RESERVES REVISIONS AND SMOOTHING: ANALYSES

OF UK OIL AND GAS COMPANIES

By
NURIDEEN ABDULAI.

A Dissertation paper prepared in fulfilment of Master of Accounting and Finance

programme at Glasgow Caledonian University.

AUG. 2012
CONTENTS

Title: RESERVES REVISIONS AND SMOOTHING: ANALYSES OF UK OIL AND GAS

COMPANIES....................................................................................................................................3

DEDICATION...................................................................................................................................4

ACKNOWLEDGEMENT.................................................................................................................5

ABSTRACT.......................................................................................................................................7

CHAPTER 1. INTRODUCTION.......................................................................................................8

CHAPTER 2. RESERVES...............................................................................................................11

2.1 Introduction and Historical Background.................................................................................11

2.2 Categorisation and Definitions...............................................................................................12

2.3 Disclosure Practices...............................................................................................................16

2.3.1 Discretionary Disclosure.................................................................................................18

2.3.2 Mandatory Disclosure.....................................................................................................19

2.4 Importance of Reserves..........................................................................................................21

2.6 Conclusion.............................................................................................................................23

CHAPTER 3. RESERVES REVISIONS & SMOOTHING.............................................................24

3.1 Introduction............................................................................................................................24

3.2 The Theory.............................................................................................................................24

3.3 Income Smoothing.................................................................................................................25

3.3.1 Income Smoothing in relation to the Research................................................................26

3.3.2 Motivation for Reserve Smoothing..................................................................................27

3.4 Revisions................................................................................................................................28

3.4.1 Potential Reasons for Reserve Revisions.........................................................................29

3.5 High Profile Reserve Revisions From 2004-2006..................................................................31

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 3.5.1 Case Study of Royal Dutch Shell (Overstatement)..........................................................31

3.5.2 Other Examples of Revisions..........................................................................................35

3.6 Reserves Auditing..................................................................................................................36

3.7 Conclusion.............................................................................................................................37

CHAPTER 4. METHODOLOGY....................................................................................................38

4.1 Introduction............................................................................................................................38

4.2 The Data.................................................................................................................................38

4.3 Research Paradigm.................................................................................................................40

4.3.1Qualitative Approach........................................................................................................40

4.2.2 Quantitative Approach.....................................................................................................41

4.2.3 Significance and Reasons of Revisions...........................................................................42

4.2.3 Smoothing Descriptors....................................................................................................42

4.4 Conclusion.............................................................................................................................44

CHAPTER 5. ANALYSES AND DISCUSSION............................................................................46

5.1 Analyses.................................................................................................................................46

5.1.1 Significant revisions........................................................................................................46

5.1.2 Reserves Smoothing........................................................................................................52

5.3 Discussion..............................................................................................................................53

CHAPTER 6. CONCLUSION.........................................................................................................57

APPENDIXES.................................................................................................................................60

REFERENCES.................................................................................................................................62

2
Title: RESERVES REVISIONS AND SMOOTHING: ANALYSES OF
UK OIL AND GAS COMPANIES
By

Nurideen Abdulai

A Dissertation paper prepared in fulfilment of Master of Accounting and Finance

programme at Glasgow Caledonian University.

GLASGOW CALEDONIAN UNIVERSITY

August 2012

“…Injustice anywhere is a threat to justice everywhere…”

Dr. Martin Luther King, Jr.

3
 DEDICATION

Dedicated to my parents

4
 ACKNOWLEDGEMENT

I cannot but express my heartfelt appreciation to the exceptional support and guidance
given to me by Dr McChlery Stuart (My Supervisor) during this piece of work. This
dissertation paper would not have been successful but for his dedicated services to its
course. I would also like to thank Mr Cherif Merrouche (My Programme Leader) for his
continuous encouragement to me during the dissertation work. Finally, I would like to
express special thanks to all my colleagues who have, in one way or the other, helped to
bring this dissertation paper to its successful completion.

5
DECLARATION
MASTER OF ACCOUNTING AND FINANCE (Suite)

Programme 2011/2012

Name of Student: NURIDEEN ABDULAI

Matriculation No.: S1133777

Title of Dissertation: RSERVES REVISIONS AND SMOOTHING:

ANALYSES OF UK OIL AND GAS COMPANIES.

“I declare that this dissertation is my own original

Declaration: work and has not been submitted elsewhere, wholly or
partly, in fulfilment of the requirements of this or any
other award.

Academic citation standards have been maintained

and due acknowledgement were given when and
whenever the work of other authors were used in
direct quotation and general reference.”

Signature of Student:

27-August-2012
Date:

Pease note:

This declaration statement should be submitted along with the student’s bound copies
of the dissertation.

6
 ABSTRACT

This research work examines the significance of reserves revisions and reserves smoothing
in the UK oil and gas industry for the period 2006-2011. This work is led by an initial
study on the high-profile reserves write-down cases from 2004-2006 (Shell, RApsol YPF,
Stone Energy and El Paso) which showed that there were attempts to ‘manage’ reserves
overstatements through ‘moratoriums’ on reserves bookings by the companies in question.
However, the primary analysis on reserves revisions showed that after the 2004-2006 high
profile reserves write-downs and the regulatory issues on disclosure practices, internal
control and auditing, some oil and gas companies in the UK seem to be more conservative
in evaluating and reporting reserves. This is shown in the significant upwards revisions
that characterise some companies and the justifications for these revisions. In addition,
using Eckel’s (1981) CV method of analysis, the researcher examined that some companies
in the UK oil and gas industry appear to be engaging in reserves smoothing. This is
evidenced in a greater variability of Net Reserves Additions (NA) before revisions
compared with the variability of RRR after revisions in those companies.

Keywords: Reserves Smoothing, Significant Revisions, Overstatements, write-down.

7
CHAPTER 1. INTRODUCTION

There is an increasing importance of oil and gas reserves in the Exploration and Producing
(E & P) industry which lead to continues revisions to regulatory requirements on reserves
disclosure practices by standard setters. This study is intended to examine reserves
revisions and smoothing in the E & P oil and gas industry in the UK for the period 2006-
2011. In doing this the researcher, however, gave a window of opportunity to the high
profile reserves write-down cases from 2004-2006 that raised issues about enforcement of
regulatory requirements on reserves evaluation and disclosure practices, reserves auditing
and internal control of E & P companies across the world. This paper focuses only on
reserve quantum because of the impact of exogenous variables on crude oil and natural gas
prices which increase volatility in the companies’ value. The objectives of the study are,
therefore, as follows:

a) To examine the significance of oil and gas reserves revisions in the UK and the
justifications for these significant revisions, and

b) To determine the existence of reserve smoothing in the E & P oil and gas industry in
the UK

The research is based on a case study of the 2004 high profile reserves write-down by
Royal Dutch Shell (Shell) and examples of significant downward revisions from El Paso,
Stone Energy, Rapsol YPF etc. and the impact of these revisions on regulatory
requirements, internal control and auditing. The researcher, therefore, conducts a
longitudinal study on oil and gas reserves and revisions in the UK focusing on three
important questions in the E & P oil and gas industry: 1) whether reserve revisions are
significant 2) are there any justifications for significant reserves revisions, and 3) whether
there is the possibility of reserve smoothing behaviour by companies.

Oil and Gas reserves form a greater percentage of an E & P companies’ worth and are used
in their ( i.e. The companies) valuation for debt covenants and to reduce contracting cost.

8
Given the importance of reserves to an E & P company, significant reserves revisions lead
to ‘disclosure quality risk’ [Dharan, 2004] due to significant value distraction to the
company [Olsen, 2010]. The researcher first show in the high profile write-downs cases
that there were attempts to ‘manage’ overstatements through ‘moratoriums’ on reserves
booking due to the perceived effects of downwards revisions to the companies (Davis and
Wardwell, 2004), which lead to the three research questions stated above. The case study
on Shell revealed that overstatements were mainly due to non-conformity to SEC’s reserves
booking requirements and aggressive reserves bookings resulting from Shell’s
compensation scheme which was tied to reserve replacement targets in an attempt “to push
the envelope of credibility in efforts to buoy investor confidence and thus increase stock
value” [US house of Rep. Report on Financial Services, 2004, p. 2].

The primary research on significant revisions however seems to suggest that after the 2004-
2006 write-down cases, E & P companies seem are more meticulous and conservative in
the evaluation and reporting of oil and gas reserves. This is because all significant revisions
for the study period (2006-2011) were found to be positive. Moreover, a thorough
investigation of the significant revisions from the ‘Operating Review’ and ‘Supplementary
Information’ section of the companies’ annual reports show that in some instances [Shell
2009 for instance], previously de-booked reserves that did not meet disclosure requirements
(Nigeria, Abu Dhabi, Brunei, Oman) are being rebooked due to on-going development
activities. This vindicates a Shell’s representative’s statement, in the wake of Shell 2004
reserves write-down, that most of the reserves will be re-booked over time [Olsen, 2010].
Also, reports show that significant revisions mainly resulted from: improved geological and
engineering data as well as exploration success; reclassifications or rebooking; changes in
disclosure requirements, and changes in economic conditions.

In addition, the research adopts Eckel’s [1981] coefficient of variation (CV) method as
employed by several researchers in the income soothing literature in determining
companies that smoothing their reported earnings[Albrecht and Richardson, 1990; Ashari,
Koh, Tan, and Wong. 1994; Booth, Kallunki, and Martikainen,1995, Michelson, Jordan-
Wagner and Wooton, 1995]. Using the CV method for oil and gas reserve-based
smoothing, it was found that some E & P companies in the UK appear to engage in reserve

9
smoothing. The researcher argues that E & P companies might use the opportunities
available to them and the flexibilities allowed by oil and gas reserves accounting to hedge
exploration risk after hedging oil and gas price volatility with derivatives [Pincus and
Rajgopal, 2002]. The rational for this is that analyst and investors might be more contempt
with smoothed (less volatile) reserves than unsmoothed (more volatile) reserves.

The remainder of the paper is organised as follows. In chapter 2, the researcher gives a
background study of reserves, highlighting the various classifications, definitions and
importance. Chapter 3 follows with the focus on reserve revisions and smoothing, relating
them to the theory. Chapter 4 details the methods used for the research study. Chapter 5
analyses of data and discussion of findings and chapter 6 the conclusion.

10
CHAPTER 2. RESERVES
2.1 Introduction and Historical Background
Exploration and producing oil and gas companies are into business to search and find
reserves, as well as produce and sell crude oil and or natural gas. Thus, the most important
revenue to these companies is that which accrue from the sale of crude oil and natural gas
and the most crucial cost is that incurred to find oil and gas reserves, yet these reserves are
not recognised as assets in primary financial statements because of continues revisions to
previous reserve estimates. As reserves account for a greater percentage of an exploratory
and producing oil and gas companies’ value [Dharan, 2004; Donker, Alex, Kuldip, 2006]
and are used in their valuations, the extent of revisions to previous estimates can cause
significant value distraction and make investors feel fooled. In recent times, what is
considered best practice in the extractive industry accounting is reserves measurement and
disclosure practices that gives users of financial statements a better understanding of E and
P companies’ values and the extant literature in the upstream oil and gas industry [Wise,
2010; Pratt, 1998; Berry and Wright, 2001; Taylor,, 2011 Richardson, Tower, Hancock;
Mirza and Zimmer, 2001; 1999; Fletcher, 2004; IASB DP. 2009; Wright and Brock, 1999;
Wise and Spear, 2000] focus on this. In US, there have been changes in reserves disclosure
requirements, from Historical cost-based accounting through Reserve Recognition
Accounting (RRA) to mandatory supplemental disclosure of proved reserves in the form of
Standardised Measure of Oil and Gas (SMOG). In response to the oil price volatility in the
late 1970s, there was an attempt by Security and Exchange Commission (SEC) to recognise
reserves on the balance sheet through Reserve Recognition Accounting (RRA). The
Financial Accounting Standards Board (FASB) introduced RRA [FASB No. 19], disclosure
of reserve quantities, to replace the Full cost (FC) and Successful Efforts (SE) accounting
and recognised a firm’s proven reserves as assets on the balance sheet. But RRA failed
during its trial period in 1981 because of revisions to previous reserve estimates, and
arbitrary choices in its application [Johnston, 2009]. This was followed by SFAS 25 which
gave preference to SE method of accounting for oil and gas exploration and producing
activities while allowing for unaudited supplemental based proved reserves disclosure
[Kurdi, 2008]. Subsequently, FASB 69 was developed which also initially mandated
disclosure of Standardised Measure of Future Discounted Net Cash Flows relating to only

