DISCLOSURE OF RESERVES: YEAR- END PRICES VERSUS AVERAGE PRICES Institute/docs... · DISCLOSURE OF RESERVES: YEAR-END PRICES VERSUS AVERAGE PRICES Terry L. Crain Bradley E. Lail* On

DISCLOSURE OF RESERVES: YEAR-END PRICES VERSUS AVERAGE

PRICESTerry L. Crain

Bradley E. Lail*

On December 12, 2007, the Securities Exchange Commission (SEC) publisheda Concept Release on possible revisions to the disclosure requirements relating tooil and gas reserves. The SEC was concerned that the existing rules, adopted in1978 and 1982, may not be informative for investors and other users of financialstatements to make decisions. Based on comments received by oil and gascompanies, public accounting firms, law firms, and industry associations, the SECreleased Modernization of Oil and Gas Reporting in December 2008, effective forfilings with the SEC in 2010. The FASB then amended section ASC 932-235-20to conform the definition of proved reserves to that of the SEC effective for filingsin 2010.

Nichols (2011) summarizes the major areas of the SEC release and examines indetail the characteristics of companies choosing to disclose probable reserves. Shefinds that most publicly-traded exploration and production companies chose not todisclose probable reserves. Those that did disclose probable reserves were morehighly-leveraged companies.

In this study, we examine a portion of another major provision of theModernization of Oil and Gas Reporting document: the revision of the definitionof proved reserves. The SEC release contains two provisions that relate to thedefinition of proved reserves for disclosure purposes. The first provision expandsthe categories of resources to include in the definition reserves from non-traditional sources such as bitumen, shale, and coalbed methane. The secondprovision, and the issue that we examine in this paper, is that companies must nowuse an average monthly price of oil and gas during the year, as opposed to thefiscal year-end price of oil and gas, to determine the economic producibility of thereserves. The motivation for the SEC to change the measurement of price was toreduce the price-induced volatility in the measurement of proved reserves. Theargument follows that the use of an average, as opposed to a single price point, canreflect current economic trends but is less likely to be influenced by economicconditions at a single point in time (i.e., fiscal year-end). While this change doesnot affect the determination of proved reserves used in calculations in the basicfinancial statements, it does affect the disclosure of proved reserves and thecalculation of the standardized measure of both oil and gas in the notes to thefinancial statements.

* The authors are, respectively, Associate Professor of Accounting at the University of Oklahomaand Assistant Professor of Accounting at Baylor University.

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We compare year-end prices with average first-of-the-month prices for the yearfor both oil and gas for several time periods to examine the actual difference inprice variations. For oil reserves, our results show that no significant differenceexists between between the methodologies in both the mean of the prices and thevariance in the prices. That is, there is no more variation in year-end prices thanin average first-of-month prices for oil over periods of 5, 10, 15, 20, and 25 yearsending December 2010. We perform a similar but separate analysis for gasreserves, as prior research has shown that prices for these reserves behavedifferently from oil prices due to a stronger seasonality effect. We document ahigher mean for the year-end prices as compared to the average first-of-monthprices for the full sample (25 years of data) which is most likely driven by winterseasonality effects and our sample of predominantly December year-end compa-nies. However, we still find that the variances in the price of proven gas reservesare not significantly different between the two measures.

Based upon our findings, we argue that the SEC mandated change in themethod of computing reserves for footnote disclosures was not justified, at leastas it relates to the variability of the two measures under consideration. Theredefining of the measure for proved oil and gas reserves results in pricinginconsistencies within SEC filings. Financial statement calculations for reservesstill rely upon year-end prices, while the footnote disclosure calculations use thenew first-of-month average price measure. Companies now incur greater coststhrough additional resources to calculate both measures. This new approach isalso inconsistent with the concept of “fair value” which is becoming moreimportant in financial reporting. If the newly required average measure proved tobe more useful to investors for decision making, the additional costs andinconsistencies might be worthwhile, but our findings are contrary to thissupposition.

