A couple of posts ago, I wrote about the SEC’s project for revamping the reserves disclosures made by oil and gas companies. In particular, I focused on appropriate prices to be used for measuring the value of recognized reserves. Notwithstanding the absence of logic in the SEC’s proposals with respect to the pricing of disclosed reserves, I’m going to now focus on why the quantity of reserves being reported leaves much to be desired.
First, I need to acknowledge the essential contributions to this post of my good friend, Bob Hinkel. Bob recently co-founded Elang Energy, Inc., and when I first met him, he was matriculating in Thunderbird’s two-year executive masters program, while working for Unocal as their head of procurement. After Bob was promoted to manager of all of Unocal’s vast operations in Indonesia, I was fortunate enough to assist him on a couple of projects on the island of Borneo.
Among other fascinating things I learned about the country, its people and natural resources, Indonesia pioneered the oil and gas ‘production sharing contract,’ which has been subsequently adopted in many other parts of the world. In contrast to the royalty-based licenses common to the U.S., PSC contracts tightly align the interests of the oil company with the interest of resource owners. Basically, a PSC contract turns over a portion of the oil production to the host government on a basis similar to an income tax. The result is efficient in the respect that an investment project that is profitable before taxes will assuredly be profitable after taxes. The same can’t be said of U.S. tax regimes, which takes a portion of the production ‘off the top’ as a royalty. Therefore, a domestic project that is profitable before taxes may not be profitable after taxes, having the effect of leaving oil in the ground that would have been extracted under a PSC.
Some Examples of Disclosure Problems New Rules Won’t Fix
This discussion of PSC contracts might seem like a digression, but their relevance to the topic of SEC financial reporting lies with U.S.-centric disclosure rules. Bob gave me these two examples:
Under a PSC, the oil company is credited with barrels of oil to offset the operating costs it pays in currency. If oil prices rise, it takes fewer barrels of oil to reimburse the oil company for its out-of-pocket costs. This is an unambiguously good thing for both the shareholders of the oil company and the foreign owner of the resources, because both share in the increased profit. But, paradoxically, the quantity of reserves that the oil company reports will decline as oil prices rise. That’s because even though their “profit barrels” increase somewhat, their loss of “cost recovery barrels” can be greater.
- International gas discoveries cannot be booked as reserves until the reporting company actually has a sales contract in hand for the gas. In contrast, domestic gas discoveries, no matter how remote or deep the water, can be booked immediately. Bob says that all of the gas Unocal discovered in Indonesia during his tenure remained “unbooked” despite being directly adjacent to a pipeline feeding the largest liquefied natural gas plant in the world. Bob further contends that it allowed Chevron to purchase Unocal from its shareholders in 2005 for a lower price as a result. I believe him.
In order to understand the third example Bob gave me, you need to know that there are currently three layers of recognized reserves: (1) proven, developed and producing; (2) proven, developed and non-producing; and (3) proven and undeveloped. (The SEC is proposing to add disclosures of ‘probable’ in addition to ‘proven’ reserves, but that’s another matter.) The first category is pretty straightforward, but for the latter two categories the oil company has to determine, on a field-by-field basis, that the reserves are justifiable on technical grounds – and only then on economic grounds based on some price (see my earlier post on this part) and estimated future production costs. The subjectivity associated with these more uncertain quantities combined with the so-called ‘double trigger’ for recognition in the disclosures permits companies to manage their reserves to ensure the appearance of a continually growing resource base.
From these observations, I want to make three points. First, I am not aware that anything the SEC does will fix any of these anomalies I have mentioned, and there are surely many more. Second, no matter how the SEC decides to tweak the disclosure rules, they are unlikely to result in better information for investors, due to the ease with which recognition of reserve quantities can be ‘managed.’ Moreover, I doubt if auditors provide anywhere near the same level of scrutiny to financial statement notes as they do to amounts in the statements themselves.
Third, and this continues a theme of my recent post on off-balance sheet financing, disclosures could be greatly simplified, and would be more reliable, if oil companies were required to report some measure of the current value of their properties in the financial statements. We are learning the hard way that financial reporting is always better if disclosures supplement what is recognized in the financial statements, as opposed to what is not.
In the case of oil and gas companies, no one can seriously dispute that the numbers currently being reported on the financial statements aren’t worth a fig anyway. The SEC is fiddling with the disclosures and ignoring the fundamental problem: untold millions of dollars are spent producing and auditing GAAP financial statements that bear no relation to the value and performance of companies in the extractive industries.
A Semi-Random Tidbit
Finally, this is somewhat of a digression, but perhaps some of you may find it worthwhile food for thought. If the U.S. revamped its inefficient royalty system of taxation on oil and gas operations, then many millions of untapped reserves in developed fields might become economic on an after-tax basis. The significance of the current political debate about whether we should be allowing new off-shore drilling could pale in comparison to the amount of oil that has been left in the ground from decades of tax-driven decision making.