Effective January 1, 2010, the SEC adopted amendments to its oil and gas reporting requirements for publicly traded exploration and production companies. Among the amendments was the expansion of the definition of “PUD” (proved undeveloped reserves). Under the new rules, E&P companies are allowed to include in their reserve report PUDs that they were not able to disclose under the previous rules. The catch is that if an E&P company does not timely develop its PUDs, it may be forced to write them off.
Fast forward five years: 2015 – The price of oil has dropped dramatically causing E&P companies to significantly reign in their operations. But what about developing those PUDs that E&P companies listed on their reserve report five years ago? This article will address how changes to the SEC disclosure rules five years ago are impacting E&P companies today.
The New PUD Definition and the Five Year Rule
The concept of E&P companies listing PUDs as assets is an old practice. Things get interesting, however, when the SEC changes the standard used to assess and quantify PUDs and tacks on a requirement that PUDs must be developed within five years.
The SEC initially adopted its oil and gas disclosure requirements in 1978 and 1982. These disclosures were intended to provide investors with a method to value oil and gas companies, but the SEC was also concerned that unreliable technology would lead to investors receiving inaccurate information. Needless to say, the reliability of technology used in the oil and gas industry has increased by leaps and bounds since 1982. Nonetheless, prior to January 1, 2010, E&P companies disclosing their reserves to the SEC were still bound by original definitions based on outdated technology. Although modern technology enabled E&P companies to accurately identify and quantify reserves which they were previously unable to identify and/or quantify, the companies were not permitted to disclose PUD reserves pursuant to the SEC’s original disclosure requirements. Thus, ironically, investors were not being provided with available and accurate information to value a reporting company’s assets. The pendulum had swung so far in the other direction with respect to technology that the SEC’s disclosure requirements no longer served their original purpose.
In an effort to align its disclosure requirements with current industry practices, the SEC adopted various changes to its disclosure requirements. This alignment effort was intended to provide greater usefulness to the oil and gas market and investors by allowing the use of alternative technologies to establish proved reserves instead of requiring companies to use specific tests. As part of this effort, the SEC, among other things, broadened the definition of a PUD.
The original definition of a PUD was not complicated:
“Proved undeveloped oil and gas reserves are reserves that are expected to be recovered from new wells on undrilled acreage, or from existing wells where a relatively major expenditure is required for recompletion. Reserves on undrilled acreage shall be limited to those drilling units offsetting productive units that are reasonably certain of production when drilled. Proved reserves for other undrilled units can be claimed only where it can be demonstrated with certainty that there is continuity of production from the existing productive formation.”
Although the first sentence above remains the same, the SEC’s disclosure regulations promulgated in 2010 changed the last part of the definition, as follows:
- Reserves on undrilled acreage shall be limited to those directly offsetting development spacing areas that are reasonably certain of production when drilled, unless evidence using reliable technology exists that establishes reasonable certainty of economic producibility at greater distances.
- Undrilled locations can be classified as having undeveloped reserves only if a development plan has been adopted indicating that they are scheduled to be drilled within five years, unless the specific circumstances justify a longer time.  17 C.F.R. §210.4010(31) (emphasis added).
The new definition includes three major changes. First, it eliminates the distinction between undrilled units offsetting productive units and other undrilled units. The SEC now applies the “reasonable certainty” standard to both undrilled units offsetting productive units and other undrilled units. The definition of “reasonable certainty” depends on whether “deterministic methods” or “probabilistic methods” are employed. If “deterministic methods” (all data is known before hand) are employed, “reasonable certainty” means a “high degree of confidence that the quantities will be recovered.”  See SEC, Modernization of Oil and Gas Reporting, 74 Fed. Reg. 2158, 2160 (January 14, 2009). If “probabilistic methods” (an element of chance is involved) are used, “reasonable certainty” means that “there should be a 90% probability that the quantities actually recovered will equal or exceed the estimate.”  Id.
