SEC comments

This article is the latest in a series of articles summarizing the Division's staff reviews of E&P companies' SEC filings. The staff expresses its views on how reporting E&P companies are complying with the SEC's oil and gas disclosure rules in comment letters it issues to the companies. These comment letters (and the companies' responses to those comments) are made publicly available on the SEC's EDGAR system, but not sooner than at least 20 business days after the date that the staff has completed its review of the filing.

Roughly speaking, this article covers comment letters and company responses made publicly available during the period beginning in the late summer of 2014 and continuing into October 2015.

HIGHLIGHTS OF 2014-15 REVIEW PERIOD

Staff comments during 2014-15 were, for the most part, typical of comments issued in prior periods. However, there were two notable developments during 2014-15:

• First, the decline in commodity prices appeared to drive the content of many staff comments in late 2014 and throughout 2015. Increasingly, the staff asked companies to provide additional disclosures about potential impacts of the lower commodity prices on their results of operations, financial condition, proved reserves and the carrying values of their oil and gas properties.
• Secondly, the staff issued numerous comments to companies that had disclosed recurring changes to their development plans for their proved reserves. Whenever it appeared that a company continued to modify development plans for its proved undeveloped reserves (PUDs) from period to period without explanation, the staff called into question whether the estimated PUDs on the company's books at a fiscal year end had truly been estimated to have "reasonable certainty" that they would be economically producible and drilled within the next five years.

These two developments are described separately in more detail below.

Since 2010, companies' development of their PUDs has been the principal disclosure topic addressed by the staff, and 2014-15 proved to be no exception (see, e.g., Apache (6/29/15); Vanguard Natural Resources LLC (6/29/15); Matador Resources Co. (6/25/15); Warren Resources (9/24/14); TransAtlantic Petroleum Ltd. (9/17/14)).

SEC rules permit undrilled locations to be classified as having undeveloped reserves only if a development plan has been adopted indicating they are scheduled to be drilled within five years, unless specific circumstances justify a longer time. Undrilled reserves that have remained booked as PUDs for more than five years, as well as newly added PUDs that will not be drilled in five years, should not be included in the proved category.

A related topic for many comments during 2014-15 was the requirement under SEC rules and financial accounting standards for companies to provide (i) a tabular presentation in sufficient detail on the various causes for the changes in their proved reserves from year to year (see, e.g, Berry Petroleum Company LLC (6/21/15); Emerald Oil (5/22/15); Royal Dutch Shell (11/10/14); Isramco (9/17/14)), and (ii) specific disclosures about material changes in their PUDs over the prior year, addressing investments and progress (including capital expenditures) made to convert PUDs into proved developed reserves (see, e.g., Atlas Resource Partners LP (5/22/15); Petrobras Argentina SA (1/6/15); Black Ridge Oil & Gas (12/30/14); Eagle Rock Energy LP (12/29/14); Warren Resources (9/24/14); Statoil ASA 9/19/14)).

Where a company's PUDs had increased 37% in a year, but its projected future development costs had increased only 3%, the staff requested clarification (Hydrocarb Energy (3/18/15); see also, Marathon Oil (6/14/14), where the company had reported a slight decrease in future development costs while its estimated PUD quantities had increased). The staff also raised questions where companies held a significant amount of undeveloped acreage under leases that would expire within a short time. In those instances, the staff inquired as to the extent to which PUDs had been assigned to locations on the undeveloped acreage that were scheduled to be drilled after the subject leases expired (see, e.g., Pioneer Natural Resources (7/15/15); Matador Resources (6/20/15); Stone Energy (9/28/14); LRR Energy LP (9/8/14); Laredo Petroleum (8/20/14); Resolute Energy (7/28/14)).

Surprisingly, there continued to be many comments identifying, and asking companies to reconcile, discrepancies between information disclosed in the text of companies' filings and information contained in the accompanying third-party reserves report (e.g., Evolution Petroleum (3/18/15); VOC Energy Trust (9/24/14); Isramco (9/17/14); Resolute Energy (7/28/14)).

IMPACT OF REDUCED COMMODITY PRICES

Impact of lower prices on reserve estimates and impairment testing

A key area of concern for the staff during 2015 was the extent to which reduced prices for oil and gas production had weakened the financial condition of E&P companies.

