Weak auditors and auditing requirements could enable reserves reporting fraud

by Carly Fabian, Research Associate
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Weak auditors and auditing requirements could enable reserves reporting fraud

As oil and gas companies face new climate regulations and declining prices, how they categorize oil and gas reserves will be crucial for evaluating how they are dealing with the energy transition. Carbon Tracker has warned that the industry faces the potential for trillions in stranded assets, but knowing when assets have become stranded will require accurate reserves reporting.

For publicly traded oil and gas companies, proved reserves are the company’s most important asset, but the imprecise nature of the measurement has made reserves valuations ripe for manipulation. In a company with weak internal controls, executives under pressure to meet unrealistic expectations could manipulate the process to hide negative developments. By failing to account for new data, new taxes or declining prices, companies could delay revealing the extent of their financial challenges.

To ensure that reporting is accurate, the financial system relies on auditors to review financial statements, as well as to assess a company’s internal controls. However, the auditing industry as a whole faces serious weaknesses, even when auditing typical companies. Market concentration and conflicts of interest in the auditing industry have led to a series of major auditing scandals, and recent evidence suggests that auditing services may be far less reliable than major firms claim, while companies face few consequences for bad behavior.

A weak auditing system could allow internal control problems to snowball into large-scale reserves fraud. In 2004, Shell surprised investors by announcing that the company would need to reduce its reserves by one-fifth. To perform internal audits for the company’s global reserves, Shell had been relying on just a single part-time, undertrained former engineer, who reported to the division he audited. According to a subsequent class action complaint, both of Shell’s auditors during this period, PricewaterhouseCoopers and KPMG, received multiple memoranda detailing these “potentially serious systemic issues with Shell’s reserves reporting,” but both auditors continued to issue clean audit opinions.

Auditing firms also have even less capacity to accurately review oil and gas company statements compared to other companies due to the dependence of these financial statements on reserves valuations. The technical and complex nature of reserve estimates makes it difficult for auditors inexperienced in reservoir engineering to properly evaluate the accuracy of company reports. Auditing firms can compound this problem by assigning young, inexperienced, or overworked employees to staff oil and gas company audits – employees who are unlikely to challenge the client’s reserve estimates.

The industry’s track record suggests that auditing firms may not be able to catch even the most egregious exaggerations. In 2017, auditing company KPMG paid the Securities and Exchange Commission (SEC) USD$6.2 million to settle allegations that it failed to notice that Miller Energy invented more than USD$400 million dollars in nonexistent oil and gas assets, allowing the penny stock company to transform itself into an exchange-listed energy company. According to the SEC order, KPMG had staffed the audit with undertrained employees who had no prior experience auditing oil and gas companies.

After the reserve overbooking scandals at Shell in 2004, as well as subsequent scandals at El Paso and Repsol YPF, concerned investors called for the SEC to require independent reserve engineers to review reserves in addition to traditional auditors. While many companies hire independent reserve engineers to assist with auditing reserves in some capacity, oil and gas companies have aggressively resisted an SEC requirement to hire them. Hiring independent reserve engineers remains optional, allowing companies to determine how and to what degree third parties are involved, as well as what information they have access to. A system that relies on two weak auditors, one of them optional, could easily create gaps for companies to manipulate.

In some cases where external auditors failed to raise the alarm, whistleblowers succeeded. El Paso’s reserves scandal was initially revealed in the Houston Business Journal by a concerned engineer. In 2016, Anadarko engineer Leah Frye filed a complaint with the SEC alleging that Anadarko Petroleum had misled investors about an oil field the company claimed was worth $4 billion but was later written off as worthless. With weak oversight of reserve reporting, whistleblowers could play an essential role in identifying companies that manipulate reserves reporting.

To encourage those with inside information to step forward, the Dodd-Frank SEC Whistleblower program allows whistleblowers, including both individuals employed at oil and gas companies and at external auditing companies, to confidentially report companies who are violating U.S. federal securities laws. Whistleblowers who provide original information that leads to successful SEC prosecution can receive between 10% and 30% of monetary sanctions. As climate risks grow, pressure on an already weak system could allow fraud to go undetected, but insiders could use this powerful whistleblower program to help detect and prosecute fraud that threatens the economy and the climate.

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