December Surprise

A month ago an old friend--in fact a former boss and mentor--hinted that the recent collapse of oil prices might lead to revisions of the oil & gas reserves that companies carry on their books. I recalled his suggestion a week ago, when the Wall Street Journal published an article on the subject of potential reserve revisions, indicating that "big chunks" of reserves might have be to declared "uneconomic", harming company valuations and potentially their ability to raise capital. This came into even sharper focus last Friday, when the January 2009 crude oil futures contract on the New York Mercantile Exchange (NYMEX) plunged sharply on its last day of trading, ending at $33.87 per barrel--the lowest oil price since February 10, 2004. I can only imagine how intently the reserves accounting groups of oil and gas companies must be scrutinizing the performance of the February contract, wondering how badly it might swoon by December 31, when the price for determining year-end "proved reserves" is established. The comparable price from which the 2007 year-end reserves were calculated was $95.98 per barrel, the highest ever. The subsequent slide puts reserves booked as long ago as 2004 at risk.

My friend knows more about oil & gas reserves and their reporting, from personal experience, than I ever will. It's an arcane subject. Despite the general designation of "reserves accounting", this task is normally carried out not by accountants, but by engineers under the supervision of a very senior and highly-experienced petroleum engineer or geoscientist. Tallying up how much oil and gas a company's leases are likely to produce involves consideration of a large array of technical and economic factors, including the market value of the future production these fields could yield. I'm sure there are other differences between the current SEC regulations, under which these figures are disclosed as part of a company's annual financial statements, and the standard industry approach set by the Society of Petroleum Engineers. The most important for the purposes of this posting is that under the SPE guidelines, the economic viability of the potential production from an oil deposit is assessed against the prevailing prices over the last 12 months, while also taking the firm's forecast of future prices into account. The SEC requires reserves to meet its standards for "proved" status at the price in effect as of the assessment, in this case at year-end.

When the price of oil was relatively stable, there wasn't much difference between these two perspectives, and thus between reserves determined under SEC or SPE guidelines. Even in the last several years, as prices rose dramatically from their roughly $20-25 per barrel range of the previous two decades, the 12-month averages were typically not drastically different from year-end prices, as for example the $66.25/bbl average for 2006, compared to $61.05/bbl on 12/29/06. However, if prices remain where they are today, we could see a $60/bbl difference between these two metrics for 2008, and a year-on-year decline of over $50/bbl. That would require any reserves that were booked at a price above $40 or so--not just this year, but going back as much as four years--to be reevaluated. (Natural gas has fallen, too, though by much less than crude oil.)

This situation is complicated by a bigger underlying question: what is the value of oil likely to be in the future, rather than at a moment in time or over some past interval? Reserves are future production, after all--in some cases extending over 20 or 30 years, or even longer. The market for prompt delivery might be glutted, and the outlook for the next year might appear pretty bleak, but without reading too much into the present steep "contango" in oil prices, there is every reason to believe that when global economic growth resumes, the fundamental conditions that pushed oil prices beyond $100/bbl will reassert themselves.

Before investors panic at the prospect of publicly-traded oil companies writing down hundreds of millions or billions of barrels of "proved reserves" for accounting disclosure purposes next year, they need to consider where the volumes in question will have gone. Were they merely shifted from the "proved" to "probable" category--thus not affecting the amount of oil that would ultimately be produced--by a temporary oil glut arising from a global recession, or did their existence depend on an oil-price bubble that is unlikely to reflate? And even if these conditions do prove to be temporary, there's a good chance that a number of oil and gas projects, including some fairly large ones, will have been deferred in the meantime, if not canceled entirely. That affects reserves in the most fundamental way possible, as well as altering the future global production profile. Since my own portfolio includes oil & gas equities, I face the same uncertainties in this regard as anyone else, as both an investor and a consumer. At the very least, this situation highlights the urgent need for a major revision of the SEC regulations covering the reporting of reserves, along the lines the Commission has already proposed, to put reserve estimates on a more meaningful and less volatile basis.

Energy Outlook will be on holiday break until next week. Merry Christmas, Happy Hanukkah, and Seasons Greetings, as appropriate!