During the year, the staff asked companies to provide additional disclosure about potential impacts of the lower oil and gas price regime on their (i) results of operations, financial condition, cash flows, liquidity and capital resources; (ii) proved reserve quantities and the value of those reserves; and (iii) periodic testing for impairment of carrying values of their oil and gas properties for financial accounting purposes.

Importantly, many of these comments requested companies to quantify the impact of the low commodity prices on their estimated proved reserves and the standardized measure of discounted future net cash flows relating to those reserves (the "standardized measure"). Many companies initially resisted any quantification, contending that estimating the impact of lower prices on proved reserves and carrying values would be imprecise and subjective, and based only upon abstract estimates of future prices, production, costs and other factors.

In rebutting these arguments, the staff relied on an SEC 2003 interpretive release that provides guidance for companies' preparing the "Management's Discussion and Analysis of Financial Condition and Results of Operations" (MD&A) section of their periodic reports filed with the SEC. MD&A disclosures are intended to provide a narrative explanation of companies' financial statements that enables investors to see the company through the eyes of management.

In their comments, the staff highlighted particular portions of the release that encouraged a company to (i) provide an introductory section in its MD&A summarizing the most important matters on which its management focuses in evaluating financial condition and operating performance; (ii) identify known trends, demands, commitments, events and uncertainties and assess their impact on the company's liquidity, capital resources or results of operations; and (iii) address uncertainties associated with assumptions underlying the company's critical accounting estimates.

A typical staff comment requesting quantification in accordance with this release asked whether the subject company had considered providing more extensive discussion (including quantification) of the impact of current commodity prices on its liquidity, capital resources and results of operations, particularly addressing its drilling plans and accounting estimates related to its ceiling test and reported reserves volumes (Gulfport Energy (3/30/15)).

In response to these comments, companies provided the staff with estimates illustrating quantified effects of lower commodity prices, principally by applying modified pricing assumptions.

• For example, to illustrate the effect of continuing low prices, some companies proposed using sensitivity-analysis type disclosures in their MD&As that would substitute New York Mercantile Exchange (NYMEX) commodity strip prices as of a more recent date in lieu of the SEC-required average of the first-day-of-the-month prices for the prior fiscal year.
• One company stated that if the relevant NYMEX commodity strip price as of December 31, 2014 had been used instead of the average price for 2014, the estimated future net revenues of the company's proved reserves and estimated proved reserve volumes as of December 31, 2014 would have decreased by approximately 43% and 6%, respectively (Breitburn Energy Partners LP (response letter dated 7/30/15)).
• Another company amended its 2014 annual report and added disclosure in its MD&A to report that if the company had used year-end 2014 NYMEX calendar year forward contract strip prices instead of the average price for 2014, the present value (applying a 10% discount) of estimated future net revenues of its proved reserves would be approximately 63% less, and its total proved reserve equivalent volumes would be about 24% smaller ((Penn Virginia (response letter dated 6/23/15)).
• After much correspondence back and forth, a company agreed that going forward, whenever ceiling test impairments were expected and its proved reserves were to be revised downward, it would provide disclosures in its periodic reports illustrating the effects of the change in prices by applying updated pricing assumptions. The company suggested using a simple average price calculated over a 12-month period, based upon actual commodity prices available for the nine months preceding the particular reporting date, and prices reasonably available after the end of that reporting period held constant for the remainder of such 12-month period (EXCO Resources (response letter 7/9/15)).
• Another company disclosed in the MD&A in its 2015 second quarter report that it anticipated a ceiling test writedown in its 2015 third quarter. It stated that by changing the 12-month average price to an estimated third quarter-ending average price (holding July 2015 prices constant for the remaining two months), it would recognize a 2015 third-quarter impairment of approximately $300 million, partially caused by a decrease in its PUDs of approximately 23% (Unit Corp. (response letter 8/13/15)).
• Chesapeake Energy Corp. reported in its 2015 second quarter report that as of June 30, 2015, it had incurred a ceiling test impairment charge of $5.015 billion. In response to ongoing staff comments, the company also disclosed in its second quarter report its expectations for the commodity prices to be used in the calculation of discounted future net revenues for 2015's third quarter (Chesapeake Energy (response letter 8/18/15)).
• Based on first-of-the-month index prices for July and August 2015 and the then-current strip prices for September 2015, the company estimated a decrease of approximately $12.31 per barrel of oil and $0.33 per Mcf of natural gas in the prices it would use to calculate estimated future net revenue of its proved reserves at September 30, 2015. These expected price decreases were expected to reduce the present value of estimated future net revenues of its proved reserves by approximately $4.1 billion in the third quarter, and would likely be a significant factor in the amount of impairment to be recorded at September 30, 2015. It also said it expected a further reduction of approximately 8% in its estimated proved reserves in 2015's third quarter, solely related to price declines.

