In late October, the U.S. Securities and Exchange Commission Division of Corporation Finance issued new compliance and disclosure interpretations, and the SEC Office of the Chief Accountant released Staff Accounting Bulletin No. 113, both of which clarify the application of the SEC’s new oil and gas disclosure rules issued in late 2008. Each of these releases is summarized below.

Background

On December 31, 2008, the SEC issued Financial Reporting Release No. 78, Modernization of Oil and Gas Reporting (Release No. 33-8995), which adopted significant and substantial amendments to oil and gas reporting disclosure requirements intended to modernize and update existing requirements. The new disclosure requirements (i) require companies to report oil and gas reserves using an average price based on the prior 12-month period rather than year-end prices, (ii) allow companies to provide information regarding sensitivity to price, (iii) permit the use of new technologies to determine proved reserves if those technologies have been demonstrated empirically to lead to reliable conclusions about reserves volumes, (iv) require disclosure of the technologies used to establish additions to reserve estimates, (v) allow companies to disclose their probable and possible reserves to investors, (vi) require companies to disclose reserves from non-traditional sources (such as bitumen, shale and coal) as oil and gas reserves, (vii) require updated tabular disclosure of reserves based on a new definition of the term “by geographic area,” (viii) require companies to disclose development of proved undeveloped reserves, (ix) require companies to report on internal controls over reserve estimation and the qualifications of those preparing or auditing reserves estimates and (x) require companies to file reports when they rely on a third party to prepare reserves estimates or conduct reserves audits. The new rules are implemented through substantial revisions and additions to the definitions contained in Rule 4-10(a) of Regulation S-X and the codification of Industry Guide 2 in a new Subpart 1200 of Regulation S-K, as well as additional revisions to the applicable sections of Regulation S-K to conform to the new rules.

Companies will be required to begin complying with the new disclosure requirements for registration statements filed on or after January 1, 2010 and for annual reports on Forms 10-K and 20-F for fiscal years ending on or after December 31, 2009.

Compliance and Disclosure Interpretations: Oil and Gas Rules

On October 26, 2009, the SEC Division of Corporation Finance released “Compliance and Disclosure Interpretations: Oil and Gas Rules” which sets forth the Division’s interpretations of some of the new oil and gas rules in Regulation S-X and Regulation S-K.

The interpretations include questions and answers regarding the definitions of deterministic estimate, development project, possible reserves, probable reserves, proved oil and gas reserves, reliable technology, reserves and undeveloped oil and gas reserves contained in Rule 4-10 of Regulation S-X and disclosure by companies engaged in oil and gas producing activities under Items 1201-1208 of Regulation S-K.

Regulation S-X

Deterministic Estimate. The C&DI make it clear that because the categories of proved, probable and possible reserves have different levels of certainty, it is not appropriate to sum up the individual deterministic estimates for those reserves into one total reserve estimate. Instead, the individual estimates for each category should be disclosed as separate estimates, with the difference in certainty for each estimate fully explained.

Development Project. In response to a question regarding what constitutes a development project, particularly if an company intends to develop a large field involving the drilling of numerous wells in multiple stages, the C&DI indicate that a development project (i) typically is a single engineering activity with a distinct beginning and end, that, when completed, results in the production, processing or transportation of crude oil or natural gas, (ii) typically has a definite cost estimate, time schedule and investment decision; is approved for funding by management; may include all classifications of reserves; and will be fully operational after the completion of the initial construction or development, and (iii) has a scope and scale such that if the project were terminated before completion, a significant portion of the previously invested capital would be lost. Further, the C&DI provide that if an investment decision has been made to develop only a portion of the primary, secondary or tertiary reserves, the remainder of the reserves would not be considered to be proved reserves until such time as management has made an investment decision to develop those additional reserves, the requisite level of certainty has been demonstrated from the initial portion of the development or by other means and the additional development is within five years of being initiated.

Possible Reserves; Probable Reserves. The C&DI indicate that it may be acceptable to assign unproved reserves below the Lowest Known Hydrocarbon (LKH) limit penetrated in a well bore if that volume of reserves meets the test for either probable or possible reserves; for example, probable reserves may be assigned if reliable technology and data exist that, in the judgment of the evaluator, support characterizing those reserves as probable reserves. However, if there is no data below LKH, the C&DI reiterate that no reserves should be assigned.

The C&DI also indicate that companies can assign probable or possible reserves in an area in which a company does not, or cannot, assign proved reserves, but disclosure of unproved reserves without associated proved reserves should be done only in exceptional cases, such as for (i) development projects where engineering, geological, marketing, financing and technical tasks have been completed, but final regulatory approval is lacking or (ii) improved recovery projects, at or near primary depletion, that await production response. The C&DI further clarify that (1) reserves should not be assigned without well penetration of the subject reservoir (rock volume) in the contiguous area that yields technical information sufficient to support the attributed reserve category and (2) volumes that are not economically producible are not reserves of any classification and should not be disclosed.

Proved Oil and Gas Reserves. The C&DI clarify that (i) unproved reserves should be evaluated using the same price used for the evaluation of proved reserves and (ii) the new definition of “proved oil and gas reserves” does not require companies to change their existing procedures for determining costs.

Reliable Technology. The C&DI indicate that the SEC staff does not intend to publish a list of reliable technologies that the SEC will accept for the determination of proved reserves. Instead, a company has the burden of establishing and documenting the technology (or set of technologies) that provides reliable results, consistent with the criteria set forth in Rule 4-10(a)(25) of Regulation S-X. Further, the C&DI advise that this information should be made available to the SEC upon request in support of any reserves estimates that the staff may be reviewing.

