View From a Height

Gas Pains

Among the corporate accounting scandals that has gotten less attention has been the overvaluing of gas and oil reserves. This is probably less understood than it should be. The Journal explains:

resisting a push by the Securities and Exchange Commission in the wake of the Royal Dutch/Shell Group scandal to change its methodology for booking oil and natural-gas reserves.

The dispute puts the oil giant at odds with U.S. securities regulators over a rule that oil companies broadly dislike but are increasingly complying with, even at the cost of reductions in reserve counts.

At issue is an SEC requirement that oil companies use year-end commodity prices to calculate their annual reserves, a number watched by investors as a sign of a company's prospects. The roughly 50% jump in oil prices this year has given the issue more urgency.

Rather than year-end prices, many of the largest oil companies have traditionally estimated reserves on the basis of long-term "planning prices," which reduced the impact of the sometimes-large year-to-year swings in the volatile energy markets.

Typically, high oil prices are seen as a boon to oil companies. But under a sort of contract that is becoming more common in the industry, high prices can force a company to report lower production levels and reserves, even as profits rise.

...

Under contracts in the U.S., the U.K. and other conventional energy basins, higher prices usually result in bigger reserves, as more projects become economic. But under so-called production-sharing agreements, a government owns the resource and guarantees the company enough oil to cover its costs plus a percentage of the oil left after those costs. As the price of oil goes up, the volume a company gets under such an agreement declines.

Reserves show up on the balance sheet as a long-term asset. By forcing down those numbers, the SEC will end up increasing the apparent leverage of these companies (ratio of debt-to-assets), possibly raising borrowing costs. It will also force up the apparent return on assets, as well, enticing invertors. I don't know if this actually is a better rule, in the sense of more accurately reflecting the companies' actual financial health. What's scary is that I don't know if the SEC does, either.