See also, Cimarex Energy (7/13/15); Halcón Resources (2/26/15).

• Another company disclosed in its 2014 Form 10-K that continued low oil and gas prices could reduce the amount of hydrocarbons it could produce economically. The staff asked the company to provide quantitative disclosure addressing the impact of low prices to its reserves that would reflect potential scenarios it deemed reasonably likely to occur. The company suggested proposed disclosures showing the impact to proved reserves at year-end 2014 of a $1.00 per MMbtu decline in natural gas prices and a $6.00 per barrel decline in crude oil prices. The staff replied that in its view, the company's proposed disclosure did not reflect potential scenarios that its management deemed reasonably likely to occur (Vanguard Natural Resources LLC (7/20/15)).
• In response, the company added disclosures in its 2015 second quarter report (filed in August 2015), which disclosed a quantified decrease in its total proved reserves as of June 30, 2015 by applying the 5-year NYMEX forward strip prices as of July 20, 2015 (Vanguard Natural Resource LLC (response letter 8/6/15)).
• The staff asked a company to explain whether it had taken steps to address risks associated with the volatility in commodity prices, and to describe the types of its derivative contracts intended to mitigate its exposure to the price changes, the duration of those contracts, how current market conditions could affect its ability to enter into similar instruments and the potential impact those circumstances may have on its future revenues (Black Stone Minerals LP (4/2/15)). In response, the company disclosed in an amendment to its registration statement the percentages of budgeted oil and natural gas production for 2015 covered by costless collars and fixed-rate swaps, and their weighted-average floor and weighted-average fixed prices, but cautioned that revenues from its production not currently hedged could decline significantly if market prices for oil and natural gas did not recover (Black Stone Minerals LP (response letter 4/10/15))

Other companies receiving comment letters in 2015 requesting additional information (including quantitative disclosure) about the expected impact of lower commodity prices include the following: Energy XXI Ltd.; EQT; Continental Resources; Legacy Reserves LP; BP plc; Cobalt International Energy; Cabot Oil & Gas; Matador Resources; Apache; Gran Tierra Energy and Eclipse Resources. In their comments, the staff did not differentiate between companies using the successful efforts method of accounting (see, e.g., Continental Resources; Penn Virginia; Cabot Oil & Gas) or those using the full cost method (see, e.g., Cimarex Energy; Apache; Chesapeake Energy; Halcón Resources).

Impact on capital expenditures and development plans

The staff also asked companies that had disclosed reduced capital expenditure budgets for 2015 due to the lower-price environment to provide disclosures about PUDs that would not be developed as a result of the changes in economics.

• A typical comment asked whether a company's reduced capital spending plan had been based on the assumption that commodity prices would stay at current levels, and requested explanation of how a continuation of the low-price environment would impact the company's ability to convert its PUDs in a timely manner. EQT (8/3/15); see also, Berry Petroleum Company LLC (7/21/15); Cimarex Energy (7/13/15); Eclipse Resources (5/20/15); Gulfport Energy (3/30/15).
• The staff noted that one company's 2014 Form 10-K had disclosed significant reductions in its drilling activities and capital expenditures planned for 2015, but that despite those reductions, it had apparently not removed any of its PUDs during 2014. The staff asked whether any of the company's PUDs reported at 2014 year-end included quantities that had been delayed, deferred or re-scheduled to future periods as a result of the planned reductions. It also requested pricing assumptions used in formulating the company's PUD development schedule (Apache (6/29/15)).
• The company replied that it had rescheduled 561 PUD locations to future periods as a result of its planning process, and that due to the volatile oil price environment, its development schedule had utilized several pricing assumptions to assess availability of capital and drilling activity. It confirmed to the staff that in future filings, whenever future development plans for undeveloped reserves assumed increases in commodity prices, it would disclose that assumption and present the volumes that would not be developed if the price increases did not occur (Apache (response letter 9/25/15)).