11
proved Oil and Gas (SMOG) [Johnston, 2009; Kurdi, 2008]. SMOG required a 10%
discount rate with year-end price of oil and gas initially but SFAS No. 69 was revised
further in 2008 to use average yearly price of oil and gas and an optional separate
disclosure of probable and possible reserves. Proved reserves are currently disclosed as
mandatory information with an optional disclosure of probable and possible reserves in the
form of SMOG in the US [SFAS No. 69]. In the UK, the Oil Industry Accounting
Committee (OIAC) also in its first Statement of Recommended Practices (SORP) in 1998
proposed that historical cost accounting is limited in its scope and usefulness because of the
absence of reserves value and lack of agreement as to how exploration and development
cost should be accounted for [Pratt, 1998]. And the International Accounting Standards
Board (IASB) formed a steering committee on extractive industries aimed at formulating a
complete and comprehensive set of standards for the extractive industry accounting [IASC,
DP. 2000]. The IASB Issue Paper (IASB DP) on extractive industry in 2000, for instance,
considered a number of things for extractive industries to include, but not limited to:
 how much of the cost of finding minerals and oil and gas reserves should be
capitalised
 the methods of DD&A that should apply to this capitalised cost
 the effect of minerals and oil and gas reserves quantities and values on recognition,
measurement and disclosure.
 And the definitions of minerals and oil and gas reserves and resources (IASB, DP.
2009).
Currently the IASB project on Extractive industries is run by the AASB [Taylor et al.
2011]. But the unique features of extractive industries make it quite daunting to get these
standards set. One issue that clearly differentiate market value from book value in the
extractive industry is accounting for reserves [Mirza and Zimmer, 1999].

2.2 Categorisation and Definitions

There exist two main different schools of definitions of reserves among regulatory bodies
and standards setters: Society of petroleum Engineers (SPE) and World Petroleum
Companies’ (WPC) definitions on one hand and the SEC definitions on the other. This is
further amplified by the differences in disclosure practices among the various regulatory
bodies and standards setters. The main reason for these differences might arise from how
12
each of the bodies envisage the upstream oil and gas industry and the attempts to get an all-
inclusive ‘optimal’ reserve estimates and disclosure practices that better serve the needs of
users. According to Fletcher [2004], Reserves are simply projections of oil and gas
productions in the foreseeable future. Among international and national standards setters,
most definitions of reserves and resources share some similarities because they stem from a
system proposed by VE McKlevey of the US geological survey in the early 1970s, called
‘the McKlevey box diagram’ [IASB DP for EI, 2010]. Moreover, the IASB [IASB, DP.
2010] adopts the SPE/WPC definitions which states that “Reserves generally refer to the
quantity of minerals or oil and gas that is estimated to be economically recoverable from
the earth. In other words, reserve quantities are an estimate of the aggregate future
production of minerals or oil and gas”[IASB DP, Section 2.4a, 2010].
While regulation S-X 4-10(a)26 of the Security and Exchange Commission made the
definition more conservative by adding the existence of legal rights and revenue interest as
well as feasibility of a project.
Reserves are measured, categorized and disclosed in terms of proved and unproven.
Unproven reserves are further classified under either probable or possible while proven
reserves are classified under proved developed and proved undeveloped reserves [IASC,
DP, 2000; Mirza and Zimmer, 2001]. Figure 1 depicts the various classifications of reserves
by standards setters and regulatory bodies while figure 2 shows the level of uncertainty
regarding the classifications. These classifications are done based on the level of
uncertainties surrounding the recoverability of estimates in relation to actual reserves
quantum on the ground [McChlery, 2010]. Major differences in definitions of the various
categories are in the form of scope and specificity and assumptions considered in
classifying them [IASB DP., 2010]. While the SPE/WPC definitions use probabilistic
estimation methods, the SEC definitions use deterministic methods of estimation which
makes them more conservative in nature. The most widely used definitions of proved,
probable and possible reserves in the petroleum industry are adopted from the World
Petroleum Companies (WPC) and Society of Petroleum Engineers (SPE) [Donkor et al,
2006]. The definitions have been adopted by standards setters and regulatory bodies as well
as the United Nation [Nichols, 2008]. The SPE definitions (until recently when SEC

13
revised its disclosure practices) were believed to be better than that of the SEC for a couple
of reasons:

 the use of proved reserves estimates with probabilistic methods which requires at
least a 90% confidence of recoverability of estimates compared to deterministic
methods as required by the SEC (still the case).

 Consideration of technological innovations in recent times in the estimation of oil

and gas reserves which did not reflect in SEC definitions.

 And the liberalization and dynamism of the oil and gas industry which were not
captured in 1978 when the SEC formulated its definitions [Nichols, 2007].

However, the SEC recent revisions of the definitions of oil and gas reserves take into
account existing technology.

The definitions of proved, probable and possible reserves per the SPE and WPC
requirements are as follows:

Proved reserves are those quantities of petroleum which, by analysis of geological

and engineering data, can be estimated with reasonable certainty to be commercially
recoverable, from a given date forward, from known reservoirs under current
economic conditions, operating methods and government regulations (ie. 90% 0f
quantities actually recovered will equal or exceed estimated proved reserves).

Probable reserves are those unproved reserves which analysis of geological and
engineering data suggest are more likely than not to be recoverable ( ie 50%
probability of quantities actually recovered will equal or exceed estimated proved
plus probable “2P”).

And Possible reserves are those unproved reserves which analysis of geological
and engineering data suggest are less likely to be recoverable than probable (ie. with
a 10% probability that the quantities actually recovered will equal or exceed the
sum of proved plus probable plus possible, “3P”).

14
Figure 1 shows the different categories of reserves by standard setters and regulatory
bodies.

Moreover, the SPE, WPE and AAPG classification included resources and depicts the
degree of uncertainty in recoverability of the reserves estimates as shown below.

15
Figure 2: Adopted from SPE/WPE and AAPG resource classifications

The level of uncertainty can be based on existing technology, available data, or even
economic viability [Fletcher, 2004; Mirza and Zimmer, 2001] which in turn characterise the
extent of revisions to previous quantum estimates. These uncertainties led to a more tightly
and conservative measurement, definitions and disclosure requirements by SEC in the oil
and gas industry to protect investors and analyst in decision making [Oil and Gas Journal,
1997].

2.3 Disclosure Practices

Reserve estimates are based on various factors which can involve subjective valuation of
estimates. Reserves disclosure practices differ by jurisdictions and between industries.

16
Taylor, et al. [2011] documents that the roles played by standard setters, security regulators
and stock exchanges influence reserves disclosure and disclosure practices by E&P firms
significantly. Currently, reserves are disclosed as supplemental information (see table 1) in
the financial statements of exploratory and producing companies [Taylor et al,2011;
Donkor, et al 2006], and there does not exist complete and comprehensive set standards for
extractive industry accounting by standards setters and regulatory bodies [Taylor et al,
2011]. The main disclosure practices can be grouped into two – discretionary and
mandatory – as explained below.

Table 1. Reserves estimates disclosure of XCorp. for begining 2002

At 1st Jan. 2002 UK US SA Australia

Proven ××× ××× ××× ×××

Probable ××× ××× ××× ×××

Possible ××× ××× ××× ×××

Total reserves ××× ××× ××× ×××

Proven Developed ××× ××× ××× ×××

Proven Undeveloped ××× ××× ××× ×××

Changes attributable to:

Revisions to previous estimates ××× ××× ××× ×××

Improved recovery ××× ××× ××× ×××

Purchases of reserves-in-place ××× ××× ××× ×××

Discoveries and extensions ××× ××× ××× ×××

Production ××× ××× ××× ×××

Sales of reserves-in-place ××× ××× ××× ×××

17
 Net additions ××× ××× ××× ×××

Table 1 depicts the quantum reserves disclosure portion of annual reports and the interest in
this research is in proved reserves and all the variables that cause changes in the estimated
reserves quantum as represented in annual reports.

2.3.1 Discretionary Disclosure

In the UK, Norway and Canada, probabilistic methods of reserves estimation is allowed
[Arnot, 2004]. Moreover, most standards setters - The International Accounting Standards
Board (IASB), Australian Accounting Standards Board (AASB) and the UK Statement Of
Recommended Practices (SORP) under the Operating Financial Review (OPR) - require the
disclosure of proved, proved plus probable, plus Possible separately and together as
supplemental information [discretionary] [Donkor, et al, 2006, Arnot, 2004]. The dream of
the IASB to get its complete and comprehensive set of standards for EI implemented by
2011 did not materialise [Nichols, 2007] as they are still stuck in the mud with many issues
to attend to. However, the IASB Steering Committee on EI, the AASB, OIAC require
discretionary supplemental disclosure of reserve estimates in the balance sheet. In
Australia, for instance, all the categories of oil and gas reserves are considered in the
market valuation of an upstream oil and gas company in various percentages. In the
valuation process, all proved reserves are considered with 60% of probable reserves
estimates and 30% of possible reserve estimates. Moreover, companies under UK and
Canada basically disclose all categories separately and combined [Donkor et al, 2006]. The
OIAC’s SORP require disclosure of:

 Commercial oil and gas reserves at the start and end of each financial year.

 Narrative on the source and basis of each estimated reserves quantities.

 Changes in net quantities and revisions to previous quantities

And the OFR require companies to incorporate:

 Key Performance indicators (KPI) of reserves replacement and targets set to

replace produced reserves.
18
  And movement of reserves volumes for the year. [OIAC, SORP, 2001].

In a survey of the Australian extractive firms, Mirza and Zimmer [2001] found that the
decision to disclose reserves estimates (given the discretionary disclosure practices) is
partially influenced by the certainty of the quantum estimates which depends on the
marginal cost of reducing the uncertainty of estimates to an optimum level in terms of the
opportunity cost of capital. They confirmed in their survey that one of the determinants of
reserve disclosure in the annual reports of Australian Extractive firms is stage of firm’s
operation – the firm is privy to more reliable data after it starts production.

2.3.2 Mandatory Disclosure

The SEC initially mandated disclosure of only proved reserve values in the form of
Standardised Measure of Discounted future net cash flow of Oil and Gas [SFAS 69] which
was revised to included proved reserves (1P) [mandatory] and probable (2P) and possible
reserves (3P) [optional] (Loucks, 2010). It require companies listed in the US stock market
to disclose the present value of future discounted reserves estimated values using a 10%
discount rate as well as the expected timing of production with an average yearly price of
crude oil and natural gas (Haines,2009). SFAS No. 69 also required disclosure or analysis
of reasons for change in SMOG values compared to previous years which may include
among other changes revisions of previous quantity estimates [Gallum, et al, 2001].

19
Table 2. Shows SMOG Calculation

Future Revenue as at Dec. 31st 20XA

20XB 20XC 20XD Total

Future production/bbl………………XXX XXX XXX XXX

× Year-end price/bbl ………………. XXX XXX XXX XXX
Future revenue……………………... XXX XXX XXX XXX
× PV factor @ 10%..........................XXX XXX XXX XXX
PV (future revenue)…………………XXX XXX XXX XXX

Note: the above calculation gives the present value of future expected discounted cash flows of the company
holding other changes constant. But as reserves are subjected to various changes such as revisions of previous
quantities, SEC required disclosure of the analysis of explanations of the effect of changes in these other
factors on the SMOG value.

Hence, the efforts by standards setters to get the true value of an E and P company
represented in a company’s annual report for users is focused on the reliability and
comprehensiveness of oil and gas reserves disclosure because they are the driver of the
company’s worth. Fletcher [2004], argues that reserve information should therefore reflect
transparency, consistency and utility on the published reports for users to make informed
decisions. However, making it an option for companies listed under SEC to disclose
probable and possible reserves estimates does not reflect the true value of the companies
[Arnott, 2004] as some investors consider these reserves categories before making their
decisions [Johnston, 2009].

