Steep downward revisions to oil and gas reserves at the end of this year are likely to increase scrutiny of how energy companies tally future barrels - a process that has become more opaque with the rise of shale drilling.

The revisions due in December will reflect a deep plunge in crude prices and should not come as a surprise for investors who have been pouring billions of dollars into U.S. oil companies betting that crude prices will recover.

But investors may not fully appreciate other risks stemming from the wide variety of methods companies use to estimate and vet their reserves, or economically-recoverable oil and gas.

Reserves have long underpinned company stock prices. Reserve growth is used at companies, including ConocoPhillips as a component of the chief executive's compensation.

Yet there is plenty of uncertainty in the industry as measuring unconventional resources such as shale oil is a young science and there is no uniform process for reserve reporting, geologists, investors and lawyers say.

In contrast to financial reporting, the U.S. Securities Exchange Commision does not require outside auditing for reserves. That leaves the process "a little opaque" according to Stewart Glickman, director of energy research at S&P Capital IQ in New York.

A Reuters analysis of public filings by companies in the Dow Jones U.S. Oil and Gas index reveals a wide variety of practices used to report them.

Of the 41 exploration and production companies in the Dow Jones Oil and Gas Producers Index, 15 companies had independent petroleum engineers generate their reserves estimates for them.

Another 18 companies came up with the estimates themselves and had an independent engineering firm audit those results, Securities and Exchange Commission filings show.

Four of the firms generated their own results and had consultants review the procedures and methods used to prepare the estimate, but not review the underlying data.

Meanwhile, four other companies had no outside reviews. Exxon Mobil Corp, Chevron Corp, Murphy Oil Corp and Newfield Exploration Co prepared the reserve estimates entirely on their own.

Chevron and Exxon both said they take a rigorous approach to booking reserves and comply with all relevant standards.

Newfield said it has always reported its own reserves.

"Our founder often stated that 'no one knows the reserves like our own engineers,'" spokesman Steve Campbell said.

John Lee, a reserves expert at the University of Houston, said the SEC debated whether to require an outside reserve auditor when modernizing rules in 2009, but ultimately decided a company's own engineers knew acreage better than third parties.

He also said there likely would not be enough auditors available to do the work if an independent evaluation were required. The SEC declined comment.

Bala Dharan, a professor at Harvard Law School, said that while progress was made after the 2009 SEC changes, more could be done. "The next step would be to look at the feasibility of requiring more widespread adoption of external review," he said.

CAUTIONARY TALE

Another source of concern is a provision introduced in 2009 when the SEC modernized reserve rules that allows companies to add reserves by letting companies report reserves from undrilled locations provided they plan to develop the property within five years.

Since then, the SEC has sent letters to dozens of companies to inquire about their "proved undeveloped reserves" and at times demanded some be removed, according to public filings and lawyers. In May, well-known short-seller David Einhorn took aim at shale oil companies, saying most of their undeveloped reserves cannot be profitably produced..

Samantha Holroyd, who is responsible for valuing and managing oil and gas properties for private equity firm Denham Capital in Houston, offered a cautionary tale.

She had about $50 million to invest and was given a reserve report about a seller's acreage that had been reviewed by a third-party consultancy. She later discovered the firm had not done any extra work and just regurgitated the client's numbers.

"I was potentially having the wool pulled over my eyes," she told a recent meeting of petroleum engineers in Houston.

The lack of clarity around reserves reporting adds to a longstanding criticism of the shale industry's capital intensive business model, in which new wells must be constantly drilled to replace output from existing ones that rapidly decline.

Calculating how much oil and gas can be produced from conventional resources has always been an inexact science.

But wells drilled into shales and other rocks have made the process even tougher as such oil reserves vary a lot between wells.

Experts also say the industry has little grasp on the actual length and width of cracks made in rock by hydraulic fracturing. Those cracks, made by blasting chemicals, water and sand down a well, largely determine a well's production.

"The problem is more difficult in shale," said the University of Houston's Lee. "We don't have measurement techniques that are sufficiently accurate."

Source: www.offshoreenergytoday.com

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