1 The SEC Perspective - Avoiding Reserve Writedowns Whats Happening & What We Can Expect? Bob Wagner, Ryder Scott Company April 10, 2007 Evangeline Section of SPE Lafayette, Louisiana THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 2 Does Anybody Really Care? THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 3 What Have We Seen? 2004 A Bad Year for Reserves Reporting Shell writes down over 4 Billion BOE Chairman, CFO, & President resign Over 150 MM$ in SEC fines El Paso writes down 1.8 TCF Chairman & President resign, new board elected, Huge technical staff turnover 2005 More Bad News Stone Energy writes down 161 BCFE One Director, One Officer, and One Senior Manager resign, SEC investigation 2006 The Story Continues Repsol YPF writes down 1.3 Billion BOE 2007 Not Again Cairn Energy writes off 213 BCFE Hydro writes down Front Runner & 9 other GOM Fields Shell agrees to 353 MM$ settlement with shareholders Enterra Energy writes down PUD gas reserves Expect more to be announced Lawsuits, Formal SEC and Justice Department investigations continue Shotgun mergers & Property Fire Sales continue THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 4 Why Has This Happened? SARBANES-OXLEY ACT (SOX) Law enacted July 2002 primarily in response to Enron bankruptcy Intended to provide investors with added assurance in the financial reporting of public companies Imposes direct responsibility to company executives for accurate reporting criminal and civil penalties for non-compliance or false reporting Applies to public companies that file 10-K or 20-F reports with the SEC THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 5 Actions by the SEC The SEC uses the broad reaching powers of Sarbanes - Oxley to investigate oil and gas reserves more thoroughly than ever before Increased surveillance of E&P companies by the SEC SOX mandated reviews on a 3 year cycle THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 6 Noncompliant Proved Reserve Estimates Typically Result From: Inappropriate analysis of technical data Non-compliance with established SEC reserve definitions and guidelines Lack of management controls and governance Pressure by management to book more reserves than data or regulations allow to please Wall Street or themselves THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 7 HOW DOES THE SEC ASSURE THAT COMPANIES ARE IN COMPLIANCE? IN RECENT YEARS, THE SEC STAFF HAS ISSUED COMMENT LETTERS RANGE OF QUESTIONS POSED BY ACCOUNTANTS, LAWYERS AND ENGINEERS DESIGNED TO TEST THE COMPLIANCE OF THE COMPANY WITH SEC REGULATIONS THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 8 SEC Comment Letters Ive only got a couple of questions for you One more thing Didnt you say I guess Im confused, you told me THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 9 SEC Comment Letters INITIAL LETTER ASKS GENERIC QUESTIONS ABOUT MANY ISSUES UPON PRODUCER RESPONSE, SEC MAY ASK FOLLOW UP QUESTIONS ABOUT SPECIFIC PROPERTIES THIS MAY LEAD TO A SERIES OF QUESTIONS & ANSWERS SEC MAY ASK FOR SUPPORTING DOCUMENTATION (MAPS, GEOLOGIC or ENGINEERING DATA, CONTRACT DATA, or ELECTRONIC SUMMARIES FOR EVERY RESERVE ENTRY) THE INITIAL RESPONSE MAY ALSO OPEN THE DOOR FOR QUESTIONS & COMMENTS ABOUT NEW ISSUES THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 10 SEC Comment Letter Addressed to: Company CFO 10-K for the year ended December 31, 2005 Typical Comment Letter Opening Statement: We have reviewed the above filing and have the following accounting and engineering comments. We have limited our review to the areas commented on below. Please be as detailed as necessary in your explanation. In some of our comments, we may ask you to provide us with supplemental information so we may better understand your disclosure. Please provide us with that information within ten business days of the date of this letter. After reviewing this information, we may or may not raise additional comments. Please understand that the purpose of our review process is to assist you in your compliance with the applicable disclosure requirements and to enhance the overall disclosure in your filing. We look forward to working with you in all respects. We welcome any questions you may have about our comments or on any other aspect of our review. THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 11 SIGNIFICANT REVISIONS REQUESTED BY THE SEC DE-BOOKING TYPICALLY RESULTS IN SEC REQUEST TO REMOVE CERTAIN RESERVES FROM THE NEXT (ANNUAL) RESERVES FILING GENERALLY RELATED TO SELECTED RESERVE VOLUMES GENERALLY A PRIVATE MATTER BETWEEN THE COMPANY AND THE SEC THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 12 SIGNIFICANT REVISIONS REQUESTED BY THE SEC RESTATEMENT A MUCH MORE SERIOUS CONSEQUENCE THAN DE- BOOKING BECAUSE CERTAIN PREVIOUS FILINGS MUST BE CORRECTED TO REMOVE REPORTING ERRORS OR REVISIONS MAY TRIGGER CORPORATE PENALTIES UNDER SARBANES-OXLEY MAY CAUSE FULL SCALE INVESTIGATION THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 13 Your Best Outcomes IF THE SEC SAYS We have no further questions Although we are do not endorse your analysis, we will not object however, the revision appears to be immaterial Or, You never hear from the SEC again on certain questions YOU ARE A WINNER WHAT YOU WILL NEVER HEAR Good job, We agree, You are compliant, etc. THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 14 SEC COMMENT LETTER Letter Dated: November, 2004 Topic: SOX Issues Question: We note your proved reserve disclosure [Managements Discussion and Analysis of Financial Condition and Results of Operations]. Amend your document to discuss the internal controls you have in place to assure consistency and conservatism in your proved reserve attribution, estimation and evaluation. At a minimum: a) Address