The differences that exist in measurement and disclosure requirement and practices within
standard setters and regulatory bodies and the absence of a complete and comprehensive
internationally applied metric or standards create confusion and lead to misunderstanding,
giving room for potential dysfunctional behaviour by upstream oil and gas companies in an
attempt to push forward their selfish agenda or influence policy [Fletcher, 2004]. The
United Nation’s Financial Committee (UNFC) recommends each accumulation of
20
unproven oil reserves be ranked in terms of three key factors: Economic (cost, prices and
taxes etc.); Feasibility (ie. technological and environmental viability) and Geology (ie.
quantum and reservoir characteristics) [Fletcher, 2004]. Hence, grading each category from
a scale of 1 to 3 with E1, F1, and G1 indicating a high probability of being classified as
proven under SEC requirements.

Perhaps the differences in measurement and disclosure practices of reserves intensify the
difficulty of formulating a universal set of standards for EI accounting by international
standards setters despite the role oil and gas industry play in the world’s economy and the
fact that reserves serve as the most valuable assets in the oil and gas industry.

2.4 Importance of Reserves

The question whether reserves should be recognized or not in balance sheet [Wise, 2010;
IASC, DP. 2000] or whether reserves disclosure is particularly value relevant and
informative or not [Berry and Wright, 2001; Harris and Ohlson, 1987; Clinch and
Magliolo, 1992; Wright and Brock, 1999] does not depend on whether reserves estimates
are important but rather on the uncertainties surrounding the estimates and the deviations of
estimates from actual production levels. The importance of reserves to an E and P
company’s value cannot be overemphasized, and can be expressed in many forms as
follows:

Forecasting Cash flow: Oil and gas reserves are the most valuable assets to an E and P
company and contribute to over 70% of the company’s value [Dharan, 2004]. The revenue
that accrue to an E and P company is based on the sale of crude oil and natural gas which
depends on their prices, the level of production and more importantly the reserves that the
company actually hold on the ground [Taylor et al. 2011]. Donkor et al [2006] in their
research on the usefulness of proved or probable reserves of Canadian oil and gas
companies found that in some instances proved and probable reserves disclosures are
considered to be value relevant than even earnings. Discovery of reserves is, therefore, the
most significant event and proved reserves constitute the most important asset to the EI
companies [Luther, 1996] and are used in forecasting the future strength in terms of cash
flows to the company.

21
Depreciation, Depletion and Amortization (DD&A): DD&A form an important
component of an exploration and producing company’s cost in the calculation of profit
before tax. There is not one particular formula for the calculation of DD&A, but in general,
companies are required to use the unit of production method in their DD&A calculations
[Kurdi, 2010]. The major variables considered in the calculation of DD&A are the book
value or capitalized cost at year end, production during the year under consideration and the
reserves estimates at the beginning of the year [Gallum, Wright, Nichols and Stevenson,
2001]. Production and estimated reserves at beginning of year depends on the reserves at
hand while book values relates to the cost of finding and developing these reserves. Hence,
the DD&A component of the company’s cost depends on the amount of oil and gas
reserves in place for the firm, and is sometimes used to manage the impressions of
regulatory bodies in terms of reported earnings and skirt scrutiny [Kurdi, 2010].

Investors and Share prices: reserves estimates of an exploration and producing oil and gas
firm is used to raise equity finance from shareholders. The underlying value of an
exploratory and producing oil and gas company is dependent on the reserves that it can
boast of and investors and shareholders normally rely to a large extent on these estimates in
the valuation of resource firms to make decisions [Taylor, et al. 2011; Dharan, 2004]. The
share prices of an E & P Oil and Gas Company depends on the reserves of the company
vis-à-vis the reliability of disclosed estimates and it is the share performance that attract
investors to the company [Donker et al, 2006]. When Shell wrote-down its proved reserves,
for instance, it led to immediate value reduction in its share prices by about 7.5%.
According to some researchers, companies disclose reserves to reduce contracting cost and
get easy access to the capital market [Mirza and Zimmer, 2001] because financial measures
like funding and development cost are dependent on the quantum of reserves of an
upstream oil and gas company [Dharan, 2004]. Credit ratings and company’s leverage are
therefore dependent on reserves. Hence, for an E & P oil and gas company to remain a
going concern, it will depend to a large extent on its reserves replacement ratio (RRR) and
its efforts to search and find reserves [Taylor, et al. 2011].

Recognition of future decommissioning and restoration obligations: the useful life of a

reservoir is dependent on the reserves on the ground and the level of production.

22
Decommissioning and restoration cost are spread over the expected useful life of the
reservoir based on the amount of estimated reserves to the company.

Impairment and reversal of impairment: Since reserves which form a greater percentage
of the upstream company’s value are not recognized as assets in the balance sheet, the fair
value of an upstream company will depend on the estimated reserves it hold and the
recognized assets (book value). Hence, reserves serve as the basis for impairment or
reversal of impairment of the value of an E&P company.

Business combinations: the value of reserves estimates contribute significantly to the

value of a business combination and are used to determine the expected royalty interest and
working interest shares to the various parties of a merger.

Despite the tremendous role that reserves play to both the company and investors, these
reserves are subjected to frequent revisions which create a credibility and reliability gap to
the disclosed volumes and values [Dharan, 2004].

2.6 Conclusion
Thus, given the role reserves play in the valuation of upstream oil and gas companies’
worth by investors and users, any misrepresentation of these reserves will lead to
instantaneous value distractions [Olsen, 2010] and ‘disclosure quality risk’ [Dharan, 2004]
which sometimes result in lawsuits (Shell, El Paso, Stone Energy, Rapso YPF etc., 2004).
According to Dharan [2004], for reserve disclosure to be more useful, the disclosure
credibility gap problem, which depends on the significance of revisions to previous
estimates, will have to be addressed exhaustively by improving the relevance and reliability
which will also require major improvements to the estimated, audited and reported methods
and standards setters needs to take concrete steps that will result in users perceiving the
reserve data as reliable and useful for decision making.

23
CHAPTER 3. RESERVES REVISIONS & SMOOTHING

3.1 Introduction
The inability of standards setters to include reserves in financial statement despite their role
in the valuation of an E & P company’s worth is primarily due to the uncertainties
surrounding the reserve quantum estimates leading to frequent revisions to previous
estimates [Wise, 2010; IASB DP 2000]. This research work explores 1) whether reserves
revisions are significant and justifications for significant revisions in the UK and 2)
whether managers of E & P oil and gas companies in the UK engage in reserve smoothing.
The research only considers the quantum reserves estimates. In the past decade, the oil and
gas industry recorded many significant revisions (write-downs) in previous reserves
estimate from a number of companies (Shell, Rapsol YPF, Stone Energy, El Paso etc).
While the researcher acknowledges that revisions are not alien to the Oil and Gas industry,
it becomes a problem when the revisions result from overstatements and are significant.
While upward revisions improve shareholder wealth [Costabile, 2012], shareholders feel
fooled during downwards revisions of reserves because of drops in share prices [Dharan,
2004]. But E and P companies might lose in both cases (ie. upward or downward
revisions). This chapter deals with two main issues: revisions and reserves smoothing.
Given that managers of E & P companies have information about revisions in a way that
shareholders do not, managers can disclose this information to their best interest. The next
following sections deals with agency theory and reserves.

3.2 The Theory

The research is grounded by agency theory in a corporate environment. Agency theory
states that in a contractual relationship where one party (herein Shareholders or Principal)
contracts another party (herein Manager or Agent) to perform a particular task, there exist a
ubiquitous relationship between them [Eisenhardt, 1989; Kosnik, 1992], and that by linking
compensations with performance, contracts (bonuses) could be used to align the interest of
managers (agents) with those of shareholders (principal), [Lynch and Perry, 2003]. In this
case, there are two problems: a) the existence of conflicting desires between the principal
and the agent; b) how to monitor the actions of the agent and aligning them with the
principal’s interest [Eisenhardt, 1989]. Agency Theory seeks to deal with the basic agency
structure of a principal and an agent who are engaged in cooperative behaviour, but have
24
different goals and attitudes towards risk [Eisenhardt, 1989]. The agent is privy to
information about reserves estimates for instance that the principal does not which gives a
possibility of moral hazard when they behave rationally [Ross, 1973]. Hence, checks and
balances should be put in place to align the interest of managers to that of shareholders
[Lynch and Perry, 2003]. This can be done by either using boards to monitor or by
establishing short and long-term compensation plans for managers based on performance
targets. As reserves information is a proprietary to an E & P company, managers will
disclose it in their interest in an attempt to ‘paint and sell’ the company. As reserves
become increasingly important in the E & P oil and gas industry, management performance
are based on the replacement of depleted reserves and this give room for moral hazards if
not checked.

Bonuses by nature are meant to entice managers to put up their best in meeting or beating
corporate targets and objectives. To align their interest with that of managers, shareholders,
therefore, try to predict the actions managers are likely to take given a particular
compensation scheme before they set up the scheme [Lambert, 1984]. Hall and Frickel
[2008] add that management compensations are often associated explicitly with
compensation contracts or implicitly with company’s earnings. Compensations normally
entitle benefits up to a maximum or between a minimum and a maximum, and the existence
of a maximum gives managers incentive to resort to accounting choices that smoothing
reserves .

3.3 Income Smoothing

Buckmaster (2001) defines income smoothing as behaviour intended to:

“1) … reduce the volatility of reported accounting income around some targeted
income by using acceptable accounting or business practices; 2) create or retain the
ability to reduce the volatility of reported income through convention or regulatory
process” [Buckmaster, 2001, p. 7].

The income smoothing hypothesis shows a negative relationship between earnings and
discretionary accruals. It suggest that discretionary accruals serve as an earning’s
optimizing or equalising tool between current and future years, and tend to be positive
when current year’s earnings before discretionary accruals is lower than last year’s earnings
and the vice versa. Ahmed, Lobo and Zhoo [2001] argued that CEO’s will disclose negative
25
discretionary accruals, when current performance is good and future performance is bad,
with the aim of smoothing income. Fudenberg and Tirole [1995], Weishbach [1988],
document that CEOs have an incentive to hide poor performance for wealth (bonuses), job
security, and reputational reasons. Hence, managers will borrow from (lend to) future
earnings if future performance is good (bad) through income increasing (decreasing)
discretionary accruals [DeFond and Park, 1997]. The extant literature on income smoothing
therefore show that Managers exhibit income smoothing behaviour to signal good
performance and secure their jobs [Charfeddine and Bouaine, 2012; DeFond and Park,
1997]; beat or attract analyst forecast about company’s current and future performance
resulting from credible and consistent income disclosure and to meet targeted income with
bonuses as the main driver. Moreover, Gibson, Richardson and Waterhouse [1990], argue
that investors value companies that smooth income than companies that do not.

3.3.1 Income Smoothing in relation to the Research

This study relates income smoothing to reserve smoothing in the oil and gas industry.
Lambert [1984] argues that when manager’s actions are unobservable, income smoothing
become an optimal equilibrium tool. In their study, Lambert [1984] and Dye [1988]
demonstrate that risk-averse managers who are concerned about borrowing and lending in
the capital markets are encouraged to smooth their firm's reported income in order to attract
investors. As discovery of reserves is the most significant asset to E & P oil and gas
companies [Luther, 1996], managers intent to smoothing income might be focused on oil
and gas reserves in place because Donkor et al. [2006] found in their research that investors
sometimes value reserves estimates more than earnings.

In the exploration and producing oil and gas industry where reserves are the driver of
market valuation, performance is linked to reserve replacement targets and bonuses are
mostly tied to these targets. Management who are therefore privy to reserves information
will disclose it to the best of their advantage. Given a concave compensation plan – ie a
compensation plan that increases at a decreasing rate with reserves booking - tied to
reserves and two periods of reserve reporting by a firm (current and future period), if there
is good (poor) current period reserves replacement above (below) target and an expected
future poor (good) reserves replacement performance, managers might carry the excess

26
(shortfall) in current period forward to make up to the shortfall (excess) in estimates below
(above) targets using negative or reduced (positive or increased) current revisions and
positive or increased (negative or reduced) future revisions. As this will reflect in
production quota to the company, the net effect is found in the company’s income. This is
in an attempt to signal good management performance and get the ‘nod’ of Shareholders as
it reduces volatility in earnings.

3.3.2 Motivation for Reserve Smoothing

Reserve soothing in the oil and gas industry is considered to be based on several factors
which may include but not limited to: existence of bonuses and aggressive reserve
bookings; company size; and gearing ratios. The explanatory variables are discussed below.

