Zee Beam News

Nov. 12, 2007 - Kommersant by Natalia Skorlygina
// James Pearson, head of Miller and Lents talks about the auditor's life in Russia
Recent problems with audits of oil and gas reserves have attracted attention not only in the oil industry, but among government officials as well. Miller and Lents chairman James Pearson tells Kommersant about fine points of an independent auditor's work, about recent changes in their classifications and the possibility of deceiving the auditor.
What are Miller and Lents' plans in Russia?
Mainly to continue making independent evaluations of oil and gas reserves. We do not plan to open an office for now. We want to remain a Western firm and to do all the work in Houston. But we established the Neftegazkonsalt company in Russia comparatively recently, and it will help us with its Russian experience and will make evaluations under the new Russian classifications that should come into force on January 1, 2009.
Why was it necessary to set up a new company?
In the new Russian classifications, and in the new classifications of the Society of Petroleum Engineers, there is a “resources” category that is especially complex to evaluate. Experience is needed working in the field in the region. Miller and Lents wanted to make sure it had access to that experience and to the data that we needed for those evaluations and to make use of the assistance of Russian engineers and geologists.
What is the difference between the methods for evaluating reserves used by Miller and Lents and DeGolyer & MacNaughton?
I can't tell you. Professional ethics prevent me from publicly discussing the evaluation methods of another auditing company. About ten years ago, I talked with Fred Grote, chairman of the board of D&M, and he said then that the company would not do audits of reserves, but only evaluations, but I don't know what became of that. We never compared who evaluates reserves more strictly, us or them. Competition between auditors is not that open. We do not do PR, we do almost no advertising, but we have been operating for 60 years and we always have orders.
What is the difference auditing and evaluating reserves?
They are two different kinds of work. An audit is when the client presents its evaluation of its reserves at every deposit and at every collector and input data that the evaluation is based on. The auditor checks the quality of the data and observes the evaluation procedures and writes a report about whether or not he considers the evaluation well-founded. As a rule, a evaluation made by a client of his own reserves is considered correct when it differs from the conclusions of Miller and Lents itself on the basis of analyses of the input data by no more than 10 percent. Otherwise, the auditor writes that the evaluation is incorrect and explains why. The evaluation is when the auditor independently estimates the reserves on the basis of data provided by the client.
Do Russian companies order audits or evaluations more often?
Mainly evaluations. But large companies sometimes order audits as well. We note that large international companies, like Chevron, ExxonMobil and Shell, evaluate their own reserves without turning to an independent auditor, and they have been doing it for 50 or 60 years. Depreciation of reserves happens very rarely. In the 1980s, Texaco reduced its evaluation of its gas reserves by 25 percent. The market trusts the evaluations of large international companies. But that is not so in the case of small, independent companies and, so far, that is not so in the case of Russian companies, because the West does not know them well enough. It will happen in time: they will do their own evaluations and the investors will trust them. But small companies will always need independent audits – they will always need investors, money and they will try to enter the stock market.
Oleg Mitvol, the deputy director of the Rosprirodnadzor, claimed that the evaluation of companies' reserves made by independent auditors is inadequate because the auditors make their conclusions based on data provided by the producer without checking them. Is it possible to deceive the auditor?
Yes. And Oleg Mitvol raised a really serious question. Companies like Miller and Lents work with base data provided by the client. The client comes to us and says, I want you to evaluate this deposit or that share in a project. Here is the production history, the geological maps, well log data – everything we need to know about the deposit. We do not check that information. It happens that companies provide us with false data. There are certain means against that, but not many. Oleg Mitvol is right about that. For instance, a company that owns a deposit in Western Siberia comes to Miller and Lents and gives us its data. And we know which of them have some relation to reality and which of them don't. We know how much it costs to drill a well in that region, what are the typical operating costs, what is the tax procedure. If the operator writes that he can drill a well for $100,000, we won't consider it. Whenever anything falls outside the norm, we will not accept the data. If the client has provided a falsified map or a map of a nonexistent deposit, or given false well diagrams or test well results, we try to check it.
And of they simply give you a map of someone else's deposit?
That is entirely possible to do. In general, we proceed a priori from the assumption that the asset put up for evaluation belongs to the client. At an early stage of our work in Russia, a problem of that kind arose. In 1996-1997, we evaluated the reserves of one of the large Russian companies in all its deposits. Then another large company came to us and we found deposits among its assets that we had evaluated for the former company. We showed this to them and refused to make a conclusion, but the second client said that we made a mistake with the first. I answered that, if we take those assets into account, we have to note separately that they had already been reflected in another evaluation by us. That problem was solved through the efforts of the companies themselves. But in several cases, we cannot track even that. There is a special cause in our evaluations saying that the data that were the bases of the conclusion we have made were received from the client and we did not confirm their authenticity. That is not within the sphere of our competency. Miller and Lents is a company of engineers and geologists who evaluate the technical and economic side of a project. We are not investigators or lawyers and we cannot determine whether an asset belongs to out client or not. In a word, if a corporation decides to provide us with false data, we cannot always catch it. But so far, that hasn't happened.
