through mining methods as subject to oil and gas accounting rules, which only permit capitalization of costs associated with proved reserves. Because mining guidelines do not specify percentages to establish levels of certainty for proven or probable reserves for mining activities, it is conceivable that these differences may result in different reserves estimates for these resources upon the implementation of the Final Rule.
REGULATION S-X
Rule 4-10 Definitions Revised and Supplemented
With its revisions and additions to Rule 4-10(a) of Regulation S-X, 17 CFR 210.4-10(a), the SEC updated its definitions of reserves to reflect changes in the oil and gas industry and markets and new technologies that have occurred since its current rules were adopted between 1978 and 1982. Many of the revised definitions are designed to be consistent with the Petroleum Resource Management System (PRMS) sponsored by the Society of Petroleum Engineers (SPE), the American Association of Petroleum Geologists (AAPG), the World Petroleum Council (WPC), and the Society of Petroleum Evaluation Engineers (SPEE). Regulation S-X, as amended by the Final Rule, includes the following array of definitions found in 17 CFR §210.4-10(a):
(1) Acquisition of properties – formerly 17 CFR §210.4-10(a)(14)
(2) Analogous reservoir – newly added by the Final Rule
(3) Bitumen – newly added by the Final Rule
(4) Condensate – newly added by the Final Rule
(5) Deterministic estimate – newly added by the Final Rule
(6) Developed oil and gas reserves – newly added by the Final Rule
(7) Development costs – formerly 17 CFR §210.4-10(a)(16)
(8) Development project – newly added by the Final Rule
(9) Development well – formerly 17 CFR §210.4-10(a)(11)
(10) Economically producible – newly added by the Final Rule
(11) Estimated ultimate recovery – newly added by the Final Rule
(12) Exploration costs – formerly 17 CFR Å210.4-10(a)(15)
(13) Exploratory well – formerly 17 CFR §210.4-10(a)(10), newly revised
(14) Extension well – newly added by the Final Rule
(15) Field – formerly 17 CFR §210.4-10(a)(8)
(16) Oil and gas producing activities – formerly 17 CFR §210.4-10(a)(1), newly revised
(17) Possible reserves – newly added by the Final Rule
(18) Probable reserves – newly added by the Final Rule
(19) Probabilistic estimate – newly added by the Final Rule
(20) Production costs – formerly 17 CFR §210.4-10(a)(17)
(21) Proved area – formerly 17 CFR §210.4-10(a)(7)
---- [Proved developed oil and gas reserves – formerly 17 CFR §210.4-10(a)(3), but now deleted]
(22) Proved oil and gas reserves – formerly 17 CFR §210.4-10(a)(2), newly revised
(23) Proved properties – formerly 17 CFR §210.4-10(a)(5)
---- [Proved undeveloped reserves – formerly 17 CFR §210.4-10(a)(4), but now deleted]
(24) Reasonable certainty – newly added by the Final Rule
(25) Reliable technology – newly added by the Final Rule
(26) Reserves – newly added by the Final Rule
(27) Reservoir – formerly 17 CFR §210.4-10(a)(9)
(28) Resources – newly added by the Final Rule
(29) Service well – formerly 17 CFR §210.4-10(a)(12)
(30) Stratigraphic test well – formerly 17 CFR §210.4-10(a)(13), newly revised
(31) Undeveloped oil and gas reserves – newly added by the Final Rule
(32) Unproved properties – formerly 17 CFR §210.4-10(a)(6)
Among other things, the revisions to the Regulation S-X definitions address four fundamental issues that have been of particular interest to companies, investors, and securities analysts:
(1) use of single-day year-end pricing to determine the economic producibility of reserves;
(2) exclusion of activities related to the extraction of bitumen and other "non-traditional" resources from the definition of oil and gas producing activities;
(3) limitations regarding the types of technologies that an oil and gas company may rely upon to establish the levels of certainty required to classify reserves; and
(4) limitation in the current rules that permits oil and gas companies to disclose only their proved reserves.
The 12-Month Average Price Mechanism for Oil and Gas Reserves Estimation
The Final Rule defines the term "proved oil and gas reserves" in part as "those quantities of oil and gas, which, by analysis of geoscience and engineering data, can be estimated with reasonable certainty to be economically producible – from a given date forward, from known reservoirs, and under existing economic conditions, operating methods, and government regulations – prior to the time at which contracts providing the right to operate expire, unless evidence indicates that renewal is reasonably certain, regardless of whether deterministic or probabilistic methods are used for the estimation." 17 CFR §210.4-10(a)(22).
When calculating economic producibility, a company must use a 12-month average price, calculated as the "unweighted arithmetic average of the first-day-of-the-month price for each month within such period, unless prices are defined by contractual arrangements, excluding escalations based upon future conditions." 17 CFR §210.4-10(a)(22)(v).