Firm Size and Reserve Smoothing

Larger firms are more likely to smoothing reserves for the following reasons:

 Larger firms benefit more as smoothing enhances the share performance of the firm
with the rate of reported growth and stability [Beidleman, 1973].

 Because larger firms are more diversified in their activities, it provides more
opportunities to offset gains and losses in any giving period by recognising reserves
additions at times that increases the value of the company [Chaney and Jeter, 1997].

 Moreover, larger firms sometimes want to distinguish themselves from smaller

firms by reporting more easy-to-analyse reserves estimates to signal good
performance over the years [Watson, Shrives, and Marston, 2002].

Gearing and Reserve Smoothing

Gearing is a key indicator of a company’s financing structure and measures the long-term
risk of that structure as it involves two sources of long-term finance: shareholders’ funds
and lenders’ funds. Even though interest expense on borrowings is considered a legitimate
business expense and is not taxed, debt increases financial risk as payment on interest
makes shareholders earnings stream to become more volatile [Watson et al. 2002]. Hence, a
gearing ratio which is high might show an unsustainable level of debt. An E & P company

27
with a high gearing ratio is, therefore, less attractive to investors and managers might want
to smoothing reported reserves to compensate for the high gearing ratio.

Bonuses and Reserve Smoothing

When compensation contracts are tied to reserve bookings, it serves as incentive for
smoothing behaviour [Hall and Frickel, 2008]. Maximum and minimum acceptable
performances for bonus compensations give room for managers to streamline their
performance level within those boundaries thereby using the flexibilities allowed by
accounting practices to meet or beat targets. The existence of bonuses may also lead to
aggressive reserve bookings as managers, in their attempt to achieve targets, may resort to
different measurement and recognition practices that do not comply with regulatory rules
[Davis and Wardwell, 2004].

3.4 Revisions
Paragraph 11 (a) of Statement of Financial Accounting Standards (FASB) 69 defines
revisions to reserve estimates as changes in previous estimates of proved reserves (either
upward or downward) resulting from new data (except for increase in proved acreage)
normally obtained from development drilling and production history or from a change in
economic factors [Costabile, et al, 2012]. According to Costabile [2012], revisions to
previous estimated reserves affect the weight and value relevance that investors attach to a
company’s year-end reserve estimates and have significant implications on perceived
management credibility. Revisions play a key role in shaping market expectations about a
firm's reserve disclosure. As regards reserves measurement and disclosure practices which
aim at protecting the investor, the focus has been on reserves write-downs. Costabile et al
[2012] found in a study of oil and gas companies that there is an added value to firms that
report positive revisions of reserves regardless of the information content of the revision.
They conclude that reserve revisions gives new information that drives market’s valuation
of a firm's future financial strength. With the aim to put a ceiling to reserves downgrades,
SEC therefore resorted to conservative classification and disclosure practices [OGJ, 1997].

28
However, it is suggested that SEC’s enquiry into companies’ reserves in the early 2000 was
triggered by the realization that companies were booking reserves that did not correspond
with production targets, failing to increase production, or carrying out further works on
announced discoveries [Arnot, 2004]. Mr Ven De Vijver, the then Managing Director of
Shell mentioned that markets can only be fooled by an E&P company if

a) Credibility of the company is high b) medium and long term portfolio

refreshment is real and c) positive trends can be shown on key performance
indicators” (Cummins, 2004).

Despite the fact that reserve revisions is a normal corporate activity in the upstream oil and
gas industry, the surprises are in aggressive bookings intended to 'paint and sell' the
company which results in significant downgrades even with conservative reserve bookings
as required by the SEC. Given the effects of reserves revisions to E and P companies, the
question then is why do companies revise their reserves?

3.4.1 Potential Reasons for Reserve Revisions

Generally, reserves are revised because of the uncertainties that surround the estimation
process leading to inaccurate estimates. An aggressive reserve booking is also sometimes
associated with downgrades of previous estimates. The potential reasons for revisions to
previous reserve quantities differ from company to company and are as follows:

Data Availability and Stage of Project: the quality and data availability for reserve
estimates reduces the margin of error between production and estimated reserve quantities
[Petrobjects, 2003-2004]. Mirza and Zimmer [2001], documents that uncertainty in reserves
estimation due to data availability and the risk in reserve disclosure reduces as more
reliable geological and geophysical engineering data is acquired on the field. And more
reliable data on the field is acquired after the start of production. Hence as exploration and
producing activities graduate from exploration into production, uncertainty reduces and
estimates are more likely to be near accurate.

Method of Estimation: generally, two methods exist in reserve estimations which include
the deterministic (as required by SEC) and probabilistic. Any of these methods could be
covered by analogy, volumetric, decline analysis and material balance calculation
29
depending on the stage of the project or the preference of the company [Petrobjects, 2003-
2004]. Using the deterministic methods seems to be more reliable as it ignores the
variability and uncertainty in the input data resulting in a single estimate. This method is
more commonly used by SEC registered companies. However, the probabilistic method is
more rigorous and involves the use of a distribution curve for each parameter leading to a
range of qualifying statistical information in the form of the mean, median, mode, standard
deviations and even percentiles. Hence, reserve estimates are most likely to be precise
when the deterministic method is used than the probabilistic method [Petrobjects, 2003-
2004].

Aggressive Booking of reserves: investment in the oil and gas industry is characterised by
high risk, capital intensive and very costly [Pongsiri, 2004]. As Mirza and Zimmer [2001]
documents, disclosure of reserves in some extractive firms is driven by cost of measuring
reserves and use of project financing while Taylor et al. [2011] include pledging of reserves
in debt covenants. Thus in an attempt to ‘paint and sell’ the company to potential
shareholders and creditors with the aim of getting funding to projects, some companies
resort to aggressive booking of reserves and reserves smootjing (Shell, El Paso, Stone
Energy, Rapsol YPF, etc) which result in write-downs of previous estimates in the future.

Technology and reservoir type: the geological complexities in relation to the level of
technology can also influence the certainty of reserve quantum estimates. Substantial
reserves might be discovered but might not be viable to produce or be recovered under
existing technology. As technology improves, some reserves that can be recovered under
the new technology are revised and moved from the unproven stage to the proven stage. For
instance, some companies might rely on reservoir stimulation methods to extract crude oil
and natural gas depending on the nature of the overlying rock.

Experience and Knowledge of Evaluators: one of SEC’s requirements of companies is

disclosure on the expertise and experience of technical persons primarily involved in the
reserve estimation and auditing [SEC CR. 2008]. This is probably because their experience
and the subjective judgements applied to available data greatly influence the accuracy and
credibility of reserves estimates and how much the estimates deviate from production
depends on, apart from quality of data, expert knowledge. Hence, the significance of
30
revisions to previous estimates depends to some extent on the experience of the estimators
and auditors. Based on this, the SPE designed standards pertaining to the estimating and
auditing of oil and gas reserves information [SPE, 2007] which they recommend to the
industry.

Existing Economic Conditions: reserves are said to be economically viable if, under
current oil and gas prices and production and development cost as well as tax regime,
production is feasible and firms can still make profit [Fletcher, 2004]. Each reservoir or
field has an effective economic cut off point beyond which it will not be feasible [Newman
and Burk, 2005]. When crude oil and gas prices rise without a correspondent rise in cost of
production and development for instance, two things can happen to an upstream oil and gas
firm: 1) its effective economic cut off point rises for some reservoirs, hence it can now
produce or develop fields that were considered not feasible economically 2) the value of
existing production and reserves estimates increase under the comparatively higher prices.
This results in an upgrade or upward revisions of previous proved reserves estimates to the
company. The next section gives examples of high profile reserves revisions from 2004-
2006.

3.5 High Profile Reserve Revisions From 2004-2006

3.5.1 Case Study of Royal Dutch Shell (Overstatement)

Triggered by external pressure following an internally review (Project Rockford) , Shell
announced on January 9th 2004 that it will re-categorize its disclosed proved reserves by 3.9
billion barrels of oil equivalent (bboe) (ie 20% of proved reserves) details of which were
release with Shell’s 2003 unaudited results on February 5 th 2004. This was followed by
subsequent revisions totalling 5.84 bboe (33% of proved reserves). The reserve
overstatement could largely be attributed to (a) lack of proper audit (laxity) and (b)
aggressive booking of reserves and (c) non-compliance to regulatory requirements.

Three geographic regions (Australian Gorgon, Nigerian Bonga and Oman) accounted for
over 60% of the write-down in January 9 th 2004. The Shell guidelines, which is considered
as the ‘bible’ for Shell’s reserves estimators, was revised ten times prior to 2004 to reflect
the growing importance of proved reserves in the valuation of exploration and producing
oil and gas companies. Amidst concerns within Shell that its reserve booking practices were
31
overly conservative compared to its competitors, Shell revised its guidelines for booking of
reserves in 1997. The new guidelines was implemented in four geographic regions (Nigeria,
Australia, Oman and Brunei) and prescribed the use of deterministic method and
‘expectation’ (proved plus probable) reserves for booking reserves in ‘mature’ fields and
this led Organisation Units (OU’s) to equated proved reserves to ‘expectation’ reserves
because ‘project maturity’ was not defined appropriately in the guidelines. Expectation
reserves were initially meant for internal decision making while proved reserves is for
external reporting. This increased proved reserves significantly in the four regions of about
145.5 million boe when Sir Philip Watts was the CEO of EP in the 1990s [FSA, 2004].

First of all, in the Australian Gorgon gas region, which represented the largest
overstatement case, over 500 million boe was booked based on expected market in Asia
which never materialised. Even though this criterion was allowed in the Shell guidelines at
the time, it deviated from SEC’s rules of ‘reasonable certainty’ of recoverability under
‘existing economic conditions’. The Group Reserve Coordinator admitted in the Davis and
Wardwell (2004) report they were well aware of the Gorgon gas field at the time but given
a 37% contribution to RRR, it was “too big to swallow”. Secondly, in Nigeria,
overstatement was onshore and believed to be a result of pressure from political
‘showstoppers’ and the desire of the government to secure a larger production quota from
OPEC leading to the booking of significant reserves without any development and
production plans before licence expiration. This was unusual because on-shore estimates
are mostly precise [Timmons, 2004]. Instead of de-booking the reserves, management
decided to “manage” the problem through a “moratorium” hoping for future increases in
reserves. Thirdly, in Oman, overstatement was from booking of proved reserves based on
‘expectation reserves’ without much being done to prove these reserves or de-book them
amidst declining production. And lastly, in the Brunei region, overstatement of reserves
was attributed to two factors: ‘legacy’ volumes and the booking of reserves without any
investment plan or financial commitment. This was then revised gradually to prevent any
significant swing in proved reserves quantum reported [Davis and Wardwell, 2004].

Moreover, Shell Scorecards were tied to RRR and reserves booking targets [Davis and
Wardwell 2004]. It became apparent that objective reserve booking might have been

32
compromised by management and the Group’s Auditor, Barendregt, made this clear in
2001 when he argued in a report that "The widespread use of reserves targets in scorecards
affecting variable pay is seen to affect the objectivity of staff in some OUs when proposing
reserves additions". He however, proposed scorecards should alien to project selection
which was more closely related to ‘maturation’. The SPE standards mentioned that when
engineers or auditors’ compensations are tied to reserves booking or RRR (like what
pertained in Shell) they cannot be said to be independent.
From the ‘Davis and Wardwell’ 2004 report to Shell Group, it is evident that in many cases
management were aware of overstatement but could not deal with it because the Group
guidelines: did not consider de-booking as an option; were changed frequently and did not
comply with regulatory provisions like the US SEC and UK FSA guidelines. Rather, they
decided to “manage” it through a “moratorium” with expectant future increase in
production. This was the case in Nigeria, Oman, Brunei and Gorgon in Australia. For
instance, Mr van de Vijver commented in an email that:
In Oman PDO, Abu Dhabi and Nigeria SPDC (18% of EP's estimated production)
no further proved reserves can be booked since it is no longer 'reasonably certain'
that the proved reserves will be produced within license. The overall exposure
should the OU business plans not transpire is 1,300 mln boe. Work has begun to
address this important issue." [Davis and Wardwell, 2004, p. 95]

Mr van de Vijver, the CEO of EP at the time, under increasing pressure from regulatory
bodies at some point in time considered de-booking but was being ‘coached’ by his
predecessor, Sir Philip Watts, to leave no stone unturned and achieve more than 100% RRR
for the year. For instance, in a 2002 mid-year report to the Group where the issue of
reserves was to be discussed, Watts emailed van de Vijver on May 28th and stated:

"You will be bringing the issue of reserve replacement to CMD shortly. I do hope
that this review will include consideration of all ways and means of achieving more
than 100% in 2002 ... considering the whole spectrum of possibilities and leaving
no stone unturned."