Second, it incorporates the term “reliable technology”, which is defined as “a grouping of one or more technologies (including computational methods) that has been field tested and has been demonstrated to provide reasonably certain results with consistency and repeatability in the formation being evaluated or in an analogous formation.”  17 C.F.R. §210.4-10(25). Under the old rules, a company could meet the “reasonable certainty” standard only if it used actual production or flow tests. Thus, companies were restricted in their ability to prove “reasonable certainty.” The SEC realized that technologies have developed and will continue to develop, thereby improving the quality of information that can be obtained from existing tests and creating entirely new tests not yet envisioned.
Provided that the technology meets the requirements set forth by the SEC, E&P companies are now able to disclose greater amounts of PUDs as they are no longer limited to proving “reasonable certainty” by only production or flow tests. If a company has not previously disclosed its reserves with the SEC or is disclosing material additions to its reserves, it must include a general discussion of the technologies used to establish its reserves.
Third, absent specific circumstances, the new definition requires E&P companies to produce the undeveloped reserves within five years.  The SEC did not clarify whether the five year period starts from the time the reserves were booked as PUDS or from January 1, 2010, the effective date of the SEC’s final report. Many commentators on this issue believe that the clock begins to run when the reserves were first booked. If not produced in five years, the company is required to explain the reasons why material amounts of PUD reserves remain undeveloped for five or more years.  17 C.F.R. §229.1203. The SEC fully realized the relaxation of reporting requirements for disclosing PUDs would result in an increase in the number of disclosed PUDs. However, by requiring that the PUDs be developed within five years, it also desired to hold companies accountable for disclosing PUDs and then not developing those reserves.
Highly relevant to the revised definition of PUD reserves is the term “economic producibility” which, as it relates to a resource, “means a resource that generates revenue that exceeds, or is reasonably expected to exceed, the costs of the operation.”  17 C.F.R. §210.4-10(10). Thus, whether or not a resource meets the “economic producibility” standard depends on the then existing economic conditions.  In 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 the 12-month period prior to the end of the reporting period, unless prices are defined by contractual arrangements, excluding escalations based upon future conditions. See SEC, Modernization of Oil and Gas Reporting, 74 Fed. Reg. 2158, 2160 (January 14, 2009). Notably, in June through September 2010, the price of WTI ranged between $75 and $77. By December 2010, WTI was over $89 and, in April 2011, it was $110. It dipped below $89 in September 2011, but by January 2012, the price was over $100. Given the market for WTI immediately subsequent to the disclosure changes, it made perfect sense for E&P companies to include large amounts of PUD reserves in their December 31, 2011 financial disclosures.
However, in today’s market, many of those same PUD reserves may no longer be economically producible; at the time this article was written, the price of WTI hovered in the mid-$40s. Companies that eagerly booked their PUDs five years ago may now be looking for exceptions to the five year rule. The good news is that the SEC identified the following factors a company should consider in determining whether circumstances justify an exception to the five year rule:
- The company’s level of ongoing significant development activities in the area to be developed;
- The company’s historical record at completing development of comparable long-term projects;
- The amount of time in which the company has maintained the leases, or booked the reserves, without significant development activities;
- The extent to which the company has followed a previously adopted development plan; and
- The extent to which delays in development are caused by external factors related to the physical operating environment, rather than by internal factors.  U.S. Securities and Exchange Commission, Oil and Gas Rules, http://www.sec.gov/divisions/corpfin/guidance/oilandgas-inter.htm
The bad news is that these factors do not include current unfavorable economic conditions. In other words, if the value of oil drops by 60% and it is no longer profitable for companies to develop certain PUD reserves, the SEC will likely not be persuaded to grant an exception to the five year rule. Today, companies are not engaging in prolific drilling programs; instead, most are likely employing a strategy of conducting minimal operations to maintain their leases. The SEC specifically stated that this strategy does not constitute “significant development activities.”  Id. To the extent a company is doing the bare minimum to maintain its leases, it is simultaneously jeopardizing itself by possibly violating the five year rule.
Furthermore, if a company changes its development plan several times for its PUD reserves but does not actually take “significant steps” to implement any of its development plans, it “would not be appropriate” to recognize those PUDs.  Id. Similarly, the mere intent to develop, without more, does not constitute “adoption” of a development plan; “adoption” requires a final investment decision.  Id. Again, the SEC had not defined the term “final investment decision.” As noted above, intent alone does not qualify as a “final investment decision.” However, an authorization for expenditure is also probably not necessary as these are not issued until shortly before drilling commences. The answer is nebulous and probably lies somewhere in the middle between intent and an authorization for expenditure. Also not warranting an exception to the five year rule is a company’s decision to develop a field slowly in order to extend its economic life.  Id.
