In December 2008, the US Securities and Exchange Commission (SEC) adopted new oil and gas disclosure rules, which are now in force. The new rules apply to public companies with calendar fiscal-year ends and to registration statements filed after January 1, 2010.1 For details of those rules please reference the Mayer Brown article from March 2, 2009.
Shortly after the SEC’s adopting release was issued, questions began to arise about certain of the new rules’ applications in practice. The Commission sought to address these questions on October 26, 2009, when its Division of Corporation Finance issued Compliance & Disclosure Interpretations (CDIs) to clarify interpretive issues under the new rules.2 The CDIs provide helpful guidance in a number of areas. As is so often the case with major overhauls of federal regulatory schemes, however, they also raise new uncertainties for practitioners.
The New Rules
The new rules modernize SEC oil and gas disclosure standards to better coincide with current industry practices and to provide greater transparency and clarity for investors. The most significant rule changes include:
- The economic producibility of reserves will now be calculated using a 12-month average price, instead of a year-end spot price.
- The definition of “oil and gas producing activities” will now include non-traditional and unconventional sources, such as bitumen extracted from oil sands and oil and gas extracted from coal and shale.
- The previously undefined term “reasonable certainty” is now defined to mean “high degree of confidence” to better align SEC rules with the definitions of the Petroleum Resources Management System.3
- The definition of “reliable technology” broadens the categories of technologies that a company may use to establish its reserves estimates and categories.
- Optional disclosure of “probable” and “possible” reserves is now permitted.
- Disclosures must be provided about the company’s chief technical person overseeing the company’s overall reserves estimation process.
- Third-party reports (i.e., independent petroleum engineers’ reports), where a third party has estimated or audited the company’s reserves, must be filed as exhibits.
Similar to a number of SEC rule regimes adopted in recent years, the new rules are principles-based, leaving many areas open to broad interpretation. This has led, in turn, to numerous requests for interpretation from practitioners during 2009.
Remaining Interpretive Issues and Observations
1. PUDs and the Five-Year Rule. One of the biggest areas of uncertainty that remains under the new rules deals with reserves classified as “proved undeveloped reserves” (PUDs). The new rules state that undrilled locations can be classified as having PUDs only if a development plan has been adopted. The plan must indicate that those locations are scheduled to be drilled within five years, unless “specific circumstances” justify a longer interval before development will be initiated. Examples of relevant “specific circumstances” might include projects in which offshore platforms are to be constructed or environmentally sensitive areas are to be developed. The CDIs state that classifying a location as having PUDs in instances where the location’s development is scheduled to extend more than five years in the future should be the exception, rather than the rule.
Today, many choice drilling prospects are located in difficult-to-access environments, such as deep offshore properties or uninhabited jungle locations. Thus, new productive fields can often take years to bring online. In order to classify locations as having PUD reserves whose development within five years is not probable, the CDIs indicate that a registrant should consider a list of factors — including past history of completing development of comparable long-term projects — before it may establish that an exception to the five-year rule is warranted. Neither the rules nor the CDIs provide any examples or checklists of what should be required. Consequently, the registrant should take care to document its consideration of these factors and its resulting determinations.
2. What is “reliable technology”? The new rules no longer confine companies to actual production or flow tests to establish the proven status of their reserves. Instead, one or more alternative technologies, including computational methods, may be employed as confirmation. To be considered “reliable,” the technology or technologies must have been field tested and demonstrated to provide “reasonably certain” results with consistency and repeatability in the formation being evaluated (or in an analogous formation). Companies are grappling with technologies that will satisfy this definition so that they can justify certain reserve determinations.
The new rules and CDIs do not contain specific definitions of “consistency and repeatability,” nor do they provide examples of what reliable technologies the staff will accept. The registrant will also be required to disclose the technology or technologies used to create reserve estimates and categorizations. As part of its review and comment process, the SEC’s staff may request companies to provide supplemental data regarding their reserve estimates, including information sufficient to support the conclusion that the technology used constitutes reliable technology.
3. Internal Controls and Technical Person’s Qualifications. The new oil and gas disclosure rules require a company to provide a general discussion of the internal controls that it uses to assure objectivity in its reserves estimation process. They also require disclosure of the qualifications of the technical person primarily responsible for overseeing the preparation of the company’s reserves estimates. If the company’s reserves are audited by a third party, the technical qualifications of the audit’s overseer must be described. This has led some to question whether the actual identity of the third-party technical person responsible for managing the reserves audit would be the outside engineering firm or the individual at that firm who is responsible for the technical aspects of the audit.
4. The New MD&A Requirements. Instead of rules, the SEC chose to provide guidance relative to the topics that an exploration and production company should consider in its Management’s Discussion & Analysis disclosures. These topics include: (i) changes in proven reserves; (ii) the sources to which those changes are attributable; and (iii) the technologies used by the company to establish the appropriate level of certainty for additions to, or increases in, its reserves estimates. Other topics include trends in prices and costs (and their impact on depreciation, depletion, and amortization and the full cost-ceiling test); geopolitical risks where material concentrations of reserves are located; and the need to use enhanced recovery techniques to maintain production. The fact that this guidance is contained in the SEC’s adopting release and not in its final rules may result in the inadvertent omission of important disclosures of these topics in 2010.