Also, much emphasis was placed on the achievement of at least a 100% RRR even under
intense pressure to prevent reputational damage and paint a good picture. This was
evidenced in aliening bonuses of engineers and estimators of reserves to RRR and reserve
booking targets. In addition, there had been a conscious effort by the shell management to

33
“smoothing” the Groups reserves because of the increasing importance of reserves to
shareholders and investors and the Shell guidelines was also tailored to this objective rather
than compliance to the SEC rules.
Under increasing pressure both internally and externally, Mr ven de Vijver became fed up
with ‘managing’ the problem instead of solving it and emailed Mr Watts on November 9 th
2003:
"I am becoming sick and tired about lying about the extent of our reserves issues
and the downward revisions that need to be done because of far too
aggressive/optimistic bookings in the past. Aside from the embarrassment of having
booked reserves prematurely." (Davis and Wardwell, 2004, p. 9)

The overstatements in Shell raised questions about internal control and auditing of reserves.
The FSA report described Shell’s internal audit as flawed and leaves much to be desired.
Apart from the fact that a part-time single external auditor was employed whose cycle of
audit was once every four years, and could therefore not do due diligence, the Group’s
guidelines did not comply with regulatory requirements. For instance, it was indicated in
Shell’s 2000 group reports that “SEPCo did not abide by Shell’s guidelines in certain
respects "due to SEPCo’s adhering to strict interpretations of SEC rules, which are
enforceable in the U.S...”. An internal audit on Nigeria and Oman led to ‘Project Rockford’
to identify the extent of overbooking in Shell’s reserves in 2003 which eventually led to the
January 2004 revisions. As Shell’s guidelines served as the ‘bible’ for E&P activities,
internal auditors could not give the full picture of bear facts. The full picture was therefore
presented with the help of external auditors. As the revisions created value distractions in
Shell, share price fell by 7.5% causing a loss of over 3 billion [Bickerton, et al, 2004] to the
company. A £17 million and USD 120 million claims payments were made to FSA and
SEC respectively [Dharan, 2004] as well as a USD 80 million settlement for US
shareholders and a USD 352.6 settlement with non-US shareholders [Olsen, 2010]. The
write-downs, under intense pressure, also led to the resignation of the two topmost officers
in Shell – Mr van de Vijver and Sir Philip Watts in 2004 [Timmons, 2004].

In general, two factors might have influenced aggressive bookings of reserves in Shell: the
internal reserves audit function which was understaffed and untrained with non-compliant

34
Shell guidelines to that of SEC; and Shell’s scorecards which were tied to RRR and reserve
booking targets.

3.5.2 Other Examples of Revisions

El Paso Corporation

The case of El Paso Corporation also represent aggressive reserve bookings because El
Paso was cautioned to clean up its reserves books after it acquired Coastal Corporation but
managers intervened which made reserves that did not qualify to be in the proved category
to be included in their estimates. In addition, the implementation of the Saban-Oxley Act’s
internal control certification requirement also might have contributed to the write-down
[Dharan, 2004]. Based on this, El Paso had to embark on a write-down of about 41% of its
previous estimated proved reserves in 2004 [Olsen, 2010; Dharan, 2004]. The revisions
involved: South Texas (the largest); Rocky Mountains; Gulf of Mexico and Brazil. The
write-down led to a fall in the share price of El Paso by 18% and an agreed settlement
totalling USD 273 million to Shareholders.

Rapsol YPF

Rapsol YPF announced on 1st Jan. 2006 that its reserves for end of year 2005 will be
reduced by 1,254 million boe (ie. 25%) [Canada Newswire, 2006; Olsen, 2010]. The
revisions related, largely to natural gas reserves. The revisions included fields in Bolivia
(52%), Argentina (41%), as well as Venezuela and elsewhere. The revisions were believed
to have resulted from changes in Bolivia’s legal framework due to new hydrocarbon law
and more reliable data on some fields in Both Bolivia and Argentina [Canada Newswire,
2006]. Rapsol YPF anticipated a lesser asset impairment (less than Euro 50 million)
compared to the volume of revisions because of heightened crude oil and natural gas prices
during the period under review. Management had to undertake various steps by
strengthening the internal control in the company [Olsen, 2010].

Stone Energy

Stone Energy, headquartered in Lafayette, Louisiana has majority of its assets located in the
Gulf of Mexico, Rocky Mountains and Williston. As at 31 st December 2004, proved
reserves estimate to stone energy was 825 billion cubic feet equivalent (Bcef) [Stone

35
Energy Corporation, 2005a]. This value was revised in October 2005 by 171 billion bcef
which represented over 20% downward revisions to its proved oil and gas reserves. The
reasons for the revisions according to independent auditors were (a) interference in reserve
estimation by top staffs which led to an aggressive bookings of Stone’s reserves (b) non-
compliance to SEC requirements and (c) lack of adequate internal guidance and experts on
SEC’s standards for estimating proved reserves [Stone Energy Corporation, 2005d]. The
write-down led to class actions against the company resulting in a settlement of USD 10.5
million and drop in share price of 30% [Stone Energy Corporation Securities Litigation
2010].

3.6 Reserves Auditing

The 2004/2005 lined-up write-down cases raised issues of reserve auditing, internal control,
compliance and effectiveness of regulatory requirements in the oil and gas industry aimed
at relevant and reliable reserves disclosure [Dharan, 2004; SPE, 2007]. These
overstatements in many cases were being ‘managed’ (Shell) with a moratorium/freeze
aimed at smoothing reported reserves. The main causes of the write-down cases are:
aggressive reserve bookings, inadequate expertise of estimators and auditors, and non-
compliance to regulatory requirements because of inadequate auditing. In some cases (Shell
in particular) questions have been raised as to whether tying bonuses of managers to
reserves was what might have caused the over-bookings. Even though Shell has denied this
claim, the Davis and Wardwell [2004] report affirmed it. The SPE standards, moreover,
indicated that when bonuses of reserve estimators are tied to RRR and reserves targets,
such estimates will most likely be compromised since the estimator will not be
independent. For instance, managers under SE companies would want to classify more
reserves under the proved undeveloped category since further development cost on them
will be capitalised as that will lead to lesser expenses and larger reported income in the
short-run. Pursuant to the issue about reliable reserves disclosure, the SPE revised its
Standards Pertaining to Estimating and Auditing of Oil and Gas Reserves Information,
while the Turnbull guidance as applied by the Financial Reporting Council in the UK and
the Sarbanes-Oxley Act in the US were formed to serve as a guide for a sound internal
control within organisations on conflict of interest situations. Despite the fact that, there is
an industry standard approved by SPE on Estimating and Auditing of Oil and Gas
36
Producing activities, there is no enforcement for compliance [Dharan, 2004a]. The UK
regulatory bodies for disclosure of oil and gas E & P activities still allow disclosure of
unaudited reserves. Meanwhile, SEC now require audited reserves disclosure and
disclosure on the expertise of engineers and auditors, involved for oil and gas producing
activities, in its modernised regulations for oil and gas disclosure [SEC, 2009]. While this
requirement might indicate the integrity of estimated reserve disclosure practices, the
researcher argues that mere disclosure cannot solve the problem; rather more stringent steps
need to be taken by standards setters to train estimators, engineers and auditors on
regulatory requirements.

3.7 Conclusion
In the upstream oil and gas industry where reserves are the driver of a company’s value,
much resources and attention is dedicated to its discovery and targets are sometimes set on
reserve replacement, which is likely to induce the smoothing of reported reserve quantum
by managers. Given that reserves estimates are constantly subjected to revisions with
improved geological and engineering data, and changing economic conditions, managers
might want to minimize the volatility in projected earnings in order to win investor
confidence. Pincus and Rajgopal, [2002] researched into whether exploration and
producing firms hedge exploration risk to smoothing income. They found that firms use
abnormal and discretionary accruals to hedge exploration risk. The research extend the
income smoothing literature of exploration and producing oil and gas industry to reserve-
based income smoothing and, therefore, conjecture from the extant literature that in the UK
where there is much flexibility to managers in accounting for exploration and producing oil
and gas activities, firms are likely to create an income smoothing leeway to hedge
exploration risk.

The researcher concludes that in an era characterised by increased scrutiny of oil and gas
companies for heightened prices of crude oil and natural gas coupled with significant
negative revisions to previous reserve estimates in the immediate past by a several
companies, managers might be tempted to resort to non-financial measures to hedge
earnings’ volatility and prevent scrutiny.

37
CHAPTER 4. METHODOLOGY

4.1 Introduction
This chapter explains the criteria and procedures used in selecting and collecting the data
for this research work. The chapter also gives detailed explanations of the methods used in
analysing the data and the appropriateness and validity of these methods for this research
work in particular. The chapter, therefore, help in explaining how the researcher achieves
the research objectives.

4.2 The Data

The research involves a longitudinal study of oil and gas reserves and revisions in
exploration and producing companies either incorporated or operating in the UK.
Longitudinal study involves the study of the same variable for a period of time. It is most
suited for this research because, the research examines reserves revisions and smoothing in
the UK oil and gas industry for a period of 6 years and according to Copeland [1968] the
optimal period necessary to detect the presence of smoothing by a firm is at least 3 years.
Reserves of 13 UK exploration and producing oil and gas companies are studied for a 78
firm-year period. This section explains the methods that are used to achieve the objectives
for this study - revisions and reserve smoothing in 13 selected companies. Purposive data
sampling method is used in selecting the companies for the study. Purposive sampling
technique is a subjective or judgemental sampling approach that considers the deliberate
choice of an informant due to the qualities the informant possesses (Tongco, 2007). It,
therefore, allows the researcher to include units or companies that provide the appropriate
data required for the research in terms of quality and depth. There are seven types of
purposive sampling techniques which include: maximum variation sampling; typical case
sampling; homogenous sampling; extreme case sampling; critical case sampling; total
population sampling and expert sampling. Homogenous sampling technique is used in
selecting the companies for this study because its allows the researcher to chose companies
that share similar traits as prescribed by the criteria for selecting the companies below. Two
types of data were employed: (1) data for case studies (qualitative) and (2) data for the
statistical or empirical studies (quantitative).
Chapter 3 included a case study on Royal Dutch Shell (the second largest oil and Gas
Company in the world) and a snapshot of revisions attributable to Stone Energy, Rapsol
38
YPF, and Elpaso Corporation in the literature section of this work. This provided a window
of opportunity to the not-long-ago high profile reserve write-down cases witnessed in 2004-
2006 based on the extensive reports and media coverage on these revisions. These
downwards revisions cases raised regulatory issues in the exploration and producing oil and
gas industry because of the magnitude of the downgrades and the resultant effects on the
companies on one hand and oil and gas reserves measurement and disclosure practices on
the other hand. Meanwhile, the primary research for the study includes investigation into
significant revisions of 13 companies for particular years for the period 2006-2011.

Following this initial study of previous revisions, the researcher then set the following
criteria for selecting companies for the primary study:

1) A company must be in the exploration and production of oil and gas.

2) The E & P Company must operate in the UK and/or registered with the London
Stock Exchange Market as UK incorporated. This is because the research focus is on
UK oil and gas companies and companies registered with the London Stock are more
likely to disclose on reserves and revisions.
3) The E & P company must disclose information on reserve quantum and changes
during the year in their annual reports for the study period (ie. 2006-2011)

The researcher restricts the search to these conditions and companies that did not meet the
requirements were eliminated. As peculiar with longitudinal studies, 20 UK exploration and
producing oil and gas companies were initially targeted for a period from 2006-2011 (120
firm years) for the study, but 13 companies (ie. 78 firm years) were selected because of the
information constraint. In the UK where only recommended practices are enforced by the
OIAC [SORP, 2001], and managers have the discretion to disclose oil and gas reserves or
not, many companies do not disclose extensively on reserves. Out of 146 oil and gas
exploration and producing companies registered with the London Stock Exchange at the
time, 92 were UK incorporated while only eight had reserves quantum and changes to
reserves from 2006-2011 in their annual reports. The remainder of 4 of the 13 selected
companies operate in the UK but are not traded in the London Stock Exchange Market.

