Field Notes Can Engineering Reports be Trusted?

Field Notes
Can Engineering Reports be Trusted?
by Arthur Milne

Engineering reports relating to oil and gas reserves of public companies are among the most crucial documents individual and institutional equity investors must evaluate.

Such information must be forthcoming in the markets, for without it decisions whether to acquire, hold or sell petroleum stocks would be made in the dark. That said, it is equally clear that reserves information is inherently risky in nature, and that neither the engineering firm that furnishes such information nor the securities issuer that retains them should face a negligence suit merely because the reality did not live up to the estimate. One analyst listed nine factors which might cause reserve estimates to fall short of realized values, despite the best efforts of engineering firm and issuer.

By the same token, the management of issuers have and will continue to have under any planned set of rules a strong incentive to pressure engineering firms to overstate the issuer's reserves. Presently, disclosure of engineering report information to the public markets is regulated by National Policy 2B. NP 2B applies across Canada. The main thrust of 2B, as well as its homologue with respect to mining, 2A, is to place technical information for publicly disclosed files before the investing public. In 1998, in response to a perception that 2B was deficient in a number of technical and conceptual respects, the Alberta Securities Commission (ASE) initiated and chaired a blue-ribbon panel of market participants to consider the issue of how to put public disclosure of this information on a more secure footing.

Meanwhile, while the committee's deliberations were already under way, in March 1999 Big Bear Energy acquired Blue Range Resources. Big Bear relied on information provided by Blue Range as to Blue Range's reserves. Big Bear's own analysis of Blue Range's reserves after the deal had been consummated disclosed that Blue Range's reserves were seriously overstated. There was no breach of 2B by Blue Range. Clearly this represented a challenge to the committee to get the new 2B right.

Acting with commendable speed and skill, the committee in December 1999 released for public discussion new draft standards for reservoir engineering standards. The committee called for uniform accounting standards (full cost or US FAS 69) and technical definitions of terms such as proven and probable reserves relied upon in 2B reports were tightened up. Issuers are also required to reconcile past statements of estimated reserves with present knowledge, so that past evaluations' accuracy or lack of it is made explicit to the investing public.

Formerly, issuers could rely on any engineering firm they wanted to make the reserves estimate. The new rules will apply to all continuous disclosure documents which put forward information of a 2B nature. From now on, if the draft rules hold true, issuers will be required to rely on an "independent" engineering firm. Presumably, a firm that does a major share of its total volume of business with that issuer cannot be construed as "independent."

This is conjoined with a change in corporate governance, once again with the end in view of increasing public disclosure. Under the draft rules, the "independent" engineering firm will make a representation as prescribed by the new rules, to the Board of Directors or a subcommittee of the Board for acceptance by the board and transmittal to the regulatory authority. It is these new provisions respecting procurement of an independent engineering firm and the new corporate governance provisions that will have the deepest impact on institutional investors and their nominee directors.

Under National Policy 2B, issuers-normally small or medium-sized issuers-can exploit the market weakness of engineering firms by shopping around for the most sanguine and flexible engineering company, and having found one, work hand in glove with the engineering firm to produce the most pliant report. As the industry is presently structured, only a handful of engineering firms will fulfil the committee's requirement of "independent." It is reasonable to expect that once the new rules are in place, some engineering firms will step up to the "independent" plate and others will drop from the scene.

Independence and directors' liability for adopting engineering reports will also have a significant impact on large issuers. The system that has evolved for large issuers under National Policy 2B is that the large issuer maintains a sizable complement of reservoir engineers on staff who report to management. The in-house engineers review two-thirds of their reserves in a given year, while outside engineers (which would count as independent under the proposed rules) review the other one-third. Thus a complete rollover is achieved in a three-year cycle. This process is obviously subject to pressuring of the engineers by management to bump up or bump down reservoir estimates to mitigate the effect of large writedowns.

The "independent" requirement will cut a wide swath across these practices. Taken literally, "independent" engineers, from the time the new rules are implemented forward, will review all reserves and report on their finding to the Board of Directors.

Large issuers defend their current practices on the grounds that their reserves estimating practices are inherently conservative, point to the inherently greater professionalism of their engineers, and observe that the system that evolved under the present 2B has served the industry well. Such issuers think there is no need to impose new costs on established market participants. Accordingly, the large issuers have lodged an appeal to the Committee to stay the new policy as far as their interests are concerned. What about the status of the Blue Range Resources transaction under the proposed new rules?

It is clear that the new rules by themselves would not prevent a recurrence of the Blue Range situation. What would happen is that the Blue Range board of directors would have had to consider whether the reservoir consultant was "independent," and if it accepted their report would find itself on the hook for a willful misrepresentation.

The new rules that the ASC-led committee is moving towards place a premium on inducing institutional investors to nominate as directors individuals who are directly knowledgeable of reservoir engineering evaluation, or at the very least are able to pose probing questions about these matters, as the relationship between engineering firms and issuers becomes more arm's length, and management's role is attenuated.

It is apparent that the replacement for National Policy 2B rules will have a beneficial effect on standards of reserves reporting among Canadian issuers.

Arthur Milne, BA, LLB, is a securities Lawyer in Calgary, Alberta

Transcontinental Media G.P.