The staff of the Securities and Exchange Commission’s Division of Corporation Finance, in connection with its review of periodic reports filed by exploration and production (E&P) companies in 2015, has recently issued a number of comment letters to these companies asking them to quantify the impact of low commodity prices on their proved reserves and results of operations. During periods of low commodity prices in the past, reporting E&P companies have typically included in their risk factor and MD&A disclosures general statements regarding the effects these low prices could have on their businesses. These recent staff comment letters appear to represent the first time the SEC has instructed issuers to quantify these effects.

Example of SEC staff comment: Unless you have determined that it is not reasonably possible that a continuation of the current economic environment would lead to material adverse effects, you should provide quantified information regarding the reasonably possible effects of a continuation of current commodity prices to the extent that quantified information is reasonably available. Refer to the guidance in FRC §§ 501.12.a, 501.12.b.3, and 501.14 (Sections III.A, III.B.3, and V of SEC Release Nos. 33-8350; 34- 48960; FR-72), as it relates to disclosures in an introductory section or overview, the effects of material trends and uncertainties, and critical accounting estimates.

The SEC Interpretive Release cited above was issued in 2003 in the wake of the Enron and WorldCom financial collapses, and provides guidance to issuers preparing their management’s discussion and analysis of financial condition and results of operations (MD&A) disclosures in their periodic reports. The Release suggests that an issuer’s MD&A should:

  • Include an introductory overview summarizing the most important matters on which its executives are then focusing in evaluating its financial condition and operating performance;
  • Focus on material trends and uncertainties to provide a better understanding as to information that may be indicative of its future operating results and financial condition; and,
  • Address the material implications of uncertainties associated with the methods, assumptions and estimates underlying its critical accounting estimates.

The Release relates to Item 303 of Regulation S-K, which provides instruction on the kind of information to be included in the MD&A section of periodic reports and requires companies to address the reasonably likely effects of trends and uncertainties on liquidity, capital resources and results of operations. On this basis, and taking into account the current pricing environment and the uncertainty regarding its duration, the SEC suggests that periodic reports should include more extensive discussion about the impact of current commodity prices on the carrying values of a company’s oil and gas properties, as well as its liquidity, capital resources and results of operations.

Moreover, the SEC has asked issuers to address their drilling plans, reported reserve quantities and critical accounting estimates related to impairment testing of proved and unproved properties. For instance, the SEC has focused in particular in recent years on proved undeveloped reserves (PUDs). Now, the SEC has extended this focus to suggest that companies, particularly those that disclose changes or possible changes to capital expenditure budgets due to the pricing environment, should consider disclosing the volume of PUD reserves that would not be developed as a result of changes in economics from the year-end reserve report.

Example of SEC staff comment: Please tell us whether your reduced capital spending plan is based on the assumption that commodity prices will stay at current levels and explain how the current price environment, if prolonged, would impact your ability to convert your PUDs in a timely manner.

In response to these recent SEC comments and in some cases after going several rounds with the SEC, some issuers have agreed to include enhanced disclosure in their upcoming Form 10-Q and 10-K filings. For instance, one issuer agreed to include sensitivity analysis-type disclosure in its second quarter report for 2015 to quantify the impact of the lower commodity prices. The disclosure would show that if the relevant NYMEX commodity strip price as of December 31, 2014 were used rather than the SEC-mandated average price for 2014, the estimated future net revenues of its proved reserves and its estimated proved reserves volumes as of December 31, 2014 would have decreased by approximately 43 percent and 6 percent, respectively (Breitburn Energy Partners LP).

One issuer agreed to amend its most recently filed Form 10-K to provide further disclosures regarding its proved undeveloped reserves and the effect of the price changes on its proved reserves (Penn Virginia Corp.). The Form 10-K/A included expanded disclosure regarding revisions in the company’s PUD estimates, including the statement that certain “revisions resulted from us removing predominantly natural gas reserves associated with locations that we determined would likely not be drilled during a five-year period from initial booking because of the continued depression of natural gas prices.” This issuer included additional quantified disclosure in its revised MD&A regarding the possible effects of a prolonged period of depressed commodity prices on its proved reserve estimates.

Form 10-K/A Revised MD&A in Response to SEC comments: A prolonged period of depressed commodity prices could have a significant impact on the value and volumetric quantities of our proved reserve portfolio, assuming no other changes in our development plans. At year-end NYMEX calendar year forward contract strip prices, the present value (discounted at 10% per annum) of estimated future net revenues of our proved reserves would be approximately 63% smaller and total proved reserve equivalent volumes would be approximately 24% smaller compared to the results obtained using SEC mandated 2014 beginning of the month average prices held constant, as is required for the estimation of proved reserves and the calculation of the related standardized measure of discounted future net cash flows. (Penn Virginia Corp.)

