PART ONE OF A THREE-PART SERIES
Marc Folladori and Amelia Xu, Mayer Brown LLP, Houston
This is the latest in a series of articles that address publicly-held exploration and production (E&P) companies' compliance with the amended oil and natural gas disclosure rules adopted by the Securities and Exchange Commission (SEC) in late 2008. Articles two and three will appear in the June and July issues, respectively.
It appears that the amended rules have been successful for the most part in fulfilling their primary stated goals: to modernize the SEC's 30-year-old oil and gas disclosure rules and conform the rules to more current industry standards.
Since the amended rules became effective on January 1, 2010, we have reviewed many E&P companies' public filings with the SEC and comment letters issued to companies by the staff of the Division of Corporation Finance of the SEC. The findings of our review provided insights as to whether, and to what extent, companies have been complying with the amended rules, which were summarized in our three prior articles.
Roughly speaking, there have been three "rounds" of comment letters issued by the staff on companies' compliance with the amended rules. Generally speaking, our second article covered comment letters issued by the staff during 2010 through the first half of 2011. These comments for the most part concerned disclosures in companies' annual reports on Forms 10-K or 20-F for the fiscal year ended Dec. 31, 2009.
The "second round" of comment letters were issued by the staff beginning in mid-2011, and continued through mid-2012 (generally relating to annual reports for companies' fiscal years ended December 31, 2010). The "third round" involved for the most part letters issued beginning in mid-2012 and continuing through mid-2013 (mostly relating to annual reports for companies' fiscal years ended Dec. 31, 2011 and 2012). While these "rounds" are not scientifically delineated by specific time frames, they are used in this article for purposes of analysis and discussion.
Numerous staff comments issued in the first round of letters dealt with two of the most significant areas of change under the amended rules. The first significant area of change concerned the "five-year rule" for proved undeveloped reserves (PUDs). Basically, to book PUDs for an undrilled location, a company must adopt a development plan indicating that drilling is scheduled for the undrilled location within five years. The company should remove PUDs that remain, or will remain, recorded as PUDs on the company's books for more than five years from the proved category. The amended rules provide an exception to this five-year limitation if "special circumstances" warrant a longer interval before development.
The second significant area of change under the amended rules was the broadened authority that permitted companies to prove up their reserves by applying "reliable technology" in the evaluation process. Under the amended rules, the term "reliable technology" is defined as technology (including computational methods) that has been field tested and demonstrated to provide reasonably certain results with consistency and repeatability in the subject formation or an analogous formation. This broadened authority meant that companies were no longer limited to the use of flow tests or observations of actual production to establish proved reserves.
The second round and third round comment letters revealed a more detailed analysis by the staff of companies' disclosures, resulting in more granular-level comments and questions. Especially noticeable beginning in the second round were the requests to provide the staff with spreadsheets and other detailed reserve engineering data regarding specific properties or fields. The staff also requested information regarding the costs used in calculating companies' standardized measure of discounted future net cash flows of their proved reserves (the "standardized measure"). There were also more financial and accounting comments on a variety of topics, many likely resulting from lower prevailing price regimes for North American natural gas.
Generally speaking, the third round of staff comments, issued between mid-2012 and mid-2013, were consistent with the themes and subject matters of the second round comments. The most numerous comments for both rounds related to companies' development of their PUDs.
Development of companies' PUDs
An article in the July-September 2013 issue of the Ryder Scott Petroleum Consultants newsletter, Reservoir Solutions, included a report on a Society of Petroleum Engineers (SPE) Gulf Coast Section forum held in May 2013. At this forum, Jeffery Willson who served on the SPE Oil & Gas Reserves Committee reported that development of PUD reserves had been the topic of 26% of the total SEC staff comments to the industry in the prior year — by far, the reserves issue most often commented on. Lower prevailing average prices for natural gas production in North America since 2008 have no doubt contributed to the frequency of this comment, since the margins from PUDs development that had been anticipated to result from the higher prices previously in effect, have eroded substantially for subsequent years.