Reserves. The C&DI state that all government approvals must be obtained before claiming proved reserves under a production sharing contract.

The C&DI indicate that if it is equally likely that oil or gas is present above a highest known oil (HKO) limit, the lower value product should be assigned above HKO, but only if the well or field is in a location where a market for that product exists; for example, if there is no market for gas, or no way to transport gas to a market, then any assumed gas cap volume that may exist or does exist above HKO cannot be classified as reserves.

Undeveloped Oil and Gas Reserves. The C&DI indicate that companies can assign proved undeveloped reserves to horizontal locations offsetting the toe of an existing horizontal producing well if the location is moving in the direction of other successful, analogous producing horizontal wells, so long as the technical evidence supports this assignment with reasonable certainty.

The C&DI clarify that the standard “reasonable certainty of economic producibility” in the definition of undeveloped oil and gas reserves does not mean that a company cannot assign probable or possible undeveloped reserves beyond areas containing proved undeveloped reserves. In fact, the C&DI indicate that reliable technology can be used to establish that (i) probable reserves in undeveloped locations are as likely as not and (ii) possible reserves in undeveloped locations are possible but not likely.

The C&DI indicate that the determination of “specific circumstances” must take into consideration all of the facts and circumstances and that no particular type of project per se justifies a longer time period, and any extension beyond five years should be the exception, and not the rule, although it is noted that several types of projects, such as constructing offshore platforms and development in urban areas, remote locations or environmentally sensitive locations, by their nature customarily take a longer time to develop. The C&DI then list several factors that a company should consider in determining whether circumstances justify recognizing reserves even though development may extend past five years, which include the following:

The company’s level of ongoing significant development activities in the area to be developed (for example, drilling only the minimum number of wells necessary to maintain the lease generally would not constitute significant development activities);

• The company’s historical record at completing development of comparable long-term projects;
• The amount of time the company has maintained the leases, or booked the reserves, without significant development activities;
• The extent to which the company has followed a previously adopted development plan (for example, if a company has changed its development plan several times without taking significant steps to implement any of those plans, recognizing proved undeveloped reserves typically would not be appropriate); and
• The extent to which delays in development are caused by external factors related to the physical operating environment (for example, restrictions on development on Federal lands, but not obtaining government permits), rather than by internal factors (for example, shifting resources to develop properties with higher priority).

Further, the C&DI say that a company’s decision to slowly develop a field in order to extend its economic life would not justify recognizing proved undeveloped reserves in the field beyond five years. The C&DI indicate that a company should not recognize undeveloped areas as proved undeveloped reserves if it does not anticipate initiating development in those areas within five years.

With respect to what constitutes the required adoption of a development plan under the definition of undeveloped oil and gas reserves, the C&DI indicate that adoption requires a final investment decision and not the mere intent to develop.

Finally, the C&DI confirm that there is no difference between the terms “scheduled to be drilled” used in the definition of undeveloped oil and gas reserves in Rule 4-10(a)(31) and “initiation of development” used by the Petroleum Reserves Management System of the Society of Petroleum Engineers and World Petroleum Council.

Regulation S-K

With respect to disclosures to be made by companies engaged in oil and gas producing activities under new Subpart 1200 of Regulation S-K, the C&DI clarifies the following:

• For recently drilled wells, where there is only a limited amount of production data and the production rate is expected to decline in a hyperbolic manner, but the evidence to date indicates only an exponential decline, companies can assume that the production rate will eventually begin to decline in a hyperbolic manner and claim that as proved reserves, but only when additional production data, such as from offset wells, exists demonstrating that there will be a change in the manner of decline from exponential to hyperbolic;
• Reserve quantities attributable to equity method investees should be combined with reserve quantities attributable to consolidated entities for purposes of identifying countries containing 15% or more of a company’s reserves under the tabular disclosure of reserves required by Item 1202 of Regulation S-K; and
• When a company discloses a filing that it engaged a third party to prepare or audit its reserve estimates or to conduct a process review, even if for only a limited amount of its reserves, then the company must file the third party’s report as an exhibit to the filing.

The complete C&DI can be viewed at http://www.sec.gov/divisions/corpfin/guidance/oilandgas-interp.htm.

Staff Accounting Bulletin No. 113

On October 30, 2009, the SEC Office of the Chief Accountant released Staff Accounting Bulletin No. 113 which updates Topic 12, “Oil and Gas Producing Activities,” included in the Staff Accounting Bulletin series, to make it consistent with the new oil and gas disclosure rules. The principal revisions include:

• Changing the price used in determining quantities of oil and gas reserves to reflect the new requirement that companies report oil and gas reserves using an average price based on the prior 12-month period rather than year-end prices;
• Eliminating the option to use post-quarter-end prices to evaluate write-offs of excess capitalized costs under the full cost method of accounting;
• Removing the exclusion of unconventional methods used in extracting oil and gas from oil sands or shale as an oil and gas producing activity; and
• Removing certain questions and interpretative guidance that are no longer necessary.

The staff expects companies to apply this updated guidance prospectively when companies are required to begin complying with the new oil and gas disclosure requirements.

The full text of the release can be viewed on the SEC website at http://sec.gov/interps/account/sab113.htm.

This article was prepared by Laura Ann Smith (lasmith@fulbright.com or 713 651 5304) and Harva Dockery (hdockery@fulbright.com or 214 855 8369) from Fulbright’s Securities Practice Group.