In December of 2008, the US Securities and Exchange Commission (SEC) adopted amended oil and gas disclosure rules. The adoption of these rules was a significant development for public reporting exploration and production (E&P) companies because it represented the first time in three decades that these rules had been substantially modified. According to the SEC’s adopting release, the new rules were designed to better align SEC oil and gas disclosure standards with modern industry standards.1
After their adoption, however, questions began to arise regarding the application of the new rules in a number of critical areas. The SEC’s Division of Corporation Finance issued Compliance & Disclosure Interpretations (Oil & Gas CDIs) in October 2009 in an attempt to clarify the new rules and address the industry’s questions and concerns.2
Among the most significant changes under the new disclosure regime were two new “principles-based” rules: (i) a new “five-year rule” for proved undeveloped reserves (PUDs) and (ii) a broadened authorization that permits companies to prove their reserves by the application of “reliable technology.”
Five-year rule. The five-year rule is a time-based limitation on reserves that a company can classify as PUDs. In order for PUDs to be booked for an undrilled location, the company must adopt a development plan indicating that the undrilled location is scheduled to be drilled within five years. PUDs that remain recorded on a company’s books for more than five years should be removed from the proved category. There is an exception to this rule: PUDs may be booked for more than five years if “special circumstances” justify a longer interval before development will be initiated. In the Oil & Gas CDIs, the SEC staff identified some types of projects that may, depending on the situation, constitute candidates for these “special circumstances.” These include development in urban areas, remote or environmentally sensitive locations and projects that involve the construction of offshore platforms. The Oil & Gas CDIs indicate that the ability to classify a location as a PUD location where development is scheduled to begin more than five years in the future “should be the exception, not the rule.”3
Reliable Technology. Under the old rules, companies were generally confined to using flow tests or observing actual production in proving up their reserves. Given the technological advances in the industry over the past 30 years, the new rules now permit companies to use “reliable technology” in making their proved reserves determinations. The new rules define reliable technology as technology that has been field tested and demonstrated to provide “reasonably certain” results with consistency and repeatability in the subject formation or an analogous formation. By broadly defining reliable technology in this way, the SEC intended that companies may use their existing proprietary methods or develop new methods for determining their proved reserves.
Calendar-fiscal-year-reporting E&P companies were first required to comply with the new rules with respect to the disclosures contained in their Annual Reports on Form 10-K for their fiscal year ended December 31, 2009. This first round of reporting under the new rules provided the SEC staff an opportunity to analyze whether their application was congruent with the SEC’s expectations. The views of the staff on the companies’ compliance with the new rules in their SEC filings were expressed in comment letters issued by the staff in 2010 and early 2011.
The Comment Letters
Many comment letters dealt with (i) the extent of companies’ compliance with the five-year rule and (ii) what constitutes sufficient support for booking new reserves that were added through the use of reliable technology.
Five-year rule. The staff generally took issue with descriptions of PUDs being converted to proved developed reserves at a rate that, mathematically, would take longer than five years.4 If it did not appear to be possible to convert all existing PUDs to proved developed reserves within five years, the staff asked the companies to explain how they planned to accomplish that the conversion. The staff sometimes asked companies to provide the amount and percentage of PUDs that had been converted to proved developed reserves during years prior to 2009.
The staff also took issue with PUDs that had been listed as such for longer than five years, and asked those companies to explain why these PUDs remained undeveloped. For some companies that had provided these explanations, the staff also wanted to know when the companies planned on drilling and producing from those locations, and emphasized that if those companies were not reasonably certain of developing the wells within the next five years, the reserves estimates attributable to those locations should be removed.5
- There were numerous comments dealing with insufficient explanations of material changes in PUDs, year-over-year, and the reasons for these changes.6
- Where PUDs attributable to a particular project or property were significant, the staff requested additional information about the development schedule and other factors regarding the project properties (e.g., whether there was one development project or multiple development projects, the terms of the relevant leases, etc.).7
- Where a company had disclosed that it expected to drill 90 percent of its undrilled locations within the next five years, but there had been no material conversions in 2009, the staff requested expanded disclosures to clarify the company’s planned schedule for development of those reserves, and compliance with the SEC’s new rule requiring disclosures of “investments and progress” made during the year to convert PUDs to proved developed status, including capital expenditures.8
Where a company had disclosed “special circumstances” to justify why certain PUDs would not be developed until year six or later, the staff asked for the total proved reserve figures for those particular PUD locations and the conditions that may prevent their initial development within five years of booking. There were other comment letters that dealt with field development and PUDs:
- The staff sometimes requested additional detailed information on how booked PUDs would be developed within the next five years.9 If PUDs were expected to be developed and classified as proved developed reserves within five years due to special recovery methods, such as the use of compression techniques, the staff inquired whether the company had made a final investment decision on installing the requisite special recovery equipment and facilities in the field.10
- If it appeared that a company’s liquidity to fund development plans was insufficient, the staff asked for additional information explaining how the PUDs could be developed within the time frame disclosed.11
- Where a company had argued that PUDs in one field could not be developed in five years because of factors largely “out of its control,” the staff disagreed, stating that the factors in question—a lack of access to hydraulic fracturing services, rental equipment (primarily completion rigs) and associated contract services—were all known factors at the time the reserves were estimated, and that those PUDs therefore should have been removed.12
- Where additional PUDs had been added and the additions were attributable to a number of different factors, the staff requested disclosures on which portions of the additional reserves had been attributable to (i) drilling, (ii) acquisitions and (iii) revisions.13
Reliable technology. A number of comment letters requested expanded disclosures of the specific technologies used to establish “reasonable certainty” for the additions to the companies’ disclosed reserves estimates. The level of required detail was referred to in several letters as a description, a general discussion and an explanation of the methods used.14 Under the new rules, reliable technology must have been field tested and demonstrated to provide “reasonably certain” results with consistency and repeatability in the subject formation in order to establish the appropriate level of certainty. Thus, the staff requested disclosure on the actual technologies employed and why companies believed they were reliable in the geological environment in which they were applied. The staff also requested disclosure on how many proved reserves were determined by using alternative methods and technologies, including production flow tests. Still other comment letters dealt with reliable technology disclosures:
- Broad, imprecise descriptions of the technologies relied upon were found by the staff to not meet the reasonable certainty threshold.15 Where there was only a general reference that technology had been employed (e.g., “the application of reliable technologies”), the staff asked the company to provide a detailed description of what those technologies were.16
- Where references to the use of certain specific technologies were made, the staff sometimes requested explanation in greater detail (e.g., information regarding the “microseismic operations and reservoir simulation modeling” used to estimate reserves).17
The SEC staff comments discussed above represent only a small portion of the types of shortcomings in oil and gas disclosures (in the staffs’ view) that were addressed in other comment letters to E&P companies.18 The staff will review filings of additional E&P companies in 2011 and beyond, which will deal with the same issues addressed in this article, but will also no doubt raise new areas of concern. Based on the staff’s views to date, publicly reporting E&P companies should keep in mind the following:
- The staff maintains a strong presumption against companies’ ability to maintain their PUDs on their books for more than five years, and
Despite concerns that disclosures might be competitively harmful and not protective of their proprietary information, companies should be prepared to:
- Disclose their development plans (including projected capital expenditures) for converting existing PUDs to proved developed reserves; and
- Provide detailed descriptions of the specific technologies and methodologies employed if proved reserves are added on the basis of applying “reliable technology.”