how the effectiveness of these controls is reflected in your history of proved reserve revisions over the last three years; b) Identify the personnel who have final authority over your proved reserve estimates and whether your independent engineers report to management or your board of directors; c) Disclose whether you compensate any of your employees on a basis that considers your reported proved reserves. If so, discuss these arrangements. THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 15 SEC COMMENT LETTER Letter Dated: February, 2005 Topic: Conflict from Personal Financial Interests Question: Does any employee, director or future employees or directors of [the company] have an overriding royalty, net profits interest, working interest or other personal financial interest in any of the properties that [the company] has an interest in? If so, this should be disclosed as a potential conflict of interest. You should also disclose the percent interest and how much each person was compensated for these interests in the last three years. THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 16 SEC COMMENT LETTER Letter Dated: May, 2006 Topic: Request to Debook Reserves Question: These volumes should be delegated to an unproved reserve category and not included in future SEC filings until such time that production history supports their inclusion as proved. THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 17 Reserve Writedown Red Flags Reserve bookings in conflict with estimates by other companies for the same property Restatement of reserves by other companies in the same property New discoveries in frontier areas High percentage or increasing percentage of PUDs over time No progress in developing PUDs PUDs more than one offset location away Track record of annual negative reserve revisions Bonuses directly or indirectly linked to reserve additions Lack of independent internal or external reserve reviews THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 18 SEC COMMENT LETTER Letter Dated: November, 2005 Topic: Examination of Major Reserve Revisions Question: Suplementally, submit to us: a) Narratives and engineering exhibits (e.g. performance plots, maps, volumetric calculations) for your three largest 2004 reserve revisions- both negative and positive-caused by performance, not economics; Please include data used to justify both the 12/31/2003 and 12/31/2004 volumes. b) Narratives and engineering exhibits for your three largest 2004 reserve extensions or discoveries. THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 19 SEC COMMENT LETTER Letter Dated: November, 2004 Topic: One Offset Locations Question: Rule 4-10(a)(4) of Regulation S-X provides that proved undeveloped oil and gas reserves may be attributed to locations not directly offsetting productive units only where it can be demonstrated with certainty that there is continuity of production from the existing productive formation (emphasis added). Supplementally, submit to us the engineering and geological justification for any PUD reserves you have claimed which are not in legal, technically justified locations offsetting (adjacent to) productive wells. Otherwise, either affirm to us that none of your claimed PUD reserves are attributed to such locations or delete such volumes from your disclosed proved reserves. THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 20 SEC COMMENT LETTER Letter Dated: November, 2004 Topic: Undrilled Fault Blocks & Below LKH Question: Supplementally, tell us the estimated hydrocarbon volumes, if any, you have claimed as proved reserves: a) In undrilled fault blocks; b) Below the lowest know-penetrated and assessed-structural occurrence of hydrocarbons as indicated by well logs. THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 21 SEC COMMENT LETTER Letter Dated: November, 2006 Topic: Examination of Pre/Post PUD Reserves Question: Suplementally, submit to us: a) Hindsight analysis of the amalgamated reserve estimates for all your PUD locations booked at year-end 2004 that were drilled in Include brief narratives reconciling the five largest PUD reserve estimates in this group to their current estimates. Provide all supporting maps, geological, and engineering data used to justify the pre-drilling and post drilling results. b) Address your corporate methodology for eliminating any significant sources of error here, e.g. PUD reserve estimates by analogy with recovery estimates that have a high degree of uncertainty such as recently completed wells. You may contact us for assistance in this or any other matter. THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 22 Failure to Update Volumetric Estimates with Performance Data Commonly found errors: Not revising the reserves expectations for undeveloped locations based on performance data of producing wells Not accounting for unexpected increase in water or gas production Not accounting for effects of pressure depletion on behind-pipe and infill locations over time THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 23 SEC COMMENT LETTER Letter Dated: March, 2003 Topic: MDT as Basis of Proved Downdip Limit (1) Question: Although it is possible to calculate a water contact using pressure gradient data, we feel that increasing your reserves by 35% in a given reservoir by this method is not the intent or spirit of the SEC rules for proved reserves. The rules state that you should limit proved reserves to the lowest known hydrocarbon from a well penetration. We will usually not object if there is an immaterial amount of reserves for that reservoir added by this method with compelling data. However, the problem with using this technique for a material amount of reserves is that, although you may be able to