Petroleum Reserves & The Needs of Financial Reporting October 2003 Petroleum Reserves & The Needs of Financial Reporting Michael Lynch-Bell Partner in Charge Energy, Chemicals & Utilities, Transaction Advisory Services Ernst & Young LLP +44 20 7951 3064 mlynchbell@uk.ey.com

Background There is no consistency in Financial Reporting There are several approaches US UK International Accounting Standards and many others The International Community would like one standard approach

Major Initiative In Progress To adopt International Financial Reporting Standards (IRFS) for all listed companies by 2005 In European Union South Africa Australia

Oil and Gas Accounting Accounting standards for Oil & Gas companies even more confused Specific standards in only a few countries: UK, US, Australia, Canada, Nigeria, Indonesia Often scoped out or exemptions under existing UK and International Accounting Standards And then, two inconsistent approaches: - Full cost - Successful efforts

Oil and Gas Accounting Accounting is historic cost-based (in the main) Under any of the approaches, accounts do not reflect the value of the underlying reserves and resources Balance sheet value based on any or all of: - Historic cost of exploration and development - Historic cost of licence acquisition - Fair value at the time of acquisition of exploration and producing interests - Revaluation of oil and gas interests - Reassessment for impairment

Standard setters have attempted to bring consistency to oil and gas company accounts, started by the SEC

Schedule of Applicable SEC Rules Introduced 1977 Regulation S-X Article 4 210. 4-10 FASB Statements 19, 25, 69, 109, 144 SEC Financial Reporting Release SEC – Division of Corporation Finance, current issues

Basic Rules Basically Use proved reserves Year-end prices for estimates Disclose reserve quantities and standardised measure of value Extremely conservative approach

Clarification Guidance issued, which demonstrates how the SEC is thinking Reasonable Certainty Existing Economic and Operating Conditions What is not proved Continuity of production Probabalistic methods Web site disclosure

SEC Corporation Finance Division Current Issues In order to attribute proved reserves to legal locations adjacent to such a well (i.e. offsets), there must be conclusive, unambiguous technical data which supports reasonable certainty of production of those volumes.

SEC Corporation Finance Division Current Issues If an improved recovery technique which has not been verified by routine commercial use in the area is to be applied, the hydrocarbon volumes estimated to be recoverable cannot be classified as proved reserves unless the technique has been demonstrated to be technically and economically successful by a pilot project or installed program in that specific rock volume.

SEC Corporation Finance Division Current Issues This requires the use of physical pricing determined by the market on the last day of the (fiscal) year. A monthly average is not the price on the last day of the year, even though that may be the price received for production on the last day of the year.

UK Approach Proved plus probable reserves Management’s view on prices Reserve quantity disclosure

Measures of Performance Reserve replacement Reserve valuation Finding cost per unit Production cost per unit Reserve life Value replacement Reserve distribution Standardised measure of cash flow

Other Disclosures which depend on reserve definitions Amortisation Impairment Decommissioning provisions Standardised measure of cash flow Other performance measures

IASB IASB have established a group to develop a standard Unlikely to be a standard until 2007

Current IASB Thinking: Only a revised form of successful efforts will survive (no full cost) Want one definition for reserves and resources ie commercially recoverable reserves Would like it to be the same as (consistent with) mining definitions Value-based accounts unlikely Value-based disclosures very likely Agree that the use of year-end prices for estimates could be misleading (but this is not the SEC view)

Where do we need to get to? Any reserve definition to be useful for financial reporting must reflect the following Commerciality of reserves Likely future prices to be received for the reserves produced: Forward sales contract Hedging Management view Forum curve Timing of production Cost of production Use of technology, existing and likely future

Most Sensitive Issues Less Sensitive Issues Views on future prices Views on availability of technology We need help in demonstrating that any approach is not aggressive Less Sensitive Issues Cost of production Timing of production Geology

Conclusion Output of what you are doing is very important to financial reporting BUT SEC concerned about using any definition other than proved IASB has not got extractive industries very high on the agenda, and reserve definitions even lower down the priority list, however by 2005 they will be looking for an answer

You have the time to influence the international accounting debate

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