Some clarity about how companies estimate their oil reserves

The recent cuts in the estimates of oil and natural gas reserves at Shell, El Paso and other energy companies have raised questions about how companies could suddenly have far less potential oil and gas than they initially reported. The answer is in a mixture of imprecise regulations, geological guesswork and corporate culture that goes into the accounting of such reserves.
The starting point is the Securities and Exchange Commission requirements for what constitutes an oil or gas reserve. As with many regulations, they are open to broad interpretation, though it is also a best effort, considering how difficult it is to find oil in the first place, analysts and industry experts say.

The government requires companies to disclose their "proved oil and gas reserves," which it defines as "estimated quantities of crude oil, natural gas and natural gas liquids" that can be shown "with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operatingconditions."
The phrase "reasonable certainty" is crucial. One company may decide that a 90 % probability of finding and extracting oil is reasonable, while others may want more proof. Despite the opportunity for wide-ranging readings, the phrase has been on the books since 1978.

Companies break down their proved reserves by whether they are developed or undeveloped. Developed proved reserves can be extracted with equipment already in use, and therefore are better indicators of potential production. Undeveloped proved reserves may require the drilling of new wells or other investments.
The SEC requires companies to account for these reserves using one of two methods. The first, called the "successful efforts" method, is generally considered more conservative because companies write off their failures more rigorously.

The other, known as the "full-cost method," allows more leeway in acknowledging failures and is typically used by smaller drillers. Most investors want to know -- and few companies are willing to say -- how long it takes to drill a new well and how much it costs. Many analysts are also eager to know how quickly companies can extract that oil and how much it costs to get it to market.
The SEC's phrase "recoverable in future years" also invites an assortment of interpretations. An optimistic executive might keep an undeveloped well on the books longer than a company inclined to cut its losses.

The calculations that companies make about their reserves, some industry experts argue, should be limited because that information may give competitors an unfair advantage. But others say the disclosure of more detail would help investors determine the prospect of an oil company producing a return on its reserves.
"It'll be inexact no matter what you do," said Mark Easterbrook, a managing director at RBC Capital Markets in Dallas, who follows the oil industry. "But at least you can get more specific about the assumptions."

One figure that leaves little doubt is the price of oil or gas.The SEC requires that companies compute the value of their reserves using oil or gas prices on Dec. 31.
At best, this presents a snapshot of what reserves are worth on a given day. At worst, it can lead to wide distortions if, for instance, prices are low much of the year but soar in December because of unseasonably cold weather. Some experts say companies would be better off using the average price from the preceding year; others recommend applying a forecast for the coming year.

Either way, different gas prices will do little to clarify the much harder task of figuring out how much oil is in the rocks below ground and how to move it to the surface. Seismologists, geologists and engineers spend years studying ways to determine the size of oil reservoirs and the ratio of fluids to rock in those reservoirs, among many other factors.
"All of these are interpretations," said Ronald Harrell, the chairman and CEO of Ryder Scott, a petroleum consultant in Houston. "Our equations are pretty good, but we still have to calibrate them."