The objective of reserves estimation is to provide the public with comparable information about volumes, not fair value, of a company's reserves available to enable investors to compare the business prospects of different companies. The use of a 12-month average historical price to determine the economic producibility of reserves quantities increases comparability between companies' oil and gas reserve disclosures, while mitigating any additional variability that a single-day price may have on reserve estimates.
These measures do not attempt to portray a reflection of their fair value. A pricing system that incorporates assumptions about estimated future market prices and costs related to extraction could be a more appropriate basis for estimation if the objective of reserve disclosures were to provide fair value information.
Prices Used for Disclosure vs. Accounting Purposes
The SEC explained that the Final Rule revises both its disclosure rules and its full-cost accounting rules related to oil and gas reserves by utilizing a single price based on a 12-month average. The SEC noted that it will continue to communicate with the FASB staff to align their accounting standards with the Final Rule. As its revisions are discussed with the FASB, the SEC will consider whether to delay the Final Rule’s compliance date further.
Alternate Pricing Schemes – Futures Prices and Fair Value of Reserves
The SEC rejected comments suggesting that oil and gas futures prices, or management’s forecast of future prices, would better represent the value of the reserves and be better aligned with fair value of the reserves.
The reserves estimates in the SEC's disclosure rules are not designed to be, nor are they intended to represent, an estimation of the fair market value of the reserves. Rather, the reserves disclosures are intended to provide investors with an indication of the relative quantity of reserves that is likely to be extracted in the future using a methodology that minimizes the use of non-reserves-specific variables. By eliminating assumptions underlying the pricing variable, as any historical pricing method would do, investors are able to compare reserves estimates where the differences are driven primarily by reserves-specific information, such as the location of the reserves and the grade of the underlying resource. Energy markets are continuing to develop. Therefore, the SEC stated that it was not adopting a rule that requires companies to use futures prices to estimate reserves at this time.
Time Period Over Which the Average Price is to be Calculated
The SEC is adopting a pricing formula based on the average of prices at the beginning of each month in the 12-month period prior to the end of the reporting period. The use of first-of-the-month prices would provide companies with one month more to prepare the reserves disclosures, while still aligning the time period with the fiscal year.
The Final Rule replaces the SEC's current single-day, end-of-period spot commodity price for the determination of whether resources are "economically producible" based on "current economic conditions." To reflect current economic conditions more appropriately and maintain consistency with industry standards, the Final Rule generally requires reserve estimates to be calculated based on a historical average price, which must be calculated as the unweighted average of the closing prices on the first day of each month in the prior 12-month reporting period. The Final Rule also will permit a company to use prices set by contractual arrangements, excluding escalations based on future conditions, in lieu of a 12-month average price, if such arrangements are applicable. The SEC believes that the historical average price will preserve a high level of comparability among oil and gas companies while reducing the effects of increased year-end commodity price volatility.
“Oil and Gas Producing Activities" – Bitumen and Other Non-Traditional Resources
The SEC's current definition of "oil and gas producing activities" explicitly excludes sources of oil and gas from "non-traditional" or "unconventional" sources such as bitumen extracted from oil sands, and oil and gas extracted from coal and shales. The Final Rule revises the definition of "oil and gas producing activities", 17 CFR §210.4-10(a)(16), to include activities relating to the processing or upgrading of natural resources from which synthetic oil or gas can be extracted, but the definition continues to exclude:
(1) transporting, refining, processing (other than field processing of gas to extract liquid hydrocarbons by the company and the upgrading of natural resources extracted by the company other than oil or gas into synthetic oil or gas) or marketing oil and gas;
(2) the production of natural resources other than oil, gas, or natural resources from which synthetic oil and gas can be extracted; and
(3) the production of geothermal steam.
The Final Rule's definition of "oil and gas producing activities" is intended to draw attention to the final product of the activity, irrespective of the extraction technology utilized. Oil and gas producing activities include the extraction of saleable hydrocarbons, in a solid, liquid, or gaseous state, from oil sands, shale, coalbeds, or other nonrenewable natural resources which are intended to be upgraded into synthetic oil or gas, and activities undertaken with a view to such extraction. The final product is saleable if it is in a state in which it can be sold even if there is no ready market for that hydrocarbon product in the geographic location of the project. Thus, the absence of a market does not preclude the activity from being considered an oil and gas producing activity, but in order to claim reserves for that final product, there must be a market or a reasonable expectation of a market for that final product.
Distinguishing between traditional and unconventional resources can be material to investors because unconventional resources often involve significantly different economics and company resources than oil and gas from traditional wells.