Impact on credit facilities

The staff often requested expanded disclosures where a company had disclosed potential impacts of continuing low commodity prices on its credit facilities.

• One company was asked to provide quantitative disclosure about the expected impact of lower prices on its borrowing base, and the steps the company intended to take to address uncertainties with respect to its liquidity (Black Stone Minerals LP (4/2/15)).
• Where another company disclosed possibilities of a reduction in the borrowing base under its revolving credit facility if the decline in commodity prices continued, the staff asked the company to provide additional disclosure addressing the extent to which the borrowing base could decrease based on expected oil and gas reserve values and other relevant factors (Energy XXI Ltd. (4/3/15)).
• A 2014 Form 10-K MD&A disclosed that a credit rating downgrade could result in the company's counterparties requiring it to post additional collateral under its existing contracts. The staff asked whether the company had considered disclosing information about the nature of the contracts, the collateral posted and the incremental collateral requirements that would result from a downgrade. In reply, the company stated that it had concluded its liquidity was sufficient to cover the additional collateral that could be required, but that it would, beginning with its 2015 third quarter report, disclose information addressing this risk in its MD&A, and provide additional detail about its collateral requirements, including the types of information requested by the staff (Black Hills (response letter 9/29/15)).

Recurring Modifications to Development Plans

Where companies changed their development plans for their PUDs from period to period without adequately disclosing their reasons for doing so - in other words, PUDs attributable to different drilling locations being moved into and out of the companies' estimated proved reserves from year to year with no explanation - the staff called into question whether the PUDs when booked had truly been estimated as having "reasonable certainty" that they would be economically producible and drilled within five years. The definition of proved oil and gas reserves contained in the SEC's Regulation S-X requires that reserves be estimated with "reasonable certainty" to be economically producible from that date forward, from known reservoirs and under then-existing economic conditions, operating methods and government regulations, and prior to lease or concession expiration.

For an undrilled location to be classified as having undeveloped reserves that can be booked as PUDs, the SEC requires that there be a development plan adopted by the company indicating that the location will be drilled within five years, unless specific circumstances justify a longer time. Staff guidance provides that the mere intent to develop those PUDs by itself does not constitute "adoption" of a development plan, and by itself would not justify recognition of reserves. According to the staff, adoption of a development plan requires a "final investment decision" made by the producer.

In 2014-15, the staff issued a number of comment letters to companies that apparently had made numerous changes to their development plans, interpreting those changes as a lack of commitment by those companies to their previously approved plans and calling into question the reasonable certainty of their reported reserves. In many of these letters, the staff also requested whether the companies' internal controls over their reserves estimation process were effective.

