Peeling away financial reporting issues one layer at a time

SEC on Oil and Gas Disclosures: Current Prices Aren’t “Meaningful”?

The issue I’m going to focus on is one that has been on everyone’s mind for the last few months, although in a somewhat different context: the price of oil.

The SEC has issued proposed rulemaking release No. 33-8935, Modernization of the Oil and Gas Reporting Requirements, to “modernize and update the oil and gas disclosure requirements, and to align them with current practices and changes in technology.” But buried underneath the high-minded title is a bone to big oil — the prices that are used to measure the value of reserves.

Background

The strengths and weaknesses of an accounting principle are often best exposed when tested against extreme cases. For historic cost accounting, there may be no better illustration of its limited ability to provide relevant information to investors than the exploration and production (E&P) of underground natural resources—oil and gas, coal, precious metals, etc. Let’s keep it simple by focusing on oil.

Without question, the most significant event in the life of an E&P company is discovery of oil; but, you couldn’t tell that from the income statement or balance sheet. The affect on income is precisely nil until product is shipped to a customer, and that could be decades after discovery. The costs of discovery often bear little relation to the value of the discovery, so the balance sheet (even when all exploration costs are capitalized) doesn’t provide relevant information to investors either. So, in 1978, the SEC tried to do the right thing for investors by introducing a new form of accounting known as Reserve Recognition Accounting (RRA). It required E&P companies to recognize in income the net present value of reserves discovered during the period, as well as changes to the NPV of existing reserves.

RRA didn’t sit well with the E&P companies, ostensibly because the inputs required were too subjective, but more likely because it caused reported income to swing wildly. Everything else equal, nothing discovered in a period meant no income under RRA. Big Oil pined to return to the good ole days when their earnings could be manipulated simply by changing extraction rates.

So, under pressure in 1982, the SEC abandoned the RRA experiment, relegating it to notes (see SFAS 69) and created additional extensive disclosures with regards to present quantities of oil reserves. There is no way an analyst can begin to understand an E&P company’s performance for a period without looking closely at the reserve disclosures.

Which brings us back to the SEC’s current proposal.

Oil Price Volatility is So Inconvenient

Current disclosures of assessments of commercial feasibility and dollar values for reserves rely, logically enough, on the price of oil as of the balance sheet date. Now, the SEC is proposing to change the price used in calculating reserves from a single-day closing price to a 12-month average price. Before we look at what they said about it in their proposing release, let’s think about it in general terms. Would you calculate the value of your personal investment portfolio based on the 12-month average prices of the securities you hold, or would you look at the current price quotes? If you held oil in your portfolio, does that change your answer? Of course not, but if you’re BIG Oil, then this SEC is willing to listen to you, no matter how pathetic your whining might sound to others.

Here’s what the SEC has to say about their proposal to use average prices:

Most commenters on the Concept Release recommended that we replace our current use of a single-day, fiscal year-end spot price to determine whether resources are economically producible based on current economic conditions with a different test. Some believed that reliance on a single-day spot price is subject to significant volatility and results in frequent adjustment of reserves. [footnote omitted] These commenters expressed the view that variations in single-day prices provide temporary alterations in reserve quantities that are not meaningful or may lead investors to incorrect conclusions, do not represent the general price trend, and do not provide a meaningful basis for determination of reserve or enterprise value.” [italics supplied by me]

Whew. Let’s take a look at this piece-by-piece:

  • Most commenters—Since when is the SEC in the business of counting votes, and are all votes equal? I LOL when I think about how the SEC ignored the protestations of “most [reasoned] commenters” who opposed eliminating the IFRS-to-GAAP reconciliation requirement for foreign companies listed in the U.S.
  • Frequent adjustment of reserves—When the value of a marketable security changes because the price dropped on the last day of the period, should we ignore it? If you can’t think of a single good reason that we should, then you shouldn’t make an exception for oil.Ironically, the normal approach to standard setting is to cure compromises made in financial statements with rigorous disclosure. Here, the exact opposite is taking place. The SEC is not proposing to change the prices that are used for accounting purposes, so for purposes of applying historic cost accounting in the financial statements (successful efforts method per SFAS 19, or full cost accounting per Regulation S-X), a company would use a value of proved reserves based on a single-day, year-end price. However, the SEC believes that RRA disclosures required by SFAS 69 should be prepared using the 12-month average price. In other words, it’s okay to be loosey-goosey in the disclosures about prices, just so long as use the right price for the financial statements, which, being based on historic costs, have little relevance to investors anyway.
  • Meaningful—I really dislike that ’70s made-up word, especially when used in place of ‘relevant.’ Put ‘relevant in that sentence and see if it makes any sense; it doesn’t, of course.
  • General price trend—Do they mean the future price trend? That’s the only one that matters. If future prices of oil could be predicted by past prices, then any person who can perform that trick is in the wrong business—unless they are already oil speculators. I have vivid memories of consulting for an E&P company during a year when they sold their entire production forward, because they speculated that prices would go down. Unfortunately for them, prices went way up; and the operations managers I was working with, whose bonuses and shareholdings depended on oil revenues, were not pleased with the ‘economists’ at corporate headquarters who conjured that one up.

Don’t Bet Against Cox

I think I can usually tell when the fix is in. First, big lies are woven into a large dose of truth, so they won’t look to be as big as they are. There are certainly many things in the SEC’s proposal to recommend it, especially along the lines of expanding the types of reserves that would be disclosed, and updating important definitions.

Second, when the justification for a proposal makes no sense, there can be no debate; you can’t tell the emperor he’s naked. The lesson of Cox’s SEC is to never forget about the big special interests that write big checks to the big politicians who made him our capital markets emperor.

1 Comment

  1. Reply David J Phillips July 30, 2008

    According to my recent review of the SEC proposal: commercial feasibility is that it is defined as “reasonable certainty” of recovery, or as defined as “much more likely to be achieved than not,” (90% probability) will serve as the threshold standard to establishing proved reserves.
    http://industry.bnet.com/energy/2008/07/08/sec-gives-boost-to-suncor-energys-oil-reserves/
    My Best,
    David

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