News Detail Banner
All News & Events

Article: August 2015: Energy Litigation Update

Business Litigation Reports

Reserve Reports During the Oil Slump. The collapse of oil prices in the latter half of 2014 has led to SEC scrutiny of exploration and production (E&P) company compliance with rules regarding the calculation and reporting of proved reserves. Litigation in that respect could well be on the horizon. That is because oil and gas reserves in the ground are an E&P company’s most valuable assets. Reliable estimates of proved reserves are critical to investors and lenders. In addition to supporting valuation, proved reserves secure loans and are the subject of loan covenants. Increased proved reserves lead to increased borrowing capacity. In addition, proved reserves have a direct impact on income statements because increased proved reserves decrease the depletion, depreciation, and amortization expense (DD&A) that must be recognized in a given reporting period under E&P accounting rules.

Under the SEC rules, “proved reserves” are defined as quantities that “can be estimated with reasonable certainty to be economically producible . . . under existing economic conditions” before the contractual right to operate expires. 17 C.F.R. § 210.4-10(a)(22) (emphasis added). “Reasonable certainty” means “a high degree of confidence that the [reported] quantities will be recovered,” or “at least a 90% probability” if probabilistic methods are used. Id. at § 210.4-10(a)(24). A reserve is economically producible if it “generates revenue that exceeds, or is reasonably expected to exceed, the costs of the operation.” Id. at § 210.4-10(a)(10).

“Proved developed reserves” are “reserves that can be expected to be recovered . . . [t]hrough existing wells and existing equipment and operating methods or in which the cost of the required equipment is relatively minor compared to the cost of a new well.” Id. at § 210.4-10(a)(6)(i). “Proved undeveloped reserves” (PUDs) are associated with new wells on undrilled acreage and/or a “relatively major expenditure” on additional equipment. Id. at § 210.4-10(a)(31). To book PUDs for undrilled locations, there must be a “development plan . . . indicating that [the locations] are scheduled to be drilled within five years, unless the specific circumstances justify a longer time.” Id. at § 210.4-10 (a)(31)(ii). Under current market conditions, compliance with the five-year PUD rule may become an issue.

After natural gas prices collapsed in 2008, the SEC initiated investigations to determine the impact market conditions had on E&P companies’ intent to develop natural gas reserves and whether actual or potential changes in plans had been disclosed to investors. The same questions may be asked now about compliance with the five-year PUD rule, particularly if a prolonged slump results in significant reserves write-downs or performance fails to meet expectations.

After the oil price collapse, E&P companies laid off thousands of workers, idled hundreds of drilling rigs, and slashed capital spending. Unconventional drillers (i.e., shale drillers), which must constantly drill new wells to replace the reserves from wells that deplete rapidly, have focused on their best wells and wrung costs out of their budgets by drilling faster and cheaper—reducing the break-even commodity price needed to establish proved reserves. Many have delayed completion of drilled wells to avoid completion costs (up to 60% of the well cost), effectively storing oil in the ground until prices recover. Some companies have benefitted from higher-price hedges. But, these hedges are starting to roll off and there is a limit to how much costs can be reduced. If market conditions remain the same for an extended period or deteriorate, some E&P companies, particularly highly leveraged companies operating in basins with higher break-even pricing, will face significant distress.

By the time 2014 reserve numbers were reported, companies were already slashing their 2015 capital budgets. Presumably, this meant that development of some PUDs would be deferred beyond 2015. If deferral pushed planned development beyond the five-year window, changed economic conditions will not excuse the delay under the SEC rules. Moreover, if the year-end plan was to drill the delayed wells within the five year window but after 2015, the company may have assumed improved pricing or costs reductions and that the company would have the capability to drill both the deferred wells and the wells that were otherwise scheduled to be drilled post-2015 in the later period. These assumptions may be challenged, particularly if they have no historical precedent or deviate materially from peer assumptions.

The stakes are high for the industry, which to date has been shored up by a remarkable access to capital. Since the price collapse, North American E&P companies have raised over $13 billion in 30 separate secondary equity offerings. Public debt offerings and private equity have generated tens of billions more. It is remarkable, say some observers, that such a dramatic drop in oil prices was followed by so much capital rushing into the industry. Some industry observers believe that this money has come from generalists investing in a distressed sector expecting to reap profits from a nearterm recovery. Yet, as prices dropped again in early July, a near-term recovery appears unlikely. Credit and equity markets for the weaker operators are drying up, which should lead to financial distress and investor losses.

In this environment, year-end 2014 plans for developing reported PUDs will be scrutinized. Moreover, if it has become apparent that those plans must change materially, disclosure issues may arise, particularly in connection with the many public offerings that continued to reference the year-end 2014 reserve reports. Identifying a possible change in plans as a risk factor is not sufficient if it was obvious that the risk will be realized. As companies calculate and report their reserves for 2015, they should carefully consider whether their assumptions are overly aggressive and deviate from historical operating precedent or peer assumptions.