The distinction between a company's traditional and unconventional activities is an important one from an investor's perspective because many of the unconventional activities are costlier and, therefore, have a much higher threshold of economic producibility. Therefore, Item 1202, discussed above, was revised to require separation of reserves based on final product, and distinguishing between final products that are traditional oil or gas from final products of synthetic oil or gas.
"Proved Oil and Gas Reserves"
The Final Rule significantly revises the definition of "proved oil and gas reserves." The price used to establish economic producibility is based upon the average price during the 12-month period prior to the ending date of the period covered by the report, determined as an unweighted arithmetic average of the first-day-of-the-month price for each month within such period. If the price is set by contractual arrangements, the appropriate price to use for establishing economic producibility is the price set by those contractual arrangements. A company may claim proved reserves beyond those development spacing areas that are immediately adjacent to developed spacing areas if the company can establish with reasonable certainty, as defined in 17 CFR §210.4-10(a)(24), that these reserves are economically producible, as defined in 17 CFR §210.4-10(a)(10).
"Reasonable Certainty"
The Final Rule incorporates the "high degree of confidence" standard found in the PRMS, which means that the recovery of the estimated quantities is “much more likely to be achieved than not and, as changes due to increased availability of geoscience (geological, geophysical, and geochemical), engineering, and economic data are made to estimated ultimate recovery (EUR) with time, reasonably certain EUR is much more likely to increase or remain constant than to decrease.” If deterministic methods are used, “reasonable certainty” means a high degree of confidence that the estimated quantities will be recovered. If probabilistic methods are used, there should be at least a 90% probability that the quantities actually recovered will equal or exceed the estimate.
"Developed Oil and Gas Reserves"
The SEC proposed to define the term "proved developed oil and gas reserves" as proved reserves that:
(1) in projects that extract oil and gas through wells, can be expected to be recovered through existing wells with existing equipment and operating methods; and
(2) in projects that extract oil and gas in other ways, can be expected to be recovered through extraction technology installed and operational at the time of the reserves estimate.
Consistent with the PRMS, which is expected to improve compliance with the SEC's Final Rule – and consistent with the SEC's current definition of the term "proved undeveloped reserves" (PUDs) which includes reserves on which a well exists but a relatively "major" expenditure is required for recompletion – reserves are considered developed if the cost of any required equipment is relatively minor compared to the cost of a new well or the installed equipment. The Final Rule also provides that reserves are developed if the cost of any required equipment is relatively minor compared to the cost of a new well.
"Undeveloped Oil and Gas Reserves"
The definition of the term "proved undeveloped oil and gas reserves" replaced the current "certainty" test for reserves in areas located beyond one offsetting drilling unit from a productive well with the same, less rigorous, "reasonable certainty" test applicable to reserves located in drilling units immediately adjacent to the drilling unit containing a producing well. This same standard – "reasonable certainty" – applies to all proved reserves under the Final Rule.
The Final Rule allows the recognition of reserves in projects that are expected to run more than five years, regardless of whether existing circumstances are "unusual." Item 1203 of Regulation S-K would require a company to disclose why such undeveloped reserves have not been developed.
The term "undeveloped oil and gas reserves" permits the use of techniques that have been proved effective by actual production from projects in the same reservoir or an analogous reservoir or "by other evidence using reliable technology that establishes reasonable certainty."
"Reliable Technology"
A company currently must use actual production or flow tests to meet the "reasonable certainty" standard needed to establish the proved status of its reserves and satisfy bright line tests for determining fluid contacts, such as lowest known hydrocarbons and highest known oil, which establish the volume of the hydrocarbons in place. As defined in the Final Rule, "reliable technology" permits the use of technology (including computational methods) that has been field tested and has demonstrated consistency and repeatability in the formation being evaluated or in an analogous formation. The SEC eliminated the requirement that "reliable technology" had to be "widely accepted" and further eliminated the bright line 90% success rate threshold from the Final Rule.
Disclosure of Technologies Used
The required disclosure of technologies used is limited to a concise summary of the technology or technologies used to create the estimate. No company will be required by the Final Rule to disclose proprietary technologies, or a proprietary mix of technologies, at a level of specificity that would cause competitive harm. Rather, the disclosure may be more general.
A company need not disclose the technologies relied upon to establish reserves previously disclosed by it under SEC rules because the permitted technologies had been limited to those permitted by the SEC's prior rules.
Unproved Reserves
When producing an estimate of the amount of oil and gas that is recoverable from a particular reservoir, a company can make three types of estimates:
(1) an estimate that is reasonably certain;
(2) an estimate that is as likely as not to be achieved; and
(3) an estimate that might be achieved, but only under more favorable circumstances than are likely.
These three types of estimates are known in the industry as (1) proved, (2) proved plus probable, and (3) proved plus probable plus possible reserves estimates. Under the Final Rule, a company may disclose its probable and possible reserves.