39
The information required include: Company reserves quantum estimates at the beginning of
each year and changes attributable to; revisions of prior estimates, new discoveries,
extensions, improved recoveries, purchases and sales as well as production for the year.
Most of the data was collected from companies’ annual reports as published in their
websites while on few occasions, missing reports were either mailed (hard copies) or
emailed electronically on request. The reserves estimates disclosed in the annual reports are
considered the primary data for the research since it is not tempered with or has not been
analysed or doctored by any other third party. Secondary data for the research includes
academic literature which was of vital importance to the study and published information
on significant reserves downgrades from 2004-2006.

4.3 Research Paradigm

Within the Barrel and Morgan Paradigms, the research falls under both interpretive and
functionalist methods of research studies. Unlike this study, most accounting research
studies fall under the functionalist approach to research studies. This research, therefore,
employs both qualitative and quantitative methods in achieving its objectives. Both
methods are used because of the diverse nature of what is covered. The qualitative aspect
takes the form of an in-depth study of reserves revisions from Shell plus significant
revisions from the data of the 78 firm year period studied, while the quantitative aspect
takes the form of a content analysis of oil and gas reserves and revisions in some UK
companies.

4.3.1Qualitative Approach
Qualitative research studies are tools used in understanding and describing our
understanding of human experience [Myers, 2000]. This approach is judged by its quality
in terms of authenticity of source of information and involves interviews, videos, tape
recordings or substance. According to Myers [2000] “…qualitative methodology is
legitimate and valuable, possessing distinctive characteristics that make it ideal for many
types of investigations…” It involves subjective valuation of issues, rejects both cause-and-
effect constructs as well as universal laws [Munhall, 1989] and takes a descriptive or
interpretive form. This method allows inferences to be drawn about the whole from an in-
depth study of its parts [Myers, 2000]. The weakness in this method is its subjective nature
based on human experience and observation and laws cannot be drawn from the study. In
40
this study, two steps of qualitative approaches are employed. Firstly, a case study of Royal
Dutch Shell 2004 reserves revisions (write-down) and other high profile write-down cases
involving Stone Energy, Rapsol YPF and El Paso from the period 2004-2006 in the
literature section and secondly, company years with significant revisions from the data.

4.2.2 Quantitative Approach

Quantitative research study is, however, judged by facts and figures of its content and is
more numerical based. In this research study, quantitative method takes the form of content
analysis. Content analysis is a research technique used for the objective, systematic, and
quantitative description of apparent content of the variable(s) under study. Content analysis
is more or less a product of electronic age and can indicate pertinent features such as
completeness of coverage or the intentions, biases, prejudices, and oversights of authors,
publishers, as well as all other persons responsible for the content of materials. Its
parameters focuses on concepts and not just words and semantic relationships rather than
simply presence [de Sola Pool, 1960]. There are two main types of content analysis:
conceptual analysis and relational analysis.

In conceptual analysis, “…the content is coded for certain words, concepts, or themes, and
the analyst makes inferences based on the patterns that emerge” [Wilson, 2011, p. 177].
Usually, some people interchange content analysis with conceptual analysis. A concept is
chosen for examination and the number of its observed occurrence recorded. Here, terms
are defined to limit the subjectivity of the analysis [Busha and Harter, 1980]. In conceptual
analysis, the researcher is mostly interested in the presence of the concept(s) and
quantifying it not how they are related.

However, relational analysis builds on content analysis by identifying the relationship

among concepts in a text [Busha and Harter, 1980]. There are diverse ways of the
applicability of relational analysis which makes it quite popular. The advantage in using
this approach is that it maintains a high degree of statistical rigor without losing the
richness of details noticeable in even more qualitative methods.

41
The method of relational analysis is employed in this study because we build on the
analysis of the reserves estimates to examine whether reserves revisions are significant and
also whether the companies engage in reserve smoothing in the UK oil and gas industry.

4.2.3 Significance and Reasons of Revisions

To determine the significance and reasons of revisions, the researcher first computes
revisions as a percentage of reported reserves. This is done by dividing the revisions during
the year by the reserves estimates at the beginning of the year. Any revisions that form
about 20% or more of its beginning-of-year estimated total reserves is significant. The basis
for a 20% is the high profile significant revision cases from 2004-2006. Significant
revisions are then singled out and analysed from the annual reports highlighting the
reasons. The researcher categorises each of these revisions under four types of revisions:
changes in Geophysical and Engineering data as well as Exploration Success; changes in
Economic conditions; changes in Disclosure Requirements and Reclassifications or
Rebooking.

4.2.3 Smoothing Descriptors

In examining the presence of reserve smoothing among the companies, Eckel’s [1981]
method of coefficient of variation (CV) as employed by Michelson, Jordan-Wagner and
Wooton [2000] is adopted for this research. Many researchers [Albrecht and Richardson,
1990; Ashari, Koh, Tan, and Wong. 1994; Booth, Kallunki, and Martikainen,1995;
Michelson, Jordan-Wagner and Wooton, 1995] have employed this method in determining
the presence of income smoothing in some companies. The CV is useful because it is a
dimensionless measure of variability of a sample between two or more related variables
[Abrecht and Richardson, 1990]. CV also allows for the understanding of the standard
deviations (SD) of a variable in terms of its mean values. The standard deviation increases
or decreases proportionately with the mean. And when SD divides the mean to give the CV,
the SD effect is removed in terms of variability and the CV then becomes the “…
standardisation of the SD that allows comparison of variability estimates regardless of the
magnitude of analytic concentration…” [Reed, Lynn and Meade, 2002, p.1235] between
the two variables.

42
In regard to income smoothing, Michelson et al [2000] emphasized on the aggregation of
variables as Zmijewski and Hagerman[1981] suggested that companies select accounting
choices based on their total effect on income. They assumed that if changes in income
results from smoothing then, applying the coefficient of variation method, this will reflect
in the variability of changes in sales to changes in operating income measure. They used
Albrecht and Richardson’s (1990) application of the model where they showed that a firm
is not a smoother if:
CV∆I ≥ CV∆s

Where CV∆I is the coefficient of variation of one period change in income and

CV∆s is the coefficient of variation of one period change in sales.

CV = Standard Deviation ÷ Expected Value

If the variability of change in sales is greater than the variability of change in income then
the firm is classified a smoother, otherwise, a non-smoother. Sale and operating income are
supposed to vary proportionately but if this relationship does not exist, there is a possibility
of income smoothing.

The researcher borrows the Eckel’s [1981] CV method onto reserve-based- smoothing in
the oil and gas industry and proposes that since the underlying value of the oil and gas
company is reserve-based, managers might engage in reserve smoothing as was the case of
Shell, El Paso, Stone Energy and Rapsol YPF early 2000s where significant overstatements
were “managed” through “moratorium” in most cases to maintain the value of the company
or prevent stakeholder lawsuits. In applying the model for this study, the smoothing object
is the reported reserves, the smoothing variable is net reserves addition and the
discretionary accrual is revisions as found by Kurdi [2010]. This is possible because of the
information asymmetry on revision data that exists between managers of E & P oil and gas
companies and investors as well as shareholders. Furthermore, the main focus in the oil and
gas industry is on reserve replacement as represented by the Net Reserves Additions (NA)
and RRR accounts for Net Reserves Additions. Reserve replacement (herein RRR) is based
on net reserves additions in terms of the extent to which depleted reserves are being

43
replaced. The NA is divided by production and sales to give the RRR. Even though there
are different ways of calculating RRR, the researcher calculates RRR as:

RRR = [Extensions and Discoveries + Improved recoveries + Purchases + Revisions] ÷

[Production + Sales]

ie. Reserve Inflow ÷ Reserve Outflow

Where RRR measures the extent to which depleted reserves is being replaced by the
company and is expressed in terms of a percentage.

Thus, RRR takes into account both net additions, productions and sales during the year in
question. The researcher argues that since production and sales are real variables and
cannot be manipulat, their effect on the variability of RRR is insignificant. Hence, changes
in an E & P company’s NA should reflect on changes in its RRR for the same period. If this
change does not reflect then the company might be smoothing its reported reserves. The
CV method is thus used to separate smoothers from non-smoothers in this case. The
research compares RRR after revisions to NA before additions.

Using the model, the rule is that a company is not considered a smoother if

CV∆RRR ≥ CV∆RA

Where CV∆RRR is the coefficient of variation of the company’s RRR and CV∆RA the
coefficient of variation of the net additions to reserves during the year. This implies that if
the variability of change in RRR is greater than the variability of change in net reserve
addition, then the company is not regarded as a smoother, otherwise the company is
regarded as a smoother.

4.4 Conclusion
The methods employed in this research work as explained above (purposive data collection,
reserves-revisions ratios and the coefficient of variation), are appropriate for small samples
size as in this research. In addition, the qualitative and quantitative (ie. functionalist and
interpretive) methods employed in this research work give a middle-range thinking into
accounting research design. This can help expand accounting research paradigm - which is
skewed to functionalist or quantitative analysis.
44
There are however some challenges with this methodology. The module does not give room
for determining smoothing variables which is key for the CV to determine smoothers from
non-smoothers. Also, the methods employed in this research work are not appropriate for
large sample size research, hence, usage is only limited to small sample size. Finally, in
situations where the effect of production and sales on the variability of RRR is significant,
the outcome of the test might not be reliable.

45
CHAPTER 5. ANALYSES AND DISCUSSION

This section deals with the analyses and discussions of findings in this research and focuses
on two key areas: a) significant revisions, highlighting and giving an in-depth report on
outliers; and b) to investigate whether E & P companies in the UK smoothing their reported
recoverable reserves estimates or not.

5.1 Analyses

5.1.1 Significant revisions

Based on the 2004-2006 high-profile revision cases, any revisions that form over 20% of
previous reserve estimates is regarded as significant. The researcher highlights detailed
explanations of these revisions with analyses of the annual reports. The revisions are put
under 4 main categories as shown in Table 4 below: a) improved Geophysical and
Engineering data as well as Exploration success (∆GE & E); b) Re-bookings or Re-
Classifications (RR); c) Changes in Economic conditions (∆EC) and d) changes in
Disclosure Practices. Seven companies had significant revisions in particular years - all
being upwards revisions - which include: BG Group (2008); Tullow (2007 & 2008);
Melrose (2008); Soco (2006); Nexen (2006); Salamander (2008) and Shell (2009). Table 3
below shows highlights of significant reserves revisions of some of the companies under
study followed by explanations of reasons for each significant revision from the
‘Supplementary Information’ and the ‘Review of Operations’ portions of the companies.