Definition of Price in Determining Reserves

In November 1982, the Financial Accounting Standards Board issued Statement69 (FAS 69) which set out requirements for oil and gas producing companies todisclose additional information, including proved reserves. For publicly-traded oiland gas companies, SEC Regulation 4-X (in effect through 2009) further definesproved reserves as “the estimated quantities of crude oil, natural gas and naturalgas liquids which geological and engineering data demonstrate with reasonablecertainty to be recoverable in future years from known reservoirs under existingeconomic and operating conditions, i.e., prices and costs as of the date theestimate is made.” The “date the estimate is made” clause of the definitionrequired companies to use a single year-end price.

When the SEC issued their Concept Release in December 2007, theyspecifically requested comments on the definition of proved reserves, whichincluded the price which should be used to estimate proved reserves. Oil pricesduring the two-year review period (2007–2008) went from $51.23 on January 16,2007, to a high of $145.31 per barrel on July 3, 2008, and subsequently fell back

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to $30.28 on December 23, 2008.1 These fluctuations in prices during the reviewperiod illustrated the concern that many interested parties had in using a singleprice point for estimating oil and gas reserves.

The SEC received 80 comments from a myriad of interested parties includingoil and gas companies, accounting firms, law firms, consultants, governmentagencies, and public interest groups. Many commenters recommended that theSEC instead use an average price for the year as opposed to a single-day, fiscalyear-end spot price to determine whether resources are economically producible,They reasoned that single-day prices did not represent general price trends andcurrent economic conditions which might ultimately lead investors to incorrectconclusions regarding proved reserves. Many comment letters suggested anaverage month-end price to eliminate the volatility in oil and gas prices.2 Otheroptions suggested by comment letters included (1) a futures price, (2) manage-ment’s forecasted price, (3) an average price over three months, and (4) an averageprice over two years.

While most of the comment letters supported an average price for the year,opinions varied on how to calculate the average annual price. Some suggestedusing a twelve-month period that ended before the entity’s year-end as opposed toan annual month-end average. For example, if a company had a year-end ofDecember 31, 2009, then the price of oil or gas could be averaged over atwelve-month period ending before December 31, 2009, to give the companysufficient time to complete the analysis needed to provide the disclosure with itsSEC filing. EnCana Corporation suggested a three-month lag period so that aDecember 31 year-end company would end its twelve-month period on September30.3 EnCana Corporation also suggested a daily average for the price of oil andgas as opposed to a monthly average to further eliminate volatility.4 Pricewater-houseCoopers and Chesapeake Energy Corporation both recommended that theaverage price be calculated using the beginning-of-month prices to give thecompany sufficient time to complete the additional calculations.5

On June 26, 2008, the SEC issued its report entitled Modernization of the Oiland Gas Reporting Requirements effective for filings with the SEC in 2009. Inenacting the new rules, the SEC took into account the comments on timing andselected an unweighted monthly average using the sum of the prices on the firstday of the month for the twelve months of the fiscal year, divided by twelve. Soa December 31 year end company would add the prices on January 1, February

1 Prices are for one barrel of West Texas Intermediate oil for Delivery in Cushing, OK per theEnergy Information Administration website http://www.eia.gov/.

2 See, for example, the comment letter from Evolution Petroleum Corporation dated September8, 2008.

3 EnCana Corporation comment letter dated February 19, 2008.4 EnCana Corporation comment letter dated September 8, 2008.5 See PricewaterhouseCoopers’ comment letter dated September 5, 2008 and Chesapeake Energy

Corporation comment letter dated September 8, 2008.

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1, . . . , December 1, then divide by twelve. This would give the company a onemonth period to make the calculations necessary to provide the reserve disclosure.The change implementing the unweighted average price was finalized by the SECand published in the Federal Register on January 14, 2009.

The FASB issued Accounting Standards Update (ASU) 2010-3 in January 2010in which they modified ASC 932 effective for annual reporting periods ending onor after December 31, 2009. In ASU 2010-3, the FASB adopted the SEC’s changefrom a single price at year-end to that of a twelve-month average historical price.The FASB reasoned that the average price would mitigate the volatility that asingle date price would have on reserve estimates. ASC 932-235-20 defines theprice to be used as “the average price during the 12-month period before theending date of the period covered by the report, determined as an unweightedarithmetic average of the first-day-of-the-month price for each month within suchperiod, unless prices are defined by contractual arrangements, excluding escala-tions based upon future conditions.”