The SEC accounting rule that contains most of the definitions for oil and gas terms — Regulation S-X § 4-10(a) — provides that absent special circumstances that justify a longer time period, reserves attributed to an undrilled location may be classified as undeveloped reserves if a development plan has been adopted indicating that the locations are scheduled to be drilled within five years. Questions have been raised to the staff in recent years about the staff's interpretation of the term "drilled" under this definition and within the context of a company's development schedule for its PUDs. The authors understand that the term "drilled" in this context does not refer to the commencement of drilling the well. However, it likely does not mean that the well must reach the status of being completed, either. The term should logically refer to that point in time when the reserves attributed to the well location move from "undeveloped" to "developed" status. In this context, Regulation S-X § 4-10(a)(6) provides that "developed" oil and gas reserves are reserves that can be expected to be recovered through existing wells with existing equipment, or "in which the cost of the required equipment is relatively minor compared to the cost of a new well." Thus, if an engineering estimate indicates that undeveloped reserves can be attributed to a well at a point in time when the required equipment costs to complete or re-complete the well would be relatively minor compared to the costs of a new well, it would appear that the reserves could, as of that time, be classified as "developed."
During the third round, the staff continued to focus on whether companies' PUDs would be developed within five years. Where it appeared likely that material amounts of PUDs would remain undeveloped for more than five years after their initial booking, the staff commonly asked the company to explain how it planned to achieve full conversion. The staff often issued comments when a company's recent annual rates of conversion made it appear mathematically difficult, if not impossible, for the company to convert all of its PUDs to proved developed status within five years. For example, in the Resolute Energy Corp. letter dated Aug. 29, 2012, the staff noted that the company had converted only 5% of its PUDs to proved developed reserves (PDs) in 2011, and only 2% in 2012. In those cases, the staff generally asked the company to explain how they planned to accomplish full conversion within five years.
As in prior years, many companies responded by arguing that sufficient "specific circumstances" were present to justify their previously-booked PUDs to remain on their books for more than five years, or to book new PUDs where the new PUDs would not be developed within five years. However, the authors have been unable to find any instance where the staff was convinced there was sufficient justification to warrant any exception to the five-year rule with respect to companies concentrated in US onshore properties. Through the third round, no letter has cited any development plan for US onshore properties that would constitute sufficient special circumstances to justify maintaining the booking of PUDs without development for more than five years. The staff has generally been dismissive of company arguments in favor of an exception, sometimes characterizing a company's claimed development "plan" as a mere "drilling program," and requesting the company either to submit more conclusive evidence or remove the claimed volumes from its disclosed PUDs (Approach Resources, Inc. (Dec. 20, 2012 and Jan. 22, 2013)).
It appears that "specific circumstances" have only been found where larger, multinational companies' non-US properties were the subject of large-scale projects. For example, in its letter to the staff dated Oct. 1, 2012 replying to a question about its conversion rates and the five-year rule, Eni S.p.A. stated that it had a number of large-scale conventional projects ongoing in Kazakhstan, Angola, Libya, Siberia, Venezuela, Norway, and Iraq, many of which were located in remote areas and would be dependent upon the completion of infrastructure and plant capacity (Eni S.p.A. (August 23, 2012)). The staff asked PetroChina Company Ltd. a similar question about a portion of its natural gas PUDs in China that would take more than five years to develop (PetroChina Company Ltd. (Sept. 21, 2012)). In a response letter dated Nov. 5, 2012, the company explained that the longer development timetable for these PUDs was primarily the result of long-term natural gas supply contracts with its customers (some of which had terms ranging from 20 to 30 years).
It is probably worthwhile to compare the circumstances with respect to these multinational companies' PUDs with those for smaller companies having large concentrations in US onshore properties. Smaller companies' US onshore PUDs that would not be developed within five years would likely constitute a larger percentage of thecompanies' total proved reserves than would likely be the case with large, multinational companies' PUDs where it appeared that exceptions were permitted.