I would say that a more serious risk is that of the dishonesty of the auditor itself. I have seen the largest oil and gas industry – one more solid than Miller and Lents, D&M, Ryder Scott – lose everything because they took money, huge money, to make a false report. And it got out. Now that company no longer exists. Yes, they have fired us more than all the others combined, but everybody knows that our reports are not fabricated and are independent from the client. I've seen many bad reports by engineers and they main occurred because the client tried to pressure them or even blackmail them with the threat of not paying. That is a real danger.
Have Russian companies tried to pressure you?
I wouldn't say pressure. Companies often dispute our evaluations of their reserves, but we are ready for that. Sometimes their arguments are well-grounded, sometimes they provide us with additional data and we change our position, because we are interested in giving the most accurate evaluation. And to do that, you have to work with the client, because he knows his assets better than we do. Two very large Russian companies refused our services because they disagreed with our evaluation of their reserves and we refused to change it. In one case, they considered our evaluation too high and, in the other, too low. In the end, they proved to be true, because proof was eventually found that their reserves were higher. But, in the case when the client thought we had made a too high evaluation, he hired another auditor, who gave him an even higher evaluation.
You said that companies that try to deceive you can be caught. How?
In the 30 years that I have been working, we have been absolutely sure several times that our client gave us false information and we refused the order. Sometimes they gave us counterfeit well logs, but the counterfeits were overly ridiculous – people just took data from another well, which is easy enough to catch. But that hasn't happened in Russia. The thing is that one of the documents that we always ask for is the statistical account of the hydrocarbon raw materials balance. Sometimes there wasn't one that we could get the exact information we needed from. From the beginning, there was a very high-quality internal control method in Russia through the State Reserves Commission, better than in the United States, since in the U.S. there is no special agency that controls the reserves accounting of all companies.
What data do you ask your clients for?
It's a rather long list, which sometimes causes problems. It seems to the client that we ask for too much. There are geological maps, well log data for every well, isopach maps, development maps, results from test wells. There are electric log diagrams for individual wells, with which we check whether or not the electric log diagrams show the right oil net pay. And, finally, the statistical account of the hydrocarbon raw materials balance. We also ask for a lot of economic information. We give the client a form to fill out. It's information on the price of oil for calculating transport costs and export duties, operational expenses, capital expenditures for drilling and the creation of infrastructure. And the main thing is the client's plans. We evaluate the deposit based on them.
What do you think about the new Russian classification of reserves? You participated in their development to some extent.
I read the classification and wrote to [chief auditor of the development group for the new classification Grigory] Gabrielyants with my views, and I think that he included some of them, but I did not play a large role. I consider it a huge step forward. The State Reserves Commission understood the importance of economics and decided to bring Russian standards into line with world practices and brought them closer to the classifications of the Society of Petroleum Engineers, London Stock Exchange and U.S. Securities and Exchange Commission. The current classification is more geological and answers the question of how much can be produced technically. But the new classification says how much is economically expedient to produce. Under the new classification, you can't call anything a reserve if it is noncommercial. That is called conditional resources. Even though the old A, B, C1 and C2 categories remain, they are closer to what we have. That is, A is closer to what we call drilled proven developed reserves, B to drilled proven undeveloped reserves, C1 to proven undeveloped, C2 to likely or possible reserves. It seems to me that the Western community will now receive the Russian reserves classification with greater enthusiasm than before, because it will be more understandable.
What does Russia need a classification similar to that if the SOE when there is the SPE classification?
I have already been asked that. Honestly, I don't know. Maybe Russia needs its own classification. What I do know is that the new classification is closer to what is accepted in the world.
What changes were made in the SPE standards in March?
I was on the commission for their development. The main reason for the changes in the classification was the need to expand their scope. The classification had been limited only to reserves, but a significant part of the value of a company was not reflected. For example, its assets in geological exploration. The new classification includes not only reserves, but also conditional resources – those reserves that will become commercial, for instance, when the price of oil rises or new technologies are developed – and perspective resources – assets in geological exploration. Here a problem may arise with the practical implementation of the classification. I know very well that no two geologists will evaluate perspective resources the same. They will not agree on the questions of risk evaluation and potential. The problem is not in the classification or the idea – it is an excellent idea – but in its practical embodiment.
Gazprom has asked foreign companies onto the Shtokman deposit as contractors but those companies have said repeatedly that they will be able to place part of the Shtokman reserves on their own balances. Is that possible?
It's possible. Everything depends on the agreement between partners. If it says in it that the partners will be said for their services but Gazprom will remain the owner of the reserves, the partner will not be able to place them on its balance. But if it is said, as it is in some product-sharing agreements, that the partner will be paid from a share of net profit in barrels necessary to cover the investment, the partner may be allowed to place a share of the reserves on its balance. Everything depends on the text of the agreement. Even in old production regions, such as the U.S., disagreement arises about who owns the reserves, because of payment for the investor's services through a share in the net profit. It happened not long ago. The operator said, I am making all the decisions, I am managing the deposit, I bear all expenses and pay only a share in my net profit, when it accrues, as interest in a loan. So all the reserves are mine. But the SEC said no. Those who have a share in the net profit have the right to calculate how many barrels of oil they can receive from it and place those reserves on their balance. At Shtokman, I am sure, it is a question of whom the reserves belong to and how the Western partners will be paid for their participation, and it will be prescribed with crystal clarity. And the conditions of the contract will determine the presence of absence of that possibility.