Fraudulent reserves reporting could hide stranded oil and gas assets

by Carly Fabian, Research Associate

Published on December 21, 2020

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Fraudulent reserves reporting could hide stranded oil and gas assets

As oil and gas companies face growing risks from climate change and the energy transition, unprepared oil and gas executives will face enormous pressure to prove that the industry still has a viable investment thesis. To delay climate consequences, the industry is already employing a number of deceptive strategies, including aggressive lobbying and deceptive advertising. While most of these strategies will undoubtedly be legal, some companies could embrace an “all of the above strategy” that includes not just legal deception but also financial fraud. To do so, executives under pressure could turn to “the problem that no one talks about”: reserves overbooking.

Reserves are the estimated quantities of oil or gas that a company can extract, and “proved” reserves are the quantities that a company reasonably believes it can recover given existing economic conditions, operating methods, and government regulations. For publicly traded oil and gas companies, proved reserves are the company’s most important asset, a crucial performance metric for investors, and an important factor for credit scores and financing.

Inherent uncertainties in measuring a substance so far underground, however, have made reserves reporting ripe for manipulation. Executives unwilling to admit mistakes or reveal weaknesses could take advantage of a weak oversight of reserves reporting.

To determine whether reserves qualify as “proved,” companies depend on engineering and technological data, as well as information such as the current price, the cost of extraction, and whether the company has contracts to sell it. In order to hide climate impacts, companies could manipulate reserves reporting by hiding new data showing that an area has less oil or gas than previously thought, fail to account for new carbon taxes, or make unrealistic predictions about prices or contracts.

While companies could not get away with this type of fraud indefinitely, they would not need to succeed for long; overstating reserves ahead of key points such as a major public debt offering or an acquisition could have a substantial impact. As the industry rapidly declines, these key pressure points will become increasingly consequential.

Overly aggressive booking practices (or overly conservative debooking practices) have snowballed into major financial scandals before. In the early 2000s, weak internal controls at Shell allowed the company to substantially overstate oil and gas reserves. After Shell shocked investors in 2004 by reducing its proved reserves by more than one-fifth, the company was forced to settle with regulators and investors for well over half a billion dollars. Similar scandals have also occurred at El Paso, Repsol YPF, and Stone Energy Corporation.

Recent allegations suggest growing pressure could be motivating this type of large-scale manipulation at major U.S. companies. An ongoing securities class action suit alleges that a major write-down by Exxon in 2017 resulted from the company’s failure to account for climate costs. According to the complaint, as the price of oil and gas declined in 2014, Exxon failed to adjust to declining prices and to account for carbon costs, such as a new Canadian carbon tax, and the company did not include a proxy cost for carbon in its impairment determinations for its reserve assets. The complaint alleges that Exxon artificially inflated its stock price and influenced rating agencies to issue strong ratings on Exxon’s $20 billion of outstanding debt, ahead of a $12 billion-dollar public debt offering.

Similar allegations have been raised regarding a major write-down at Anadarko Petroleum. According to a 2016 whistleblower complaint and a securities class action complaint, Anadarko inflated the value of its reserves by millions or even billions of dollars before it was purchased by Occidental Petroleum in 2019 for $38 billion, a delay that allowed executives to receive million dollar bonuses for the sale. Lea Frye, the former reservoir engineer who blew the whistle, alleges that executives rejected and hid internal drilling reports from engineers when reports showed that the Shenandoah field had far less oil than previously predicted.

As financial pressure grows, executives attempting to meet unrealistic expectations may take an overly optimistic or aggressive approach to debooking reserves. Management interference in engineering decisions could put otherwise ethical reserve engineers in the difficult position of choosing between pleasing their boss and enabling fraud.

Reservoir engineers and other employees willing to confidentially alert regulators could become crucial to protecting investors and the climate from fraudulent reserves reporting. Employees who find themselves in this situation can use the Dodd-Frank SEC Whistleblower to blow the whistle on companies for misleading investors through fraudulent reserves reporting. Oil and gas whistleblowers can keep their identities confidential and qualify for a significant financial reward.

Whistleblowers are the first line of defense against fraud and the single-most effective source of information about fraud. Whistleblowing reservoir engineers like the anonymous employee who sounded the alarm at El Paso and Lea Frye at Anadarko have already been instrumental in preventing this easily manipulated metric from hiding million or billion-dollar fraud. Through the Dodd-Frank SEC Whistleblower program, oil and gas employees willing to blow the whistle could play a crucial role in protecting investors, and the climate, from fraudulent reserves reporting, while protecting their own identity and qualifying for a reward.

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