Management Trends

Implications of Sarbanes- Oxley for energy companies

Volatile commodity prices, demise of merchant function and onslaught of new regulations: Conditions for the perfect storm?

 Alexandra Pruner, Gulf Publishing Company

 Despite a recent, slight uptick in the rig count that could portend supply relief for a tight fuels market, all indications are that commodity prices for natural gas and oil will remain volatile for the foreseeable future. Equity Analyst Tom Driscoll of Lehman Brothers foresees a decrease in demand for natural gas to bring the market into alignment, Table 1. With an uncertain outlook as to whether demand will decrease to match supply, or supply will increase to match demand, volatile prices are a virtual certainty.

 Traditionally, producing companies have had a robust secondary market to help hedge and monetize their natural gas supplies. The collapse of Enron, however, began a death march of other integrated companies’ merchant functions. Today, producing companies are taking on new risks when selecting counterparties for marketing energy commodities. According to Steve McAleavy, Director of the Energy Division of Search Consultants International, Inc., the role of the risk manager within an energy company is more crucial than ever. “Risk analytics in an illiquid environment is very different from a situation of substantial liquidity. Individuals with strong quantitative, modeling and analytic capabilities are in demand,” noted McAleavy. The credit cost of dealing with unknown counterparties goes beyond the bottom line of a financial statement and extends into the Board Room for companies operating in the US, thanks to a recent slate of regulations mandated under the Sarbanes-Oxley Act of 2002.

 Signed into law on July 30, the Act is designed to help restore public confidence in the markets by strengthening audit controls, disclosure requirements, board-level standards and oversight of outside auditors. At last count, the Sarbanes-Oxley Act of 2002 has generated 10 new regulations, with an additional four proposed by the Securities Exchange Commission (SEC) for public comment. These regulations are compounded by related rules mandated by the securities exchanges. 

 The increased risks of working with unknown counterparties with heightened penalties envisioned under Sarbanes-Oxley are creating what could be considered “the perfect storm” in the realm of energy risk management. Sarbanes-Oxley includes enhanced penalties for violations, including longer prison terms and forfeiture of executives’ income. 

 Section 302 of the Act places the onus of accurate reporting squarely on the shoulders of CEOs and CFOs. When the regulations went into effect for reporting periods after August 29, 2002, public companies issued a string of announcements, affirming their executives’ planned certifications. The regulations go deeper, and also require top executives to vouch for their internal information collection, verification and reporting controls. Although all industry segments are responsible for certification of these internal reporting controls, the issue could be particularly vexing for energy companies dealing with the new challenge of having to identify, assess, quantify and then disclose credit-costs associated with risk management and energy marketing efforts. Energy companies are rapidly embarking upon enterprise risk management efforts to establish systems for controls and disclosures. 

 According to a recent report by KPMG LLP entitled, “Sarbanes-Oxley: A Closer Look,” failure to maintain adequate disclosure controls and procedures, review them, and otherwise comply with the certification rules could be subject to SEC actions even if the failure did not lead to flawed disclosure. In other words, energy executives are vulnerable to penalties associated with the process and not merely the outcome. 

 The industry-wide imposition of new laws and regulations, which were implemented in response to failures in the energy patch, will have broad implications for energy-related companies.