Change in Price Not to Affect Other Accounting Provisions

Although the SEC modified the method by which the price of reserves wasdetermined for the disclosure of reserves, it chose not to change how reserveswere computed for other financial accounting purposes. “Notwithstanding ourproposal to change the single-day, year-end pricing for the estimation of reserves,we are not proposing to change the prices that are used for accounting purposes.”6

Oil and gas companies continue to depreciate property, plant, and equipmentrelated to oil and gas producing activities using a units-of-production basis overproved developed reserves or proved reserves, as applicable, with such reservesdetermined using single-day, year-end prices of oil and gas. In addition,companies using the full cost accounting method will continue to use thesingle-day, year-end rate for purposes of determining the limitation on capitalizedcosts (i.e., the ceiling test). This results in two different presentations of provedreserves using two different economic producibility assumptions. For purposes ofthe FAS 69 disclosure of reserves, proved reserves are calculated using averageprices for the year. However for the calculation of depreciation, depletion, andamortization (DD&A) expense reported on the income statement and accumulatedon the balance sheet, reserves are calculated using single-day year-end prices foroil and gas.

The decision to compute proved reserves differently for FAS 69 disclosuresversus the financial statements drew disapproval from the accounting profession.The comment letters from Deloitte, Ernst & Young, Grant Thornton, KPMG, andPricewaterhouseCoopers criticized the use of different definitions of provedreserves for the basic financial statements and for the FAS 69 disclosures.7 Theaccounting firms cited inconsistency and nontransparency for the investors and

6 Modernization of the Oil and Gas Reporting Requirements, p. 20.7 See comment letters from Deloitte (September 8, 2008), Ernst & Young (September 3, 2008),


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added costs of compliance for the oil and gas companies as their major criticisms.Deloitte also raised the issue of moving away from a year-end price to an averageprice as being out of alignment with the FASB’s move toward fair value.

The oil and gas companies as well as industry groups also questioned the useof two measures of proved reserves. Both the American Petroleum Institute andExxonMobil questioned the SEC’s estimate of 35 additional hours required byeach registrant. They both estimated the compliance for large oil and gascompanies to be an additional 15,000 to 20,000 hours annually.8

Effect on Oil versus GasA final issue is whether the change from a year-end price to an average monthly

price will have a similar effect on both oil reserves and gas reserves. Brown andYucel (2008) state that “Because natural gas consumption is seasonal butproduction is not, natural gas inventories are built up during the summer for usein the winter. This seasonality leads to higher winter prices and lower summerprices.” Given that a large majority of publicly-traded oil and gas companies havea December 31 year-end, then natural gas producing companies have been pricingreserves at a seasonally adjusted higher price. Now that they are required to pricereserves at an average price for the year, their reserves may be negatively affected.The same argument does not hold for crude oil. Therefore, gas companies mightbe disadvantaged when compared to oil companies.

Given the issues raised above including: (1) internal inconsistencies indocuments filed with the SEC, (2) the additional time necessary to computeproved reserves using two methods, (3) the misalignment with “fair value”reporting, and (4) possible different effects on oil versus gas, we test whether thevariances between year end prices and average first-of-month prices are signifi-cantly different separately for both oil and gas.

Tests to Determine the Effect on Oil Price VolatilityIn this paper, we examine whether there is a significant difference between a

single date price as of fiscal year-end and an average annual monthly price forboth oil and gas proved reserves. For our analysis, we gathered daily prices for oiland gas from the Energy Information Administration for the years 1986–2010. Weused the monthly Cushing, OK West Texas Intermediate (WTI) spot price FOB foroil and the U.S. Natural Gas wellhead price for gas. These are the most commonbenchmarks for oil and gas production in the United States. We computed theaverage price of oil for the year by using the unweighted arithmetic average fromthe first day of the month price consistent with new SEC guidance as well as ASC932-235-20. Table 1 provides the average price and year-end prices, and Figure 1illustrates these prices along with the monthly prices for each year in our sampleperiod.

