The massive oil and gas reserve revisions announced in the past few months by Royal Dutch/Shell Group and El Paso Corp. during a period of high commodity prices casts an “ominous shadow” on bookings by other producers that use full-cost accounting, a Standard & Poor’s (S&P) analyst said in a report issued on Thursday.

The report, “Are Global Oil and Gas Reserve Revisions Cause for Panic or Part of the Business?” was written by S&P’s John Thieroff. He said, “Current trends, such as increasing rates of production decline, smaller exploration targets and the greater need to explore frontier areas, put pressure on companies to do what they can to keep pace in terms of replacing production and keeping costs competitive. This, in turn, could lead to more aggressive reserve booking which, while enabling the producer to post stronger results in the near term, can create significantly larger problems down the road and lead to a serious erosion in credibility.”

Once reserves are written down under ceiling tests, they cannot be restored to the balance sheet “no matter how high subsequent commodity prices go,” Thieroff said. “Thus, companies using full-cost accounting could be exposed to large write-downs during periods of low oil or natural gas prices.” Both El Paso and Shell use full-cost accounting.

Commodity prices have been “particularly robust” since late 2002, and ceiling test write-downs have been rare. The high commodity price environment is masking “full-cost sins,” Thieroff said, which should be a particular concern for companies using full-cost accounting.

Some of the largest independents in North America now use full-cost accounting, including Anadarko Petroleum Corp., Apache Corp, Canadian Natural Resources Ltd., Comstock Resources Inc., Devon Energy Corp., EnCana Corp., Energy Partners Ltd., Husky Oil Ltd., and Newfield Exploration Co., Pioneer Natural Resources Co., Pogo Producing Co., Range Resources Corp., Vintage Petroleum Inc., Wiser Oil Co. and XTO Energy Inc.

“Among these companies, Devon, EnCana, Pioneer and XTO have made large, expensive acquisitions and could be particularly vulnerable to ceiling test write-downs when commodity prices weaken,” Thieroff wrote. “By expensing dry holes as they occur, companies using successful-efforts reserve accounting more accurately reflect the costs directly attributable to booked reserves and have less exposure to write-downs during periods of low commodity prices.”

Both methods are “commonly used and acceptable,” noted Thieroff, but S&P views successful-efforts reserve accounting as a more accurate reflection of current period results, and a “more conservative measurement of book value for proved reserves.”

Focusing on Shell, the analyst said that the oil major was able to book about 3 Tcf in its Gorgon gas field offshore Australia “without a final investment decision, sufficient markets or infrastructure and no clear understanding when any of these factors would be resolved. Such a booking, along with overbookings in Nigeria, Oman and Brunei, helped mask poor finding and development results over a multi-year period.”

In El Paso’s case, Thieroff said that the company “undoubtedly felt pressure to show that its oil and gas business was a healthy cash generator, while the company faced serious financial deterioration due to a series of events in its other businesses. Aggressive overbookings in many of its core operating areas, including 511 Bcf of coalbed methane reserve in the Raton Basin that lacked contractual and regulatory approvals, helped mask serious reserve base declines at a period when the company lacked the capital necessary to adequately reinvest in this business.”

The credibility behind reserve reporting is essential, Thieroff explained. “A questionable reserve report is worthless.” Because of that fact, independent reserve engineers should be used more, which would be viewed as “credibility-enhancing and credit strengthening.” Enhanced reserve reporting bears substantial costs, he noted, but “investors would be better served by stronger reporting requirements.”

To read the full eight-page report, visit www.standardandpoors.com.

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