Another issuer proposed to include additional disclosures in future quarterly and annual reports, whenever applicable, in order to clarify potential near-term effects of changes in oil and natural gas prices on its ceiling limitation and proved reserves as of the most recent reporting date (EXCO Resources, Inc.). These additional disclosures would be provided in periodic reports when, as a result of changes in prices, ceiling test impairments were anticipated and proved reserves were to be revised downward for the applicable period. The disclosures would show the effects of the changes in prices by applying an average price calculated over a 12-month period, based upon actual commodity prices available for the nine months preceding the reporting date and prices reasonably available (and held constant) after the end of the reporting period.

Citing the decline in commodity prices in the MD&A section of its 2014 annual report, another issuer disclosed that it anticipated ceiling test write-downs in 2015 and that it had reduced the number of wells it had planned to drill in 2015 by 62 percent (Unit Corp.). The staff commented that it would expect there to be reasonable bases to quantify (i) reasonably possible near-term ceiling test impairments attributable to lower pricing and (ii) reasonably possible near-term changes to reserves and development plans. The issuer responded by disclosing in the MD&A in its second quarter report for 2015 that, by adjusting the 12-month average price used at 2014 year-end to an estimated average price for the third quarter of 2015, it anticipated it would recognize a 2015 third quarter impairment of approximately $300 million, partially resulting from a decrease in PUDs of approximately 23 percent. The issuer qualified its disclosure, however, by noting the inherent difficulty, due to the numerous variable factors involved, in predicting with any reasonable certainty the amount of expected future impairments.

Form 10-Q MD&A in Response to SEC comments: [H]olding these factors constant and only adjusting the 12-month average price to an estimated third quarter ending average (holding July 2015 prices constant for the remaining two months), we currently anticipate that we could recognize an impairment in the third quarter of 2015 of approximately $300 million. The estimated third-quarter 2015 impairment is partially the result of a decrease in our proved undeveloped reserves of approximately 23%. This decrease was primarily due to certain locations no longer being economical under the adjusted 12-month average price for the third quarter. As a result, we have eliminated those locations from our future development plans. (Unit Corp.)

Another issuer had indicated in its 2014 annual report that a continued low price environment could cause a “significant revision” in the carrying value of its properties (Cabot Oil & Gas Corp.). The staff requested that the issuer provide quantification of the impact of the current price environment on its properties’ carrying values, including the impact of potential scenarios that could be reasonably likely to occur. The issuer’s response cited its $771 million impairment charge in 2014 and stated that it did not believe that further impairment was reasonably likely, at least for the near future. However, it did add that in the future, where it was reasonably likely that the carrying value of its properties would be affected, it would provide additional quantitative disclosure consistent with Release No. 8350.

In another example, an issuer disclosed in its first quarter report for 2015 that, as a result of the full cost ceiling test, it expected to record a material write-down of the carrying value of its properties in the second quarter of 2015. In response, the staff asked for quantification of the extent to which the impact of current prices would be reflected in the issuer’s financial reporting (Chesapeake Energy Corp). The company responded by including disclosure in its MD&A for the second quarter that presented the effect of lower commodity prices on the discounted future net revenue of its proved reserves and its full cost ceiling test limit. In a section entitled “Impairment of Oil and Natural Gas Properties” added to the discussion of the company’s results of operations, the company disclosed an impairment to carrying value of $9.991 billion. The company added that for the third quarter of 2015, it anticipated a reduction in its present value of estimated future net revenue of proved reserves of $4.1 billion and a further reduction of its estimated proved reserves of approximately 8 percent.

The issuer also received a comment from the staff requesting that it include expanded disclosure in the MD&A in the company’s first quarter report of 2015 to specifically discuss any significant changes in its reserve estimates as of March 31, 2015 as compared to that reported in its 2014 annual report, highlighting the reasons for any write-offs in reserves as required by FASB ASC 932-270-50-1 regarding interim financial reports disclosures. The company agreed to provide, when relevant, such expanded disclosures in future filings.

Other companies receiving staff comment letters in 2015 requesting additional information (including quantitative disclosures) on the expected impact of lower commodity prices include Black Stone Minerals, L.P.; Energy XXI Ltd.; Gulfport Energy Corp.; Vanguard Natural Resources, LLC; EQT Corp.; Cobalt International Energy Inc.; and Eclipse Resources Corp.

In sum, it is advisable for E&P companies, in preparing third quarter Form 10-Qs as well as looking forward to Form 10-K disclosure for the 2015 year-end, to keep this recent SEC focus in mind, especially if the company anticipates that current commodity prices may materially impact reserve volumes or result in significant impairments. Consideration should also be given to possible enhanced disclosure with respect to other areas of a company’s business that could be materially impacted by prolonged low commodity prices, such as hedging, debt covenant compliance, borrowing base calculations and drilling plans.