"Probable Reserves"
The Final Rule defines "probable reserves" as those additional reserves that are less certain to be recovered than proved reserves but which, in sum with proved reserves, are as likely as not to be recovered. When deterministic methods are used, it is as likely as not that actual remaining quantities recovered will equal or exceed the sum of estimated proved plus probable reserves. Consistent with the 50% threshold contained in the PRMS, when probabilistic methods are used, there must be at least a 50% probability that the actual quantities recovered will equal or exceed the proved plus probable reserves estimates.
"Possible Reserves"
The Final Rule defines "possible reserves" as including those additional reserves that are less certain to be recovered than probable reserves. When deterministic methods are used, the total quantities ultimately recovered from a project have a low probability to exceed the sum of proved, probable, and possible reserves. Consistent with the 10% threshold contained in the PRMS, when probabilistic methods are used, there must be at least a 10% probability that the actual quantities recovered will equal or exceed the sum of proved, probable, and possible estimates.
Disclosure of Unproven Reserves May Benefit Small Producers and Increase Litigation Risk
In the Final Rule's discussion of costs and benefits, the SEC suggests that a company's disclosure of probable and possible reserves, if it elects to do so, will allow investors, creditors, and others to better assess a company's reserves. In addition, the tabular format for disclosing probable and possible reserves should reduce investor search costs by making it easier to locate reserves disclosures and facilitating comparability among oil and gas companies. The SEC suggests that permitting the disclosure of probable and possible reserves will benefit smaller companies, in particular, since larger issuers tend to already have large amounts of proved reserves. Also, the Final Rule permits smaller companies, who often participate in a significant amount of exploratory activity, to better disclose their business prospects.
The SEC also posits that permitting a company's disclosure of probable and possible reserves could create an increased risk of litigation because estimates of these reserve categories are less certain than proved reserves. The SEC suggests that making these disclosures voluntary mitigates this concern. A company unwilling to bear any perceived additional risk may simply elect not to disclose its unproven reserves.
A further risk associated with a company's disclosure of its probable and possible reserves identified by the SEC is the revelation of a company's competitive information or business strategies, such as the targets and nature of its exploration activities. The SEC explains that if, for example, geographical detail can be gleaned from estimates of unproved reserves, this could reveal to competitors sensitive information about the value of a company’s assets and could place the company at a competitive disadvantage. The SEC reduced the level of geographical detail in order to reduce this potential burden on companies, while providing sufficient information to investors regarding concentrations of risk, including political risk.
"Reserves"
The term "reserves" is defined by the Final Rule as the estimated remaining quantities of oil and gas and related substances anticipated to be economically producible, as of a given date, by application of development projects to known accumulations. Moreover, there must exist, or there must be a reasonable expectation that there will exist, (a) the legal right to produce or a revenue interest in the production of oil and gas, (b) installed means of delivering oil and gas or related substances to market, and (c) all permits and financing required to implement the project.
The definition of "reserves" contained in the Final Rule and in the PRMS diverge to the extent the Final Rule’s definition is based on "economic producibility" rather than "commerciality" as provided in the PRMS. The SEC decided commerciality introduces a subjective aspect to the price used to establish existing economic conditions by factoring in the rate of return required before a company will commit its resources to a project. Because rates of return vary among companies, defining reserves based on subjective tests of commerciality reduces the comparability among disclosures. The Final Rule’s definition of "reserves", therefore, is based on "economic producibility." The Final Rule clarifies that resources that do not constitute "reserves" may not be disclosed in SEC filings.
'Deterministic Estimate" of Reserves
A company can derive two different types of reserves estimates depending on the method used to calculate the estimates. These two types of estimates are known as "deterministic estimates" and "probabilistic estimates." The term "deterministic estimate" is an estimate based on a single value for each parameter (from the geoscience, engineering, or economic data) in the reserves calculation that is used in the reserves estimation procedure.
"Probabilistic Estimate" of Reserves
The term "probabilistic estimate" is an estimate that is obtained when the full range of values that could reasonably occur from each unknown parameter (from the geoscience and engineering data) is used to generate a full range of possible outcomes and their associated probabilities of occurrence.
FINAL RULE'S EFFECTIVE DATE
Mandatory Implementation Date
The Final Rule requires companies to begin complying with the disclosure requirements for registration statements filed on or after January 1, 2010, and for annual reports on Forms 10-K and 20-F for fiscal years ending on or after December 31, 2009. The mandatory compliance date may be delayed if warranted by the SEC’s discussions with the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) regarding corresponding accounting standard revisions.
No Voluntary Early Implementation
The Final Rule prohibits a company from applying the SEC's revised rules to disclosures in any quarterly reports prior to the first annual report in which the revised disclosures are required.
