An immoderate proposal

We were surprised to note last week a news item about a new Securities and Exchange Commission (SEC) rule proposed for the oil and natural gas industries. The rule would permit companies in these industries to report “probable” and “possible” reserves, as well as proved reserves of oil and gas, to investors.

At first glance, this looks like permission for companies to more or less invent the extent of their assets, and the risks associated with them, luring the unwary into investing in oil and gas that might or might not exist.

Closer examination reveals that matters are not quite so bad. The SEC has not left the definition of “possible” and “probable” reserves wide open, but adopts the Society of Engineers’ Petroleum Resources Management System (PRMS) definitions. But our research also revealed that not only the definitions of possible and probable reserves, but even the definition of proved reserves, have a lot of leeway in them. That means that the financial impetus behind the gas rush on the Marcellus Shale is based on calculations open to a wide range of interpretation—and, potentially, manipulation.

According to the proposed SEC rule, proved reserves are defined as having a 90 percent or better chance of being recovered, probable reserves a 50 percent chance and possible reserves a 10 percent chance. If there is not even a 10 percent chance of a given accumulation of natural gas being recovered, it is not classified as any kind of reserve, but as “contingent resources.”

In determining these probabilities, according to the PRMS, not only engineering and geological considerations, but economic factors, must be taken into account. In fact, the PRMS specifically says that gas accumulations whose extraction does not provide a high enough rate of return using current technology must not be counted as reserves at all, but contingent resources. Given that reserves are one of the chief factors examined by potential investors in the oil and gas industries, the impact of fiscal assumptions fed into reserve calculations could be enormous.

What kind of price projections were plugged into reserve estimates back in late 2005, when natural gas prices peaked around $15 per million BTUs? Now that the price is down closer to $5, have the projections changed? Where would prices have to drop—and for how long—for the accumulations in the Marcellus Shale to cease to be classified as reserves and become merely contingent resources? Remember that the analysts responsible for these decisions are generally paid by the industry itself.

Another factor mentioned by the PRMS as determining which gas reserves are recoverable is regulation. Regulations can either increase the cost factor, or even outright forbid the extraction of certain accumulations—like the federal ban on offshore drilling. The recent lifting of that ban, and laws like the Energy Policy Act of 2005, which exempted fracking and other energy industry activities from large swaths of regulation, can therefore have an enormous and immediate impact on industry bottom lines.

Having read the proposed rule ((sec.gov/rules/proposed/2008/33-8935.pdf)), we have no particular quibble with it, per se. But that’s because we don’t think it makes any important change in a system that is flawed to begin with. We’d like to propose another amendment to the measuring and reporting of reserves that might actually make a start on creating a more workable planet.

Instead of saying in a general way that environmental regulations should be taken into account in determining recoverability, how about assigning environmental protection a certain concrete dollar value? Perhaps an appropriate environmental agency could set these numbers, and the SEC rule would require these numbers to be plugged into any formulae that determine the commercial viability, and therefore the reserve status, of any given accumulation of gas.

Include in the cost of extraction a dollar value for the violation of a watershed, the fragmentation of a habitat and the extinction of a species. Add in the medical and other costs associated with human sickness and death related to drilling. There should also be an estimated dollar value for the loss of tourist dollars and damage to domestic food security due to lost farmland. If all these true costs were taken into account, investors would be able to judge a lot more accurately whether any reservoir of gas is potentially recoverable, or so expensive it should be left in the ground.

Such a rule would represent a radical break with the way we are used to doing business. But if we don’t see to it that investors have to take such costs into account up front, we and our children will most surely wind up paying for them down the road—and not so very far down it, either.

Dr. Punnybone

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