Accurately Disclosing Oil Reserves
Yesterday’s W$J reported on an effort by oil companies to change the way reserves are reported in securities filings. SEC rules, it seems, mandate that reserves be measured in a manner that understates the actual amount of available oil. For example, the rules (available here) require that only proven reserves (those for which there is a “reasonable certainty” of actual recovery) be reported. On first glance, this doesn’t sound unreasonable, but the manner in which “reasonable certainty” is determined essentially translates the criterion into one of “virtual certainty.”
First, the reserves must be recoverable using fairly old-fashioned technology. New technologies, of course, can recover harder-to-reach oil. While oil companies know such oil is there, and are quite confident that they will be able to get it, the SEC doesn’t permit them to report the oil.
Second, it must be economically feasible to recover the oil at the end-of-year price for the previous year. There are a couple of problems here. First, the one-day, end-of-year price is notoriously variable and may bear little resemblance to the average prevailing price. For example, WTI Oil Price data reveal that the year-end price of oil in 1999 was 33.5% higher than the annual average price; in 2001, it was 23.7% lower. An average price of some sort would present a more accurate picture of economic conditions. In addition, ignoring oil that’s clearly available, but not profitably recoverable at this point in time, paints an unduly bleak picture of our energy situation. If and when prices rise a bit in response to increased demand and/or reduced supply, lots more already-discovered oil will become economically recoverable. Anyone wishing to evaluate the true state of oil reserves would want to know about this discovered, but not yet economically recoverable, oil. SEC rules pretend it doesn’t exist.
The SEC insists that its somewhat arbitrary rules are necessary to prevent fraud and to provide investors with “apples-to-apples” comparisons of energy companies’ reserves. Perhaps the rules do that, but at what cost? If the goal of mandatory disclosure is to provide investors with an accurate picture of a company’s financial condition, then shouldn’t the information disclosed be that by which the company judges its own financial health and upon which it bases operating decisions? In fact, the major oil companies, which base all sorts of business decisions on reserve data, internally measure their reserves using alternative standards jointly developed by the Society of Petroleum Engineers and the World Petroleum Council. Those same standards are used by the Energy Information Administration (EIA) of the U.S. Department of Energy and the Minerals Management Service (MMS) of the U.S. Department of Interior. Reflecting technological developments and permitting recognition of highly probable reserves, these alternative standards present a much clearer picture of how much oil is really available.
Isn’t this the information investors should have? As the W$J reported last week, venture capital is flowing freely toward developers of alternative fuels. That makes sense if that’s the highest and best use of that capital, given the current energy situation. But it doesn’t if it’s not. Of course, venture capitalists are unlikely to base their investment decisions on SEC disclosures regarding oil reserves; the capital markets will eventually see through (and ignore) metrics that are unreliable. It does seem, though, that the SEC could assist in the effort to channel capital in the right direction by ensuring that the disclosures it mandates reflect economic reality.