So, what happens if a company fails to produce its PUD reserves within five years and there are no circumstances justifying an exception? A company may be forced to write off those undeveloped reserves. Obviously, writing off reserves conveys a negative message to a company’s investors, reducing their valuation expectations and producing a chilling effect on future investments by other investors. More specifically, writing off reserves tells investors:
- The medium-term growth outlook is weaker. By booking reserves, a company is telling investors that investment plans are in place for the development of its reserves, and to generate future revenues. By writing off reserves, a company is reducing its ability to generate future revenues.
- The company’s business may not be sustainable. By dividing total year end reserves by annual production, investors are provided a view of how many years a company can sustain production. The greater the number of years of future production, the greater the value of the company and the more sustainable its business. Fewer reserves can result in a higher likelihood of less sustainability.
- The company is less valuable. A company’s reserves are vital to its valuation by offering investors a look at the company’s asset base and, hence, its future revenue potential. The fewer the reserves, the less valuable the company.
- The company is not cost efficient. Sure, a company can make a profit when WTI is $100, but can it make a profit when WTI is $50? Writing off reserves can also mean that a company was not able to reduce its costs and streamline its operations to stay competitive.
Essentially, whether a company is forced to write off a large amount of its PUD reserves or not tells investors how well managed the company is and how able it is to adapt to changing times. In other words, in a tough environment, can it cut its costs and turn a profit when the price of WTI is dramatically lower? Whether or not a company is forced to write off large areas of reserves will answer these questions.
What lessons can we take away from the existing price climate combined with the broader PUD definition and the five year rule? Companies disclosing PUD reserves must be careful to not assume future prices will support eventual development of such reserves. Companies should try to predict a worse case scenario and then be prepared to succeed during that time. To some extent, this involves looking into a crystal ball to see what the future holds for pricing. However, being prepared for future downward trends can also be achieved by utilizing strong analytics, developing cost efficient, cutting-edge technology and streamlining the workforce. A company must also be very strategic when acquiring reserves. When evaluating an acquisition of reserves, a company should consider its ability to abide by the five year rule. While disclosing vast amounts of reserves would benefit a company by boosting its value in the short term, a company may choose a more conservative approach in its acquisition strategies in light of the unpredictability of the oil and gas industry combined with the five year requirement. In other words, it’s one thing for companies to talk the talk when disclosing PUD reserves, but can they walk the walk five years later?
Footnotes [ + ]
|1.||↑||17 C.F.R. §210.4010(31) (emphasis added).|
|2.||↑||See SEC, Modernization of Oil and Gas Reporting, 74 Fed. Reg. 2158, 2160 (January 14, 2009).|
|3, 10, 11, 13.||↑||Id.|
|4.||↑||17 C.F.R. §210.4-10(25).|
|5.||↑||The SEC did not clarify whether the five year period starts from the time the reserves were booked as PUDS or from January 1, 2010, the effective date of the SEC’s final report. Many commentators on this issue believe that the clock begins to run when the reserves were first booked.|
|6.||↑||17 C.F.R. §229.1203.|
|7.||↑||17 C.F.R. §210.4-10(10).|
|8.||↑||In 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 the 12-month period prior to the end of the reporting period, unless prices are defined by contractual arrangements, excluding escalations based upon future conditions. See SEC, Modernization of Oil and Gas Reporting, 74 Fed. Reg. 2158, 2160 (January 14, 2009).|
|9.||↑||U.S. Securities and Exchange Commission, Oil and Gas Rules, http://www.sec.gov/divisions/corpfin/guidance/oilandgas-inter.htm|
|12.||↑||Id. Again, the SEC had not defined the term “final investment decision.” As noted above, intent alone does not qualify as a “final investment decision.” However, an authorization for expenditure is also probably not necessary as these are not issued until shortly before drilling commences. The answer is nebulous and probably lies somewhere in the middle between intent and an authorization for expenditure.|