• For example, one company was asked about the processes through which its historical PUD conversion rates and the changes to its previously adopted PUD development plans had been taken into account when determining whether its current year's PUD quantities had met the reasonable certainty criteria. In response, the company modified the internal controls it used in its reserve estimation process and described those changes in its 2014 Form 10-K, which included implementation of a "PUD Review Committee" comprised of senior executives and its reservoir engineering manager (Petroquest Energy (response letter 3/2/15)).
• According to the company, the PUD Review Committee would review all PUD locations in terms of technical and financial merit, but it also would apply a more robust evaluation of the timing and reasonable certainty of the company's development plan in light of all known circumstances, including its budget, the market outlook and the location of ongoing drilling programs. The Committee would evaluate the reasonable certainty of the company's development plan by assessing near-term drilling plans for its PUDs, and reviewing deviations to its previously adopted development plans and its historical PUD conversion rates. See also, Eclipse Resources (4/22/15).
• In another company's 2014 Form 10-K, the staff noted downward revisions to the company's PUDs for each of its 2014, 2013 and 2012 fiscal years. In the staff's view, these revisions represented reversals of the company's prior investment decisions for its PUDs for approximately 39%, 24% and 27% of the total PUDs it had disclosed at the beginning of 2014, 2013 and 2012, respectively (Atlas Resource Partners LP (5/22/15)).
• The staff requested an explanation of the company's processes in preparing its annual reserves estimates, including processes intended to ensure that PUDs were claimed only for locations where a final investment decision had been made, and processes that took into consideration changes to previously-adopted development plans and the reasonable certainty criteria.
• In its response, the company provided the staff with a reconciliation of the reserve volumes that had been removed each year to the amount of the affected volumes in the respective fiscal years in which those volumes had been initially disclosed. The company also replied that its removal of PUDs from locations in one of its shale plays had been the result of more favorable well economics related to new PUD locations it had acquired during the most recent year, compared to the now less-favorable well economics of the older shale play locations (Atlas Resource Partners LP (response letter 6/30/15)).
• The Form 10-K for a company's fiscal year ended June 30, 2014 indicated low annual conversion rates for its PUDs for each of the prior five fiscal years. The staff requested information about the extent to which the company had historically rescheduled the drilling of its PUD wells (Energy XXI Ltd. 12/12/14)). It also noted the company's reduced capital expenditure budget and its potential liquidity constraints over the term of the development schedule. In later comments, the staff asked the company how the impact of the changes to its development schedule that it had assumed for its June 30, 2014 reserve report, and the factors that caused these changes (such as well economics and the five-year rule for PUD development), had been considered in order to ensure that its reported PUDs were limited to quantities that were reasonably certain to be developed within five years of their initial booking (Energy XXI Ltd. (5/29/15)).
• In another company's 2014 annual report, the staff noted that the drilling schedules for a significant majority of the company's PUD locations included in its reserves totals for 2012 and 2013 had been changed at least once, and in some cases up to four times, over the periods they had been included as booked PUDs. The staff also observed that in each of fiscal 2011, 2012 and 2013, the companies' development activity with respect to its PUDs, expressed as a percentage of total PUD volumes disclosed as of the beginning of that year, had been very low (Penn Virginia (4/24/15)). Also noted were inadequacies in the information the company had provided its audit committee upon completion of its year-end reserve report, because it addressed only high-level material changes to its development plans. The company amended its 2014 annual report, providing additional disclosures about its PUDs development plan and internal controls procedures.
• The company described several factors that had impacted its PUDs conversion rates. The drop in oil prices in the second half of 2014 had significantly affected its Eagle Ford development plan, which resulted in the company's deferring the development of certain PUDs in order to concentrate its capital on locations having potential for higher economic returns.
• It also disclosed that it had implemented internal controls procedures for its personnel to provide its audit committee and board of directors with detailed information about expected material changes to its PUDs resulting from development plan changes, including an accounting of PUD locations that were deferred or written off as a result of the changes (Penn Virginia (response letter 6/23/15)).
• Another company contended that its management was capable of making "real-time adjustments" to its development plans that modified both the identification of PUD locations and the timing for their scheduled drilling. It asserted that it needed to periodically "re-optimize" its development plans and make alterations based on factors such as new data from recently completed wells, changes in projected commodity prices and infrastructure availability. These arguments were not persuasive to the staff (Gulfport Energy (1/29/15)).
• The staff asked the company to expand its disclosures to identify and discuss the effects of its adjustments whenever they resulted in material changes in its previously reported reserves or its standardized measure. The company so complied in its 2014 Form 10-K filed with the SEC on February 27, 2015 (Gulfport Energy (response letter 3/3/15)).
• The staff appeared to be more sympathetic where third party operators had the power to make changes to a company's development plan for its non-operated properties. There, the staff asked the company to add disclosure regarding the circumstances surrounding the third-party operators' decisions and the extent to which the company's management expected that the same circumstances may occur again in the future (Vanguard Natural Resources (10/6/14)).

ABOUT THE AUTHOR

Marc Folladori serves as Senior Counsel at Haynes and Boone LLP in Houston. He has represented business clients in transactional matters for more than 40 years, focusing on securities law, mergers and acquisitions and corporate governance.

The author wishes to acknowledge the contributions made in connection with the preparation of this article by Judithe Little, Counsel, at Haynes and Boone LLP in Houston.