Brent and West Texas Intermediate (WTI) crude oil prices are down for the first half of 2017. The Brent crude oil price dropped by 0.81% per barrel, while WTI oil prices were trading 0.37% lower per barrel. And current market prices are a far cry from where they were a decade ago.
The number of operating oil rigs in the United States is at its highest point in over three years — a likely reason for the price drop. Market analysts have acknowledged the continuing rise of oil rigs, suggesting that the country could do without any additional rigs if it wants a more stable market by 2018.
This is only one of the many possible explanations that international energy analysts continue to debate. Issues such as global politics and economic supply also contribute to the ups and downs of the oil markets. Plausible reasons aside, the reality is that oil prices will experience declines and increases at certain periods.
Petroleum companies and market analysts assess the market value of oil reserves for the benefit of the industry. During the assessment, they must know how to differentiate the U.S. Securities and Exchange Commission (SEC) reported value and the fair market value of the reserves. This is because there are different methodologies and reasoning for valuation depending on the purpose for determining the reserves’ value.
Fair market value is the valuation for tax purposes under the U.S. Internal Revenue Code. It takes into consideration what market participants expect in return for selling their business or assets, and it includes assumed capital structure, tax rates and synergies.
Conversely, the SEC reported value is the crude oil and natural gas reserve valuation that companies disclose to the SEC. Also known as PV-10, it is the current value of estimated future oil and gas revenues minus direct expenses and discounted at a yearly rate of 10%.
Companies disclose their oil and gas reserve valuation to the SEC for a couple of reasons – to determine the overall financial position of the organization, and to assess the risks that may affect the company’s future financial position.
A Rundown of SEC Oil and Gas Reserve Reporting
The SEC made oil and gas reserve reporting a requirement because it aims to standardize the metric that companies use for reserve valuation. Disclosure, it believes, makes all companies’ reported amounts comparable.
The Accounting Standards Codification (ASC) 932 is the SEC’s standardized measure of oil and gas. The ASC requires public companies to disclose discounted future cash flows in relation to their crude oil and natural gas reserves using a standardized measurement. The process includes several steps:
First, petroleum engineers make rough estimates based on the amount of proved reserves and their assumed production period.
Second, the SEC Final Rule compiles the estimated future cash flow by applying prices to year-end oil and gas amounts.
Third, the estimated cash flow deducts the estimated production costs and abandonment costs based on year-end economic conditions.
Fourth, the proved oil and natural gas reserves use the year-end statutory tax as the basis for future income tax expenses. The remaining tax amount is related to the reserves including properties, credits, deductions and allowances.
Last, the future net cash flows apply a 10% discount rate for the present value.
The agency’s required disclosure does not necessarily represent the fair market value of a company’s oil and gas reserves, though.
Oil and Gas Reserve Reporting Requirements Based on the SEC Final Rule
The SEC Final Rule determines the disclosure requirements for oil and gas reserve reporting. It aims to modernize oil and gas disclosure requirements, putting them on the same page as current industry practices and reliable technological advances. As such, it gives investors a more comprehensive understanding of crude oil and natural gas reserves and a better comparison of reserves among companies.
Initially, SEC rules required a single-day, fiscal-year-end spot price to determine a company’s oil and gas reserves and economic production capability. The SEC Final Rule changes this requirement to a 12-month average of the first-of-the-month prices.
In other words, it requires companies to estimate their proved oil and gas reserves based on a 12-month period, with the exception of a prior contractual arrangement or escalations based on future conditions. The intention here is to boost comparability of reserves between companies and reduce the impact of seasonality and short-term price volatility.
Guidelines for SEC Oil and Gas Reserve Reporting
The SEC is on a mission to protect investors and maintain fair and efficient markets. It contributes to the industry by providing standardized information related to oil and gas reserve reporting. Amendments to align revised disclosure and full-cost accounting rules harmonize the oil and glass disclosures of domestic issuers as well as foreign private issuers.
As such, the SEC Final Rule serves as a guide that enables companies to adequately prepare an oil and gas reserve report. Specifically, it gives a comprehensive definition of proved oil and gas reserves to standardize what it means for different companies.
The term, according to the SEC Final Rule, refers to the amount of oil and gas which, through geosciences and engineering data analysis, may be economically producible starting on a given date.
The certainty of economic producibility should fall under existing economic conditions, operating methods and government regulations. This should be the case, according to the SEC Final Rule, unless there is sufficient evidence that oil and gas renewal is certain regardless of the estimation methods.
Sierra Pine Resources International looks closely at the future of crude oil and natural gas reserves. We are currently developing industry-related case studies to help organizations and individuals keep up with the condition of the industry, determining their position in the market.