Grant Thornton (September 8, 2008), KPMG (September 8, 2008), and PricewaterhouseCoopers(September 5, 2008).

8 See comment letters from ExxonMobil (September 5, 2008) and American Petroleum Institute(September 18, 2008).


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The stability of oil prices from 1986–2003 is apparent in Figure 1, and as aresult, the differences in reserve price measures over that time period is notsignificant. The upsurge in the volatility of oil prices since 2004 has led to therecent concerns over using year-end prices. The final column in Table 1 shows thestandard deviation of monthly prices by year averaged 2.44 and did notconsistently exceed 2.50 until 2004. The final seven years of our sample showstandard deviations that were 2 to 10 times higher as oil prices rose from $32.51at the end of 2003 to a high $141.06 on July 1, 2008, before returning back below$100. With the rise in price volatility, the question is whether using an averageprice for the year would better represent these price fluctuations.

Test of Means

We first compare the means of the two measures for oil prices. From Table 1,the mean difference over the sample period is $0.14, but in periods when thevolatility of prices is higher, the differences between year-end and averagemonthly prices are significantly higher (e.g., $57.03 in 2008). To statisticallyanalyze the price differences, we first use a paired t-test to test whether thedifference between year-end and average monthly prices were different from zero.The t-statistic from the paired t-test is only 0.051 which is insignificant at anyconventional level and suggesting that over a longer period of time the twomeasures of proven reserves are not dramatically different. In Table 2, Panel A wealso compared means for 20, 15, 10, and 5 year periods ending December 31,2010 to examine whether measurement choice is more critical when pricevolatility over a shorter period, like the most recent 5-year period from 2006 to2010, is higher. Even over shorter time periods, the difference between year-end


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and average monthly prices is not large. Only the 5-year period has a meandifference larger than $1.00, but all paired t-tests indicate no significant differencein means between the two price measures.

While the test of means does not directly assess the concern that year-end pricesare more volatile than annual average monthly prices, the fact that these twomeasures produce similar means over varying time periods, even when volatilityis at its highest levels, raises concerns about recent decisions by the SEC andFASB. Companies have argued that having to calculate both measures of provedoil reserves, one for financial statement purposes and the other for footnotedisclosure, is a costly endeavor. These initial results question whether these costsare well spent given the little difference we find between the two measures.

Test of Variances

Figure 1 illustrates the volatility of oil prices, especially over the latter part ofour sample. Because the purpose of replacing year-end prices with average first ofmonth prices was to reduce the variance in the data, we also compared thevariance in the year-end means with the average monthly means using an F test.We show the results of the tests of variances over five different time periodsending December 31, 2010, in Panel B of Table 2. In all cases, the variances


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between year-end prices and average monthly prices are not significantlydifferent. The standard deviation of the fiscal year-end prices is higher than theaverage first-of-month price, but the differences in standard deviations over thesefive periods are consistently small. The most significant F test for the 5-yearperiod (2006–2010) only has a p-value of 28.1%. We conclude from these teststhat using the fiscal year-end price is no more volatile than the newly instatedaverage first-of-month calculation.

We again give specific attention to last five years of sample which providedmotivation for the SEC and FASB to change the way proven reserve prices aremeasured. Figure 2 highlights the price movement in oil from 2006 through theend of 2010. Month-to-month prices are definitely volatile and range from $40 to$141 and the volatility is magnified in 2008. Included in the figure are the twomeasures of proven oil reserves. While not perfectly in-step with one another,consistent with our statistical analyses, one could not conclude that the year-endmeasure is significantly more volatile or less poorly represents the actualmovements in oil prices. The argument and comment letters suggesting that asingle-day spot price at year-end does not reflect current economic conditionsappear to be unfounded.

Tests to Determine the Effect on Gas Prices VolatilityWe next performed a similar set of tests for gas prices.The separate concern for

natural gas prices is their seasonal nature where prices are higher in the winter(Brown and Yucel 2008). In several of the comment letters, producers of naturalgas expressed concern that using a monthly-average price for natural gas wouldnegatively affect their financial statements because most natural gas companieshave December 31 year-ends. Therefore, we examine whether year-end prices for


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natural gas are higher than average monthly prices.

