In an effort to respond to the significant changes that have occurred in the oil and gas industry over the past three decades, on June 26, 2008, the Securities and Exchange Commission (the “SEC”) issued a Release1 proposing sweeping amendments to modernize its oil and gas reporting requirements.

Expansion of “Oil and Gas Producing Activities” to Include Unconventional Resources

The amendments would expand the definition of “oil and gas producing activities” to include unconventional resources, including oil sands, coalbed methane, and oil shale. The expanded definition would continue to exclude activities that are not extraction activities (e.g., transportation, marketing, refining, and most processing). Separate disclosure would be required for conventional resources (defined as “conventional accumulations”) and unconventional resources (defined as “continuous accumulations”).

Changes to Reserve Calculations

The SEC has proposed several changes to the way companies calculate reserves, including the following:

  • 12 Month Average Pricing – The proposed amendments would continue to apply a historical price, but change the price from a single-day closing price on the last day of the fiscal year to the unweighted arithmetic average of the closing price on the last day of each month in the 12-month period of the fiscal year.
    • Sensitivity Analysis – To address concerns that historical pricing does not capture management’s outlook, the amendments would permit issuers to include a sensitivity analysis that would show total reserve estimates based on futures prices, management’s planning prices, or other price schedules.
    • No Accounting Change – The price used for accounting purposes (as opposed to reserve reporting) would not change. For purposes of applying the successful efforts method or full cost accounting method, issuers would continue to estimate the value of proved reserves based on a single-day, year-end price, although the SEC indicated it would be discussing possible changes with FASB.
  • Methods to Estimate Reserves – Consistent with methods currently used (in varying degrees) in the industry, the amendments would allow reserves to be calculated using either of the following two methods, at the issuer’s discretion:
    • Deterministic Method – Calculated based on a single “most appropriate” value (such as the company’s determination of the oil and gas in place in a reservoir); multiplied by the fraction of that oil and gas that can be recovered.
    • Probabilistic Method – An extensive statistical computer calculation using a wide range of potential values for parameters (such as geoscience, engineering and economic data) that affect the reserve estimate.

Permitted Disclosure of Probable and Possible Reserves

The new SEC rules would for the first time permit issuers to voluntarily disclose probable and possible reserves based on the Petroleum Resources Management System (PRMS) definitions. Any issuer disclosing probable or possible reserves would be required to provide disclosure in the same detail as that required for proved reserves, and would be required to identify the relative risks related to such reserves estimations. Probable and possible reserves would be defined and calculated as follows:

  • Probable Reserves. Those additional reserves that are less certain to be recovered than proved reserves but which, together with proved reserves, are as likely as not to be recovered.
    • When deterministic methods are used, it should be as likely as not that the actual remaining quantities recovered will equal or exceed the sum of the reported proved and probable reserves.
    • When probabilistic methods are used, there should be at least a 50% probability that actual quantities recovered will equal or exceed the reported proved and probable reserves.
  • Possible Reserves. Those additional reserves that are less certain to be recovered than probable reserves.
    • When deterministic methods are used, the total quantities ultimately recovered from a project will have a low probability of exceeding the sum of proved, probable and possible reserves.
    • When probabilistic methods are used, there should be at least a 10% probability that the actual quantities recovered will equal or exceed the reported proved, probable and possible reserves.

The new rules will not permit disclosure of categories of resources beyond reserves, such as contingent and prospective resources.

Clarifications to the Definition of Proved Reserves

“Proved reserves” would be defined as “the estimated quantities of crude oil, natural gas, and natural gas liquids which geological and engineering data demonstrate with reasonable certainty” to be recoverable.

  • Reasonable Certainty – The proposed amendments would add a definition of “reasonable certainty” as “much more likely to be achieved than not” and specify the following for purposes of determining reasonable certainty:
    • When deterministic methods are used, estimated ultimate recovery must be much more likely to increase than to decrease or remain constant.
    • When probabilistic methods are used, there must be at least a 90% probability that quantities actually recovered would equal or exceed the stated value.
  • Reliable Technology – To allow for the use of new technologies, the amendments would permit the use of a broad range of “reliable technology” to establish “reasonable certainty.” “Reliable technology” is that which is widely accepted in the industry, has been field tested and has demonstrated consistency and repeatability in the formation being evaluated or in an analagous formation, and has been proved empirically to lead to correct conclusions in 90% or more of its applications.
  • Expansion Beyond Offset Developed Drilling Locations -- The proposed amendments would, under certain circumstances, permit a company to claim proved reserves beyond drilling units that immediately offset developed drilling locations.
  • Commencement – For reserves to be “proved” under the proposed amendments, the project to extract the hydrocarbons must have commenced or it must be reasonably certain that the operator will commence the project within a reasonable time.

Relaxed Definition of PUDs

The amendments propose to amend the definition of “proved undeveloped reserves” to make the following changes:

  • Replace the requirement that productivity be “certain” for areas beyond the immediate area of known proved reserves with a “reasonably certain” standard.
  • Permit the use of “reliable technology” to establish “reasonable certainty.”
  • Absent unusual circumstances, prohibit PUD status for undrilled locations if a development plan has not been adopted indicating that the locations are scheduled to be drilled within five years.
  • Permits PUDs to include quantities of oil that can be recovered through improved recovery projects.

Reserve Reports

The new rules will not prohibit the internal staff of companies from preparing reserve reports and would not require reserve audits, but would require disclosure regarding the qualifications and objectivity of the person primarily responsible for preparing the reserve estimates or conducting a reserve audit (if one is conducted). The qualifications are based on guidance of the Society of Petroleum Engineers. In addition, third party reserve estimates must be filed as an exhibit to the relevant registration statement or report.

Additional Disclosures

The proposed amendments would add a significant amount of additional disclosure, including disclosure regarding technologies used for extraction and for measuring reserves, greater detail regarding properties, items required to be discussed in the MD&A, information about “extension wells” and “suspended wells” (in addition to information currently provided about “exploratory wells” and “development wells”), additional information presented in tabular format, and disclosure of any statutory or mandatory relinquishments or surrenders.

Implementation

The amendments would be implemented by eliminating the existing Industry Guide 2, revising Rule 4-10 under Regulation S-X, codifying certain disclosure requirements in a new section 1200 of Regulation S-K, and adding new sections to Regulation S-K.

Comments and Effective Date

Comments may be submitted to the SEC on the proposed amendments until September 8, 2008. If adopted, the proposed amendments would be effective for fiscal years ending after December 31, 2009, for reports filed under the Securities Exchange Act of 1934