The First Resort Of A Scoundrel

Without knowing the specifics of their program -- and being admittedly less-than-knowledgeable about the mechanisms used to determine actual reserves -- this demand by the oil industry to change the SEC mechanism for determining oil reserves smacks of Enron-style fraud. That is, in the absence of actual reserves, the energy companies, smelling their own deaths, have decided to foist upon their shareholders outright fraud, and are trying to bully the SEC in the process.

The report, by Cambridge Energy Research Associates, calls on the SEC to revamp its reserves-accounting methodology to reflect changes in the oil industry since the guideline was hatched more than 20 years ago.

Among those changes: improved technology, which allows the industry to retrieve more of the oil and gas it finds, and increasing globalization, which means that more of the world's fossil-fuel supply lies in countries where the oil and gas is owned by the state, whose policies on production don't mesh with the SEC's rules. CERA officials noted that the industry has shifted from one focused on on-shore fields in the U.S. to one increasingly reliant on deep-water production around the world.

...

Daniel Yergin, CERA's chairman, said energy companies and Wall Street already focus on a broader measure than the SEC's in assessing reserves: not just "proved" reserves, which means oil and gas that can be produced given current technology and current market prices, but "probable" reserves, which takes into account longer-term estimates of technological development and price changes.

"Companies are going ahead and, indeed, investing billions of dollars based on indirect methods for assessing reserves," said Mr. Yergin. "They're making huge bets, and it is very, very dependent upon technological innovation." An SEC reporting standard that doesn't give companies flexibility to account for expected technological improvement "penalizes present investors," he said.

In other words, no matter how badly their fields decline, the firms should be able to report reserve growth based on "expected technological improvement". That is, they should be allowed to manufacture reserves growth based on speculation. That the report "was funded by oil and gas companies, accounting firms, law firms and industry consultants" is no surprise, but that the co-conspirators should include a consultant to the estimable CALpers public employee retirement fund is.

But they aren't the only ones criticizing the SEC's method. "To continue focusing on proved reserves is what really doesn't make sense," said Eric Knight, managing director of Knight Vinke Asset Management, a money manager that campaigns for improved corporate governance.

Mr. Knight's firm has been working with the California Public Employees' Retirement System, the largest U.S. public pension fund, which also has called on oil companies to subject their reserve estimates to external auditors. SEC rules don't require outside auditing of reserve numbers.

John Heine, an SEC spokesman, said agency officials "will read the report with interest but have no immediate comment."

As well they should. What makes this interesting -- and decidedly scary -- is the oxymoronic nature of the changes CERA proposes. On the one hand, they claim that the domestic piece of the energy puzzle is now overall much smaller than it was 27 years ago, when the current reserves accounting system was put into place. This is almost certainly true: CERA claims only 20% of SEC-registered corporations' reserves are found in "Texlahoma", the oil-producing region of Texas, Louisiana, and Oklahoma; the rest are overseas. So far, so good. But from there, it becomes rather more dangerous:

• Technological change "support[s] investment decisions costing billions of dollars", but we don't hear how this translates to usable reserves. The easiest way to make a million dollars, goes the cynical saw, is to start with two million.
• Oil in foreign countries can't be recognized as proven reserves for various reasons, but isn't this essentially hiding behind the skirt of governments reticent to disclose actual depletion?

The problem of reserve calculation is obviously difficult. Matthew Simmons in a recent lecture (PDF) likened the process to making "actuarial estimates of remaining years in a human life -- a scientific guess". But that guess is increasingly boosted by technological legerdemain: according to page 22 of Simmons' presentation, 6% of reserve growth over the last 20 years came from "drill bit" success; the rest was due to "paper barrels". Similarly, price increases in world markets mean oil-producing countries get a larger percentage of oil from existing fields, and cut into companies' shares. Simmons rightly observes that "'Trust me' was fine when the world's oil supply was young"; allowing the oil companies to change the rules of the game to invent new reserves virtually at will only serves to hoodwink existing oil company investors. Simply put: if reserves growth is real, why are we paying $51/bbl for oil today? Where's all the surplus capacity?

Update 3/3: It occurs to me that there is one part of their program that amounts to a step in the right direction, and that is reserves transparancy. However, the other parts of their program (such as accounting for "expected technological developments") puts even that into question.