46
Table 3.Reserves (RES)-Revisions (REV) Ratios of UK Companies for the period
2006-2011

Revision Ratios of companies

Year 2006 2007 2008 2009 2010 2011
Company Item
BP Reserves (RES) 17615.7 17436.2 17556.3 17887.7 24466.3 17646.7
REV. 860.5 1405.8 349.2 672.9 -232.7 699.5
REV/RES 4.9 8.1 2 3.8 -1 4
BG Reserves (RES) 1611.2 2149.3 2039 2458.6 2599.9 2893.3
REV. 138 55 422.5 139 275.2 337.1
REV/RES 8.6 2.6 20.7 5.7 10.6 11.7
Premier Reserves (RES) 102.20 152.10 211.50 227.50 255.20 260.80
REV. 0.10 24.10 10.40 -0.20 3.80 5.60
REV/RES 0.10 15.84 4.92 -0.09 1.49 2.15
Tullow Reserves (RES) 357.70 506.40 551.40 314.10 893.70 1387.50
REV. 40.20 114.20 301.80 11.00 12.90 38.40
REV/RES 11.24 22.55 54.73 3.50 1.44 2.77
Melrose Reserves (RES) 45430.83 61232.00 53702.00 66603.00 69966.00 105240.00
REV. -4767.20 -9483.00 12702.00 -632.00 1961.00 -6463.00
REV/RES -10.49 -15.49 23.65 -0.95 2.80 -6.14
Soco Reserves (RES) 133.20 160.60 160.90 144.10 142.50 132.60
REV. 38.80 2.60 18.00 3.40 0.00 0.00
REV/RES 29.13 1.62 11.19 2.36 0.00 0.00
Centrica Reserves (RES) 362.50 343.50 328.50 323.83 467.20 529.20
REV. -3.20 21.00 7.30 6.83 -0.83 23.50
REV/RES -0.88 6.11 2.22 2.11 -0.18 4.44
Nexen Reserves (RES) 468.00 673.67 1594.00 2036.00 2228.00 2134.00
REV. 251.00 51.20 -18.00 -19.00 22.00 -151.00
REV/RES 53.63 7.60 -1.13 -0.93 0.99 -7.08
Salamander Reserves (RES) 17.60 42.30 38.80 67.70 64.80 66.30
REV. 3.20 -0.70 10.80 -0.30 -0.50 1.10
REV/RES 18.18 -1.65 27.84 -0.44 -0.77 1.66
Talisman Reserves (RES) 1312.00 1367.00 1347.50 1207.40 1201.00 1149.40
REV. 48.30 40.70 -69.40 89.60 16.40 12.30
REV/RES 3.68 2.98 -5.15 7.42 1.37 1.07
Hess Reserves (RES) 1093.00 1243.00 1328.00 1423.00 1437.20 1537.00
REV. 82.00 113.00 196.00 109.50 96.70 102.70
REV/RES 7.50 9.09 14.76 7.70 6.73 6.68
BHP Reserves (RES) 1406.30 1362.20 1353.00 1375.00 1381.40 1394.30
REV. 57.90 20.70 41.10 47.10 84.40 139.50
REV/RES 4.12 1.52 3.04 3.43 6.11 10.01
Shell Reserves (RES) 11238.70 11554.20 10591.80 10666.20 13862.80 14001.80
REV. -81.00 395.30 949.30 2983.00 994.20 339.80
REV/RES -0.72 3.42 8.96 27.97 7.17 2.43
NB: the values highlighted in the table indicate percentages of significant revisions greater than 20% for the period 2006-2011 .

BG Group (2008): BG Group is one of the biggest multinational oil and gas companies in
the UK traded in the London Stock Exchange. The Group’s proved reserves estimates for
2008 was 2039 mboe (2149.3mboe for 2007). This was a slight reduction from 2007
estimates. However, upwards revisions to the group’s 2007 year-end estimates during 2008
recorded the highest from 2006-2011 and was 422.5mboe representing over 20% of total
estimated recoverable reserves. The revisions were believed to have resulted mainly from
47
significant revisions in some fields in UK (51mboe) and, Asia and Middle East (347.7
mboe – the highest) regions. In the UK, revisions were largely due to improved information
from drilling in the West Franklin field and the Buzzard fields of the North Sea while
Exploration success in Brazil also contributed to the revision in 2008. In addition, on
December 2007 BG Group ceased to be a SEC registered company and even though
continued to use SEC definitions, their reporting obligation under SEC also ceased. SEC
require “reasonable certainty” under “existing economic condition” as a guide for the
classification of reserves and also require mandatory disclosure of proved Oil and Gas
reserves and an optional disclosure of probable reserves estimates. This might lead to a
relaxation of BG’s disclosure practices since disclosure under FSA and OIAC, which now
regulates the Group, is discretionary and require the disclosure of proved, probable and
possible reserves. Thus, part of the revisions in the field might have resulted from changes
in the disclosure and reporting practices.

Tullow Oil (2007 and 2008): Tullow is a multinational oil and gas company with its
activities concentrated in Africa, UK and Asia. The company’s recoverable reserves
estimates increased from 506.4mboe in 2007 to 551.4mboe in 2008. The increase in
estimates was attributable to exceptional exploration success in Africa and the UK leading
to upwards revisions to previous reserves estimates. In Africa, the acquisition of Hardman
Resource Ltd in Uganda and significant discoveries in the Jubilee field in Ghana had a
tremendous impact on the company’s reserves. Upwards revisions to the company’s 2007
estimates was 114.2 mboe and rose to 301.8mboe in 2008 representing about 22.5% and
54.7% of its recoverable reserves respectively. The revisions could largely be attributable to
the exploration success in fields in the UK and Africa (Jubilee field in Ghana and around
the Kingfisher well in Uganda). In Ghana, revisions related to improved geological and
engineering data from drilling success in the Jubilee field discovery wells of “Hyedua and
Mahogany” from 2007-2008 while in Uganda development of the Kingfisher well of the
Lake Albert Rift Basin contributed to the upwards revisions.

Melrose (2008): Melrose is a UK incorporated Oil and Gas company which has its
operations in Egypt, Bulgaria and USA. The company reported recoverable reserves as at
1st January 2008 stood at 53702mboe which was a 12.3% reduction in its 2007 estimates of

48
61232mboe. The reduction resulted from a downward revision to its 2007 estimates by
9483mboe following production of 5480mboe. In spite of the negative revisions in the
previous two years, revisions to the Company’s 2008 estimates was 12702mboe
representing an addition of over 23% of year-end 2007 estimates. The upwards revision
mainly resulted from oil and Gas reserves estimates for the year in Egypt and USA.
In Egypt, upwards revision was due to improved data from two existing aeromagnetic
surveys following an initial 2D-seismic survey in the ‘Mesaha Concession’ located in the
“Desert Egypt” as well as the El Mansoura Concession. In the El Mansoura Concession,
revisions were as a result of improved information from G & G and development work. In
the Permian Basin, revision was “as a result of the increased level of investment and a
technical review of the assets” which led to an increase net proved reserves in the Basin by
9.8 mboe, bringing the 2008 year end total to 23.2 mboe” (Melrose 2008 annual report,
p.15). Improved data from Geological and Geophysical Evaluation of the two main
producing wells in East Texas during 2008 contributed to Melrose’s upward revision for
the year. The producing fields include Rankin with six active wells and the North Raywood
field with three Gas active wells as at 2008.

Royal Dutch Shell (2009): Shell is an Anglo-Dutch company which is the second largest
multi-national integrated Oil and Gas Company in the world with its operations in Europe,
Africa, Asia and North America. Traded in the London stock market with a market
capitalisation hovering around £128962.7m (London Stock Exchange listed companies
2012), the company’s total recoverable reserves estimates as at January 2009 was
10666.2mboe, indicating an increase from its 2008 estimates of 10591.8mboe due to the
effect of improved recovery, positive revisions, purchase and extensions and discoveries
net of production and sales. Total net Upwards revisions to Shell’s January 2009 reserves
estimates reached a record high of 2983mboe (ie. 27% of recoverable reserves) from
395.5mboe in 2007. Upward revisions of beginning 2009 estimates were as a result of
reasons similar to that of 2008.
Revisions basically resulted from several reasons:
1) Improved data information from geosciences and engineering work due to ongoing
development and study activities in Brunei, Oman, Nigeria, Abu Dhabi and

49
 elsewhere in the world which led to reclassifications of reserves in these fields.
These fields were downgraded in 2004 because they had not met SEC disclosure
requirements.
2) Revised SEC disclosure practices in 2009 to include oil sand and bitumen reserves.
Even though SEC modernisation of oil and gas reporting practices was effected in
2010, its trial started in 2009 which had an impact on the reported reserves of E & P
companies registered with the commission.
3) Positive impact of economic conditions due to net effect of crude Oil and natural
Gas price changes net of production and development cost during the year.
4) Better reservoir performance in Europe from water floods.

Nexen (2006): Nexen is a Canadian-based company with its operations and working
interest stretching to the UK North Sea, US Gulf of Mexico, western Canada, Yemen,
offshore West Africa and Colombia. As at January 2006 the company’s reserves was
468mboe which was revised upwards by 251mboe representing about 53% of the January
2006 estimates. A greater part of the upward revision was from Canada (249mboe) and UK
(20mboe). In the UK and Canada, revisions were attributable to improved G & E data and
recovery factor from the Buzzard region of North Sea and Long Lake Project respectively.
The reserves of the Long Lake project were initially written off late 2004 due to low gas
prices which directly affect bitumen production, but were brought back to the proven
category because of low production cost of bitumen in 2006. As SEC revised rules allow
for reporting of bitumen reserves, this led to a 246mboe upward revision in the company’s
2006 estimates.

Soco (2006): Soco International is publicly traded in the London Stock Exchange with a
market capitalisation of about £945.7m. The company’s total proved and probable reserves
estimates as at January 2006 was 133.2mboe with revisions of 38.8mboe forming about
29% of its commercial reserves estimates. About 70% of the company’s 2006 revisions
could be attributed to drilling and exploitation success in Vietnam in the Cuu Long Basin
where 5 out of 7 exploration and appraisal wells drilled were discoveries. The revision was
as a result of improved data from the field.

50
Salamander (2008): Salamander Energy is an Asia-focused independent oil and gas
company with 21 licences across Indonesia, Thailand, Vietnam, Lao PDR and the
Philippines. In January 2008, the company reserves estimates was up to 38.8mboe which
was a slight reduction from its 2007 estimates due to the net effect of negative revision,
sales of reserves and production over extensions and discoveries during the year. However,
revisions to the 2008 estimates were 10.8mboe covering a 27.8% of the company’s
recoverable reserves for the year. A greater percentage of the revisions were from Bualang
field in Thailand where completion of drilling and development work led to improved data
gathered and reclassification of some reserves as proven. Moreover, exploration success at
the Kambuna field also led to improved Geological and engineering data resulting in
upwards revisions to the 2008 estimates.

Table 4. Showing Reasons for significant revisions as categorised

Reasons ∆ GE & E ∆EC RR ∆DR

company

BG YES NO NO YES

Tullow YES NO NO NO

Melrose YES NO NO NO

Shell YES YES YES YES

Nexen YES NO YES NO

Soco YES NO NO NO

Salamander YES NO YES NO

Where: ∆GE & E = changes in Geological and Engineering data as well as Exploration
Success

∆EC = Net effect of changes in Economic Conditions

RR = Rebooking or Reclassifications
51
∆DR = changes in Disclosure Requirements

5.1.2 Reserves Smoothing

The CV methods was used to identify companies that appear to be smoothing their reported
reserves from those that do not. Reserve Replacement is a key factor in determining the
future performance of an Oil and Gas firm and thus whether it is a going concern or not.
Firms therefore direct much attention on the RRR value and use it to signal better
performance. Based on Michelson et al [2000] application of the CV method the researcher
conceptualises that if the CV in RRR is greater than or equal to the CV in NA, then the
company does not appear to be smoothing its reported reserves. However, if the CV of a
firm’s Net Reserve Additions is greater than that of the RRR, then the company appears to
be smoothing its reserves estimates. Table 5 below shows companies’ coefficient of
variations in terms of RRR and Net Reserves Additions (NA) (see appendix A and B for
more details). Comparing the two CVs in Table 5, five companies appear to be smoothing
their reserves because the CV (variability) of these companies’ RA before revisions in each
case is greater than the CV (variability) of their RRR after revisions. However, eight
companies do not appear to be smoothing their reported reserves because of a lower CV of
RRR compared with the CV of NA. Thus from table 5, smoothers include: Tullow,
Centrica, Nexen, Salamander and BHP; and Non-smoothers include: BP, BG, Premier,
Melrose, Soco, Talisman, Hess and Shell. A comparison of the CVs of NA and RRR of
companies that appear to be smoothing their reserves is shown in table 6.

