Troubled natural gas producer and pipeline operator El Paso (NYSE:EP) is the latest to announce now-you-see-them, now-you-don't proved reserves. But it's the magnitude in this case that is shocking: Proved reserves were revised down 35% from 2002 year-end levels. The latest estimates will last 6.2 years at 2003 production rates, but let's face it, that is a gigantic revision.

Overlooking for a moment the very serious "mistakes" that precipitate such things, revisions of proven reserves are bad news. When reserves dip below production levels, a company slowly eats up its inventory -- and its future. Lowered proven reserves can also lead to cash flow issues, as companies spend to get reserves into the proved (i.e., ready for production) category.

El Paso's heart of darkness
By way of assurance, El Paso offers this with it latest earnings: "Ryder Scott [petroleum consultants] cited a difference of less than two percent with the company's internal reserve analysis, which it deemed as insignificant." In plain English, "The reserves now reported as proven are there, and the auditor agrees."

That makes the revisions sound like a non-event. That is, until you read that the company is taking a $1 billion "pre-tax ceiling test charge" in the fourth quarter. In other words, this does matter, even if it results in a non-cash charge. The charge would have been $1.5 billion more had natural gas prices been $5 per million British thermal units (MBtu) instead of $6. With natural gas prices now around $5.40/MBtu, further charges might well be coming.

Moody's (NYSE:MCO) and Standard & Poor's apparently didn't like what they saw. Both credit-rating agencies cut El Paso's debt one grade -- and both maintain a "negative" outlook. At absolute minimum, this confirms that reserves do matter.

Reserves defined
SEC Rule 4-10 classifies reserves as either proved, proved developed, or proved undeveloped. Reserves are proved if "economic producibility is supported by either actual production or conclusive formation test." That sounds pretty cut and dried. How can 35% of a company's reserves fall out of this category?

Proved developed oil and gas reserves are "reserves that can be expected to be recovered through existing wells with existing equipment and operating methods." When El Paso's final overall reserves are posted, some of the formerly proved reserves will fall into this category.

Proved undeveloped oil and gas reserves are "reserves that are expected to be recovered from new wells on undrilled acreage, or from existing wells where a relatively major expenditure is required for recompletion." Reserves that no longer qualify as proved developed will fall into this category.

Just a game
The current El Paso CEO (who started in September) and the senior executive for exploration and production (started three weeks ago) are on record as to why the reserve changes needed to be made. Certain explanations appear reasonable enough. With no sales agreement in Brazil, production cannot start. Others appear technical: Production in coalbed methane is booked in 160-acre blocks, while production indicates it will take 80-acre blocks (which are not yet contracted for) to meet previous production estimates.

OK, this is not exactly three-card monte at work, but it isn't transparent, conservative corporate governance, either.

And as mentioned, El Paso is not alone in recording significant reductions in proved reserves. In January, Royal Dutch/Shell -- represented by two trading stocks, Royal Dutch (NYSE:RD) and Shell Transport (NYSE:SC) -- cut its reported proven reserves of crude and natural gas by close to 3.9 billion barrels, correcting a reporting error it traces to 1996. That represented a 20% cut in proved reserves.

Forest Oil (NYSE:FST) also recently reported reserve reductions. At year-end, 25% of its reserves were reclassified from proved to proved undeveloped -- again, the lowest SEC-defined classification. The company cancelled its earnings release to provide time to evaluate the effect on its financial statements.

Nexen (NYSE:NXY), Canada's fourth-largest oil explorer and producer, reduced its reserves by 8%. With Canadian regulators tightening reporting standards, other Canadian producers are expected to report downward revisions -- but likely not so high as Nexen's.

Why so many adjustments?
The passage of Sarbanes-Oxley in 2002 set new standards for financial reporting. The law provides the SEC with the legal power to make company executives think twice before reporting anything but the facts. So far, the response to errors, even if they do not have a meaningful financial impact, has been to engage outside council to investigate why reserves were booked incorrectly, as Royal Dutch/Shell and El Paso have done.

If nothing else, Sarbanes-Oxley got executives to pay attention to reported estimates and results. For shareholders, that is good news, but it does raise the question of why the widely tracked reserve numbers were not handled more carefully in the past. Clearly, there are corporate governance issues involved, though you'd not know it by the actions of companies like Royal Dutch/Shell. The company tweaked its procedures, but, so far, its CEO hasn't paid any price beyond embarrassment.

This is important
When reserves are shuffled among categories, it might seem like small change. After all, oil is oil. Nothing's lost, just reclassified. But anyone who has been through a military draft or driven a big rig knows that classification can be everything. Classifications exist for a reason. In this case, proved reserves are the only reserves assured to be available for production.

Clearly, some companies (and some countries) have not been diligent about classifying oil and gas reserves. Others, like ChevronTexaco (NYSE:CVX), have gone out of their way to make it clear they have conservatively booked reserves. With Sarbanes-Oxley the law of the land, it looks like Chevron's methods will become the norm.

For investors, the bad news about reclassification is in the marketplace. For a company like Royal Dutch/Shell, the result is mostly a damaged reputation. The financial impact is negligible, the company has clearly identified its upcoming changes, and the stock will probably trade at a discounted price-to-earnings multiple until the company shows it is back on track.

Canadian companies like Nexen are expected to make adjustments to higher standards this year. The fallout will be minimal if the proved reserve reductions remain minimal.

End game
All that being said, for a company like El Paso, the impact of the latest revisions and accompanying publicity can be lasting. As longtime Fool Bill Mann points out:

The company exhibits three of the riskiest characteristics in investing: It's in a recovery, following spectacularly bad decisions that nearly tanked the company; it's weighed down by enormous amounts of debt, which it's obligated to service; and it requires additional financing for ongoing projects it needs to work its way out.

That is not a pretty picture. And speaking of pictures, El Paso's executives paint this one for 2006: earnings of $1 a share and net debt of $15 billion. Tempting as that buck in earnings may be, it's painted by an executive team that just joined the company. Do you really think these guys can see 2006 clearly or predict earnings with such clarity? If you do, the hydrocarbon shell game is for you.

Place your bets. But watch monte's hands. You want the shell with the $1 earnings.

Fool contributor W.D. Crotty owns stock in ChevronTexaco but none of the other companies mentioned. W.D. met monte in college and is richer for the experience. So is monte. The Motley Fool is investors writing for investors.