calculate the contact itself, you can only assume the value of such important factors as saturations, permeability, porosity, net thickness, etc. We feel the intent and spirit of the rules are to have penetrated the rock and acquired all the information that makes up a conclusive formation test as required for the attribution of proved reserves for those depths. THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 24 SEC COMMENT LETTER Letter Dated: April, 2005 Topic: MDT as Basis of Proved Downdip Limit (2) Question: Regarding your response number . to your letter ., we do not agree that reserves below the lowest known hydrocarbon (LKH) represent proved reserves. Although you may have collected sufficient data above the LKH to meet the requirement of a conclusive formation test in the high quality sands of the Gulf of Mexico, the requirement cannot be met in that portion of the reservoir that has yet to be drilled into. Much more information is required than just being able to estimate the location of the contact through pressure gradients. It is not the intent or spirit of the rule to include such large volumes below the LKH as you have done. Please provide to us supplementally the amount of reserves for each field that are below the LKH. THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 25 SEC Hot Button Topics TECHNICAL ISSUES VALIDATION OF PROVED UNDEVELOPED LOCATIONS (PUDS) DETERMINATION OF DOWNDIP LIMITS/LKH APPLICATION OF SEISMIC INTERPRETATIONS RECOVERY FACTORS APPLICATION OF RESERVOIR SIMULATION WITHOUT GOOD HISTORY MATCH FLOW TESTING/DATA COMPRISING A CONCLUSIVE FORMATION TEST COMMERCIAL ISSUES SEC YEAR-END PRICING COSTS-CAPEX AND OPEX NON-HYDROCARBON REVENUES FINANCIAL COMMITMENT TO DEVELOP/PROJECT STAGNATION PROJECT SANCTIONING COMMERCIALITY-LACK OF MARKET BOOKINGS UNDER PSCS THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 26 SEC COMMENT LETTER Letter Dated: November, 2005 Topic: Appropriate Capital Expenditures Question: Prepare a list of the PUD locations booked as of 12/31/2003 that were actually drilled during Include the pre-drill and actual drilling cost for each well. Explain any variances over 1%. YES, IT SAYS 1% THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 27 Incorrect Use of Operating Costs Operating costs determine economic limits Typical errors: Forecasted costs lower than historical costs Recurring well/facility costs assumed to be one time events Simplified assumption of per unit cost ($/bbl oil or $/Mscf gas) without the proper treatment of fixed cost or costs of secondary products Failure to adjust costs to operational changes (e.g. recovery mechanism) THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 28 SEC Commercial Issues Revenue from Sale on Non-Hydrocarbons SEC Prohibits All Non-Hydrocarbon Reserves or Revenue (including Sulfur, CO 2, and Helium) 3-5% non-hydrocarbon gas considered immaterial if the pipeline accepts Third party processing revenue excluded Cannot use processing income to offset or reduce operating costs THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 29 SEC COMMENT LETTER Letter Dated: November, 2006 Topic: 10-K for December 31, 2005 Question: Supplementally, submit to us the petroleum engineering reports-in hard copy and electronic spreadsheet format-you used as the basis for your 2005 proved reserve disclosures. The reports should include: a) One-line recaps for each property sorted by field and by present worth within each proved reserve category including the estimated date of first production for your proved undeveloped properties; b) Total company summary income forecast schedules for each proved reserve category with proved developed segregated into producing and non-producing properties. Reconcile the estimated production costs-both unit and annual-in your report with the production cost figures reported in your Form 10-K; THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 30 SEC COMMENT LETTER Letter Dated: February, 2006 Topic: Request for Technical Data Used Question: In the . discovery please tell us the depositional environment and lithology of the producing reservoir. What is the areal extent of the proved area? What is the approximate depth of the reservoir? How many separate reservoirs are included? What is the average net pay, porosity, oil and water saturations, permeability, initial GOR, oil gravity, formation volume factor, reservoir pressure, location of gas-oil and oil- water contacts? How were these determined? What is the original oil in-place in the proved areas and what recovery factor are you using for proved reserves and how was it determined? How many wells have been drilled and how many producers will be needed to develop the reservoir? Will you have any injection wells? If so, how many and what rates of injection will be used? Please provide us with a structure map of the producing reservoir showing the existing wells and the location of the future wells, if any. Indicate which wells, if any, will be injection wells. Also outline the proved area on the map. Provide a well log of the producing zone indicating the areas of net pay. THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 31 Build A Compelling Case Supporting Your Booked Reserves Know What Data Is Required Under The Guidelines To Support Your Case Integrate Rules and Data For A Compelling Case To Support Your Booking Know What Guidelines Within The Definitions Apply To Your Case DOCUMENT YOUR ASSUMPTIONS THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 32 Public Disclosure of SEC Comment Letters These letters and all responses are now available on the SEC website. THE SEC PERSPECTIVE-AVOIDING RESERVES WRITEDOWNS 33 The SEC Perspective Avoiding Reserve Writedowns REE Reservoir Engineer QUESTIONS?