Where companies disclosed material additions to their reserve quantities, the staff often requested enhanced disclosures about the technologies and methods the companies had applied to establish the appropriate level of certainty for the economic producibility of the added reserves, as required under Item 1202(a)(6) of SEC Regulation S-K. Thus, where one company disclosed that through extensions and discoveries, it had added approximately three-quarters of a million barrels of oil equivalents in proved reserves during fiscal 2012, the staff requested, "[g]iven the significance of this addition," an expanded discussion of the technologies used to establish the appropriate level of certainty for its estimates (Triangle Petroleum Corp. (Jan. 31, 2013)).
Disclosures of changes in companies' development plans often drew staff comments. Where a company disclosed that (i) its domestic natural gas PUDs at Dec. 31, 2012 made up approximately 47.2% of its total PUDs, (ii) substantially all of its 2013 development budget was allocated to "oil or liquids-rich projects" and (iii) it was allowing its natural gas production to decline, the staff pressed for more information about its development plans for its natural gas PUDs (Newfield Exploration Co. (June 25, 2013)).
Another company disclosed a significant number of total undeveloped locations in two specific areas, but stated that no significant drilling or development was expected to take place in those areas in 2013 due to the pricing environment for natural gas. The staff asked the company how it could claim PUD reserves in those two areas when it would not drill them under the natural gas price regime then in force, and requested the company to disclose the amounts of PUDs that the company had attributed to those two areas (Continental Resources, Inc. (May 10, 2013)).
Lease Expiration Dates and Effect on PUD Development
Another topic that received attention during 2012-13 was the potential effects of near-term lease expiration dates on a company's PUDs. For example, one company had disclosed that it held leases and concessions at year-end 2012 that represented 123 million net undeveloped acres. The staff requested that the company quantify the amount of PUDs attributed to that acreage where the expiration date(s) of the related leases or concessions would precede the scheduled date(s) for the initial development of the associated PUDs (Carrizo Oil & Gas, Inc. (June 24, 2013)). Where significant undeveloped net leased acres were scheduled to expire by year-end 2015, the staff asked the company for expanded disclosure to show the PUDs attributed to this expiring leased acreage, as well as its plans and schedules to develop the PUDs before the acreage's expiration dates (BHP Billiton Ltd. and BHP Billiton Plc (March 5, 2013)). The staff also requested disclosures required under Item 1208(b) of Regulation S-K of material undeveloped acreage to which the company would lose its exploration rights if the company did not complete specified work during the remaining terms of the relevant leases (U.S. Energy Corp. (Dec. 20, 2012)).
About the authors
Marc Folladori has been a merger and acquisition and securities attorney in Texas since 1974, and has extensive experience representing energy companies and firms engaged in energy investment and finance. He serves as outside corporate counsel for a number of publicly-held corporations and also provides US counsel to foreign companies doing business in the US.
Amelia Xu is an associate in Mayer Brown's Houston office and a member of the firm's Corporate & Securities and Energy practices. She focuses her practice on mergers and acquisitions, securities offerings and general corporate matters. She represents both US-based and international energy companies (including oil and gas exploration and production, electricity, oilfield equipment, and other energy services companies) in the acquisitions of US companies and assets, and international oil and gas interests around the world.
1The three prior articles are: "Studies show further guidance needed on revised oil and gas disclosure rules," 7 Oil & Gas Financial Journal, number 12, pg. 22 (December 2010), available at "http://www.ogfj.com/index/article-display/3482369705/articles/oil-gas-financial-journal/volume-7/issue-12/features/studies-show-further-guidance-needed-on-revised.html: SEC doubts companies' ability to book PUDs beyond 5 years," 8 Oil & Gas Financial Journal, number 8, pg. 8 (August 2011), available at http://www.ogfj.com/articles/print/volume-8/issue-8/departments/capital-perspectives/sec-doubts-companies-ability-to-book.html; and "SEC comments on companies' compliance with amended oil and gas disclosure rules," 9 Oil & Gas Financial Journal, number 12, pg. 26 (December 2012), available at http://www.ogfj.com/articles/print/volume-9/issue-12/features/sec-comments-on-companies-compliance.html; and 10 Oil & Gas Financial Journal, number 1, pg. 34 (January 2013), available at http://www.ogfj.com/articles/print/volume-10/issue-1/features/SEC-comments-on-companies-compliance.html (published in two parts).