52
 Table 5. Showing Mean, SD and CV of UK companies’ RRR and Net Reserves
Additions (NA) from 2006-2011

NA RRR
Year Mean St. Dev CV Mean St. Dev CV
BP -474.083 385.35913 -0.812851 110.6 25.16664 0.227547
BG -71.36 89.919536 -1.260083 162.5667 85.1864 0.524009
Premier 15.58333 17.660625 1.1333021 175.5833 222.618 1.267877
Tullow 131.4333 222.56299 1.6933527 809.0833 945.7758 1.168947
Melrose -2533.83 16010.246 -6.318587 143.5333 185.182 1.290167
Soco -9.18333 9.1076708 -0.991761 262.1167 435.602 1.661863
Centrica 21.9 65.470176 2.9895058 162.9 142.3581 0.873899
Nexen 134 206.58174 1.5416548 293.0833 201.5972 0.68785
Salamanda 7.366667 10.458043 1.4196439 498.5 661.1178 1.326214
Talisman -34.4 70.73104 -2.056135 98.6 58.60717 0.594393
Hess -36.45 65.510144 -1.79726 155.8333 38.88144 0.249507
BHP 6.05 147.13543 24.319906 143.2167 115.4748 0.806295
Shell -469.1 682.867 -1.455696 145.1167 113.9577 0.785283

Table 6. CV of RA compared to CV of RRR for smoothing companies

Company CVs of NA CVs of RRR

Tullow 1.6933527 1.168947

Centrica 2.9895058 0.873899

Nexen 1.5416548 0.68785

Salamander 1.4196439 1.326214

BHP 24.319906 0.806295

5.3 Discussion
First, in regard to the first research objective for this study which deals with significant
revisions, after the 2004-2006 high profile reserves write-downs, and the resulting negative
publicity that characterised it, leading to lawsuits and drops in share prices, oil and gas
53
companies in the UK seem to be more meticulous and conservative in the evaluation and
reporting of reserves. This is evidenced in this paper where all the revisions that are
considered to be significant take an upwards trend (see table 3 for details). Moreover,
Costabile et al [2012] in their research on the “market implications of earnings surprises”
found that apart from the reward that the market attaches to the content of revisions, in the
earnings surprises, there is an added value to the share prices of companies that report
positive revisions to their reserve estimates. The researcher argues that both reasons above
could contribute to the positive revision in this case – particularly the effects of the high
profile reserves write-downs between 2004-2006. While revisions to reserves estimates is
not alien to the oil and gas industry, significant revisions raise doubt about credibility of
disclosure quality. The initial case study on Shell showed that much of the revisions
resulted from:

Australia (Gorgon) – where overstatement was due to expected future market for gas in
Asia which failed to materialised

Nigeria (Bonga) - where the interplay of politics and non-compliance to SEC requirements
led to aggressive booking

Oman – where overstatement was due to non-compliant disclosure practices and

Brunei – where overstatements was due to ‘legacy volumes’ and non-compliant reporting.

Investigations into the significant revisions in primary research of this study, however,
showed upward revision to Shell’s 2009 reserves estimates was over 27%, a greater
portion of which was from the rebooking of the previous de-booked reserves (Australian
Gorgon, Nigerian Bonga, Brunei, Oman and Abu Dhabi) based on on-going development
works in those regions. Additionally, the upwards revisions among all the companies (BG,
2008; Tullow, 2008 & 2009; Melrose, 2008; Soco, 2006; Nexen, 2006; Salamander, 2008;
and Shell, 2009) resulted from four key variables: a) improved data and exploration
success, b) the net effects of changes in economic conditions, c) changes in disclosure
requirements and d) reclassification or rebooking.

54
In the UK where reserve disclosure is discretionary and probabilistic methods (as
recommended by the SPE) are mostly used in the estimation of reserves (Arnot, 2004), one
would expect the trend of revisions to be downward rather than upwards compared to the
US where deterministic methods are required. This is because probabilistic methods are
regarded as less conservative. Contrarily, this research found that revisions took an upwards
trend in the companies under study for the period 2006-2011. While the concept of
conservatism in reserve reporting is not necessarily bad and is an accounting principle,
being overly conservative can mislead regulatory bodies, standards setters and governments
in taking decisions on companies’ reported reserves estimates. Perhaps these significant
revisions that characterise the industry confirm the reason why reserves are not included in
the primary financial statement but are disclosed as supplementary information in the
annual reports [Wise, 2010].

Secondly, the income smoothing hypothesis suggest that discretionary accruals serve as an
earning’s optimizing or equalising tool between current and future years, and tend to be
positive when current year’s earnings before discretionary accruals is lower than last year’s
earnings. Hence, managers will report negative current period accruals when current period
performance is good and future performance is bad [Ahmed, Lobo and Zhoo, 2001]. As the
focus in the oil and gas industry is on reserve replacement and whether an E & P company
is a ‘going concern’ is dependent on the extent to which it replaces its depleted reserves,
discovery of reserves is the most significant asset to the E & P company [Luther,1996].
Moreover, Donkor et al. [2006] found in a survey of E & P oil and gas companies that
investors sometimes value oil and gas reserves that a company holds more than its earnings.
Thus, given that the upstream oil and gas industry is highly risky, more capital intensive
and requires more external financing, managers engage in reserves smoothing in an attempt
to ‘paint and sell’ their companies to investors. The researcher acknowledges that the
smoothing tactics employed by the companies prior to 2004-2006 write-downs (Shell, El
Paso, Stone Energy, Rapsol YPF etc.) were inappropriate as this resulted in losses.
However, as managers are privy to reserve information in a way that investors do not, and
have a greater control over reported reserves, they resort to practices that are intended to
‘paint and sell’ the company to investors by engaging in reserves smoothing. The CV
analysis used in this research work confirmed this smoothing behaviour in the UK E & P
55
oil and gas industry by showing that the variability of companies’ NA before revisions of
five companies were greater than the variability of their RRR after revisions.

56
CHAPTER 6. CONCLUSION

This research work examined the significance of oil and gas reserves revisions, the
justifications for these significant revisions and reserves smoothing in the UK E & P
industry for the period 2006-2011. Even though there have been extensive literature on
reserves revisions and income smoothing (which the researcher adopts), this research work
is the first of its kind to examine the existence of reserves smoothing and significant
reserves revisions in the E & P oil and gas industry.

The researcher first gave a window of opportunity to the high profile reserve write-down
cases between 2004-2006 that raised issues about enforcement of regulatory requirements
on internal control, auditing and compliance to disclosure practices in the oil and gas
industry. This involved an initial case study on Royal Dutch Shell (2004) write-downs and
a snapshot of significant downwards revisions from El Paso, Stone Energy and Rapsol
YPF. These studies revealed that overstatements were characterised by non-compliance to
regulatory reserve booking requirements and aggressive booking due to performance-based
reserves replacement targets in some companies. It was also found that conscious efforts
were made to ‘manage’ overstatements through ‘moratoriums’ on reserves booking rather
than downgrading them [Davis and Wardwell, 2004]. However, the primary empirical
research work on significant revisions showed that some companies reported significant
upward revisions of over 20% of their reserves estimates for particular years. Several
reasons accounted for the upwards revisions which stretch from the Net Effect of Economic
conditions, through Reclassifications and Improved data to Changes in Disclosure
requirements. In the case of Shell in particular, reserves that were de-booked in Nigerian
Bonga, Oman, Brunei, Abu Dhabi and Australian Gorgon regions for not meeting SEC
disclosure requirements are being rebooked due to improved data from on-going
development projects.

Thus, after the high profile reserves write-down cases from 2004-2006 and the resulting
effects, some UK E & P oil and gas companies seem to be more conservative in the
estimation and disclosure of oil and gas reserves. This is contrary to the assertion that
probabilistic reserve estimation methods, as employed by UK companies, are less

57
conservative. However, while conservatism is a recommended accounting principle, as the
UK is a major producer of oil and gas in Europe, and forms a significant portion of world’s
production, significant understatement of reserves: (1) misrepresent the values of the
companies and can increase the risk in the credibility of disclosure quality and can explain
why reserves are not included in the primary financial statements; (2) distorts the worlds
forecast estimates of oil and gas reserves peaks and the regulations that are based on these
peaks; and (3) further intensifies the effect of discretionary disclosure in the UK and lack of
complete set of standards in the E & P industry.

The research also tests whether there is the possibility of reserves smoothing behaviour by
E & P oil and gas companies in the UK. Applying the CV analysis, it was found that some
companies appear to be engaging in reserves smoothing behaviour. This is evidenced from
the fact that the greater variability of the Net Reserves Additions (NA) before revisions
compared with the variability of RRR after revisions in some companies for the study
period. Thus, as managers are privy to reserves information in a way investors do not and
have greater control over reported reserves, they are more likely to disclose reserves in the
interest of management. While some researchers argue that smoothing behaviour is a
legitimate tool used in accounting to project the true value of a company in an uncertain
environment and help investors and analyst to easily forecast future performance, the
researcher argues that smoothing behaviour is one way to ‘paint and sell’ a company to
investors and does not give the true and full picture of reserves that are commercially
producible to the company in individual periods for decision making.

Future research should test whether there exist any relationship between companies’
characteristics and reserves smoothing – ie. Whether smoothing behaviour could be linked
to Company Size, Gearing Ratios and Bonuses or performance-target-based compensations
on reserves booking?

A limitation of this research is the small sample size used and the study period covered
because of limited disclosure of reserves and revision information and limited time for the
research. This might limit the extension of current findings of this research to other
companies as 13 companies cannot be a true representation of all UK E & P companies.

58
The researcher, therefore, makes the following recommendations:

 As this research work is the first of its kind, more rigorous analyses is needed in the
area of reserves smoothing in future to determine the presence of reserves
smoothing in large samples.

 To address the credibility and reliability of reserves disclosure, mandatory

disclosure practices should be required in the UK and reserves should be disclosed
in audited form (as now required by SEC). Disclosed reserves should be based on
independent auditors’ reports. For this, however, to be feasible, there should be a
body responsible for the enforcement of regulatory requirements.

 And finally, 100% Proven reserves and a certain percentage of unproven reserves
should be disclosed (as used in Australia) since it is confirmed that investors use
both category of reserves in the valuation of E & P companies.

59
 APPENDIXES

Appendix A

Coefficient of variation of Net Reserves Addition (NA) for UK companies from 2006-
2011

RRR including REV

Year 2006 2007 2008 2009 2010 2011 Mean St. Dev CV
BP 92 157 119 106 88.6 101 110.6 25.16664 0.227547
BG 91.5 53.8 221.4 119 229 260.7 162.5667 85.1864 0.524009
Premier 1.4 557 220.3 272 1.4 1.4 175.5833 222.618 1.267877
Tullow 740.9 165 108.6 44.5 2448.8 1,346.70 809.0833 945.7758 1.168947
Melrose 440 0 290.5 130.7 0 0 143.5333 185.182 1.290167
Soco 269.4 30.5 1125 147.8 0 0 262.1167 435.602 1.661863
Centrica 53 68.4 91 433 199 133 162.9 142.3581 0.873899
Nexen 462 117 231 592 68.5 288 293.0833 201.5972 0.68785
Salamanda 1644 0 950 42 121 234 498.5 661.1178 1.326214
Talisman 152.6 80 9 97 80 173 98.6 58.60717 0.594393
Hess 213 161 172 103 164 122 155.8333 38.88144 0.249507
BHP 62 92.6 117 104 108 375.7 143.2167 115.4748 0.806295
Shell 124 56.7 108 373 110 99 145.1167 113.9577 0.785283

60
 Appendix B

Coefficient of variations of the companies Reserve Addition from 2006-2011

Net Reserve Addition (Excluding

REV)

Year 2006 2007 2008 2009 2010 2011 Mean St. Dev CV

BP -1007.8 -539.5 -83.7 -561 27.1 -679.6 -474.083 385.35913 -0.812851

BG -152.2 -156.7 147.2) -94.4 30 16.5 -71.36 89.919536 -1.260083

Premier -7.2 35.3 5.6 28 1.8 30 15.58333 17.660625 1.1333021

Tullow 108.5 -69.2 -25.7 -24.7 482.7 317 131.4333 222.56299 1.6933527

Melrose 20569 1953 199 2541 -26066 -14399 -2533.83 16010.246 -6.318587

Soco -14.4 -24.5 -1.6 -2.3 -10 -2.3 -9.18333 9.1076708 -0.991761

Centrica -15.8 -36 -12 136.5 63 -4.3 21.9 65.470176 2.9895058

Nexen 6.2 -39.2 131 462 -50 294 134 206.58174 1.5416548

Salamanda 21.5 -2.8 18.1 -2.6 2 8 7.366667 10.458043 1.4196439

Talisman 26.7 -72.2 -76.9 -96.1 -68 80.1 -34.4 70.73104 -2.056135

Hess 68.5 -26.4 -93.2 -104.5 3.4 -66.5 -36.45 65.510144 -1.79726

BHP -102 -30.3 -19.1 -40.8 -71.5 300 6.05 147.13543 24.319906

Shell 396.4 -1368 -851 213.1 -855.1 -350 -469.1 682.867 -1.455696

61
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