Tuesday, March 08, 2005

Reserve Accounting
A comment on yesterday's blog raised the issue of petroleum reserve accounting, which has become highly contentious in the wake of Shell's problems and the publication of an industry-sponsored report calling on the SEC to change its reserve accounting procedures. While admitting that I am hardly an expert on this complex subject, I hope I can shed a little light on the basic issues involved.

The present system of reserve accounting revolves around two fundamental, investor-focused concerns. First, with oil and gas reserves seen as a key source of the future value of an energy company, investors need to know that a firm's stated reserves have a high probability of turning into actual oil and gas production in the future. Second, they need to know that company A and company B used comparable methods to calculate their reserves, so they can properly choose which equity to buy. These two concerns sound similar, but their implications are quite different.

For one thing, comparability does not require absolute accuracy in assessing the basis for future production, as long as this is done the same way for everyone. It also ignores subtler differences in the quality of reserves. All barrels are not equal: some firms have more heavy oil, which is less valuable and requires more processing, while others have more gas, needing more infrastructure to bring it to market. Despite these shortcomings, which require greater investor sophistication to sort out, I would still argue that comparability is the crucial concern for the stock market.

For public policy, however--and arguably from a management perspective--absolute accuracy is more important. Each company must see how its future production would fare under expected conditions of price and resource access, in order to know where to invest its exploration and production budget. For quite some time now, most of the annual additions to reserves shown by the major oil companies have not come from finding new fields, but from reassessing what their existing fields can economically produce in light of expected prices and available extraction technology. So as technology improves, reserves go up without finding a single new field. This has its limits, though, and new fields must be eventually be found, a process that is always unpredictable and sporadic, leading to "lumpy" reserves additions.

The above description doesn't convey the complexity involved in this issue. There seems to be as much art as science to reserve accounting, and the majority of knowledge about this arcane practice resides within these companies, not in the SEC. For this reason, the recommendations of the industry report published by Cambridge Energy Research Associates should be evaluated carefully and with an open mind. While it is true that the oil companies might benefit from more favorable rules on reserve accounting, they will benefit more from greater transparency and investor confidence in this area, and I think most of them understand this.

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