For our analyses, we gathered price information for U.S. natural gas from theEnergy Information Administration’s website.9 While data is available on amonthly basis beginning in 1973, we use only 1986 and later to be consistent withour oil pricing data. Table 3 provides the gas prices over our sample period as wellas the calculated difference between the two and its standard deviation. Despitethe smaller prices for gas compared to oil, the $0.30 difference between the twomeasures of proven gas reserves over the full sample period is relatively larger. Toconfirm seasonal concerns, we also see that for 18 of the 25 years, year-end pricesexceed the computed monthly average, and the year-end standard deviation ishigher (2.08 vs. 1.98). Figure 3 also illustrates the annual spikes at the end of eachyear and subsequent beginning of the next as well as the rise in gas prices andgrowth in volatility nearer to 2010.

9 Prices are for 1,000 mcf of gas wellhead price per the Energy Information Administrationwebsite: http://www.eia.gov/.


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For the tests of means in Panel A of Table 4, the paired t-statistics are of greatersignificance than the same tests for oil prices. At a 10% significance level, we findthat for the full sample, the mean fiscal year-end price is significantly higherwhich is consistent with the suggested seasonal trends in natural gas prices. As wefocus on more recent sample periods, the mean differences lessen dramatically insignificance. In fact, the 5-year period shows a higher mean price for the averagemeasure, not the year-end price, though the prices are not significantly different.


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Panel B of Table 4 shows our F tests over the five sample periods. Except forthe 5-year period, the volatility of the year-end measure exceeds the averagemeasure. However, none of the F-statistics are significant at conventional levels.As with oil prices, no significant differences exist between the variance of gasprices between year-end and average monthly prices for any of the five periodswhich we examined. Consistent with concerns from the comment letters of somegas producers, a change from year end price to average first-of-month price maynegatively affect the amount of proved reserves they report.

Sensitivity of Results to December Year-end

While the majority of publicly-traded oil and gas companies have a December31 year-end, we were somewhat concerned that there might be a difference invariances if we tested different fiscal year-ends besides December. We reviewedthe pricing data and selected June 30 because it included the highest month-endprice ($139.96 in 2008). We again used an F test of the variances over 5, 10, 15,20, and 25 year periods ending June 30, 2011 and found no significant differencesin the variances between the two measure of oil and gas prices.


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Conclusion

For SEC filings in 2009, companies now have to compute and report provedreserves using two methods. They must use average first-of-month prices forsupplemental disclosures and end-of-year prices for all other computations in thefinancial statements. As previously stated in our paper, this introduces inconsis-tencies in the reports and adds additional costs to the companies. The SECreasoned that this change was necessary because of the volatility in oil and gasprices.

Based upon our analysis of oil and gas prices over a 25-year period from 1986through 2010, we find that the data does not support the SEC’s statement thataverage first-of-month prices reduce the volatility in oil and gas prices. We alsofind that gas producers are more negatively affected than oil producers due to theseasonality effect. Finally, we note that using average first-of-month prices,instead of yearend prices, is inconsistent with fair value accounting.

REFERENCESBrown, P.A. and M.K. Yucel (2008). What drives natural gas prices? The Energy Journal.

29(2): 45–61.

Comments on Modernization of the Oil and Gas Reporting Requirements, ReleaseNumber 33-8935.

Financial Accounting Standards Board, ASU 2010-3.

Financial Accounting Standards Board, Accounting Standards Codification section 932-235-20.

Nichols. L. M. (2011). A study of the distinguishing characteristics of companies choosingto disclose probable reserves. Oil, Gas & Energy Quarterly. 59(4): 665-671.

SEC Release No. 33-8870 (Dec. 12, 2007) [72 FR 71610].

SEC, Modernization of Oil and Gas Reporting, Release Number 33-8995, December 31,2008.


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Documents

DISCLOSURE OF RESERVES: YEAR- END PRICES VERSUS AVERAGE PRICES Institute/docs... · DISCLOSURE OF RESERVES: YEAR-END PRICES VERSUS AVERAGE PRICES Terry L. Crain Bradley E. Lail* On