What it means
Reserves are sorted by how certain they are. Proved reserves are those that engineers expect to recover with a high degree of confidence, while probable and possible reserves carry progressively more uncertainty.
Many investors focus on proved reserves because they are the most reliable base for lending and valuation. Reserve estimates depend on the oil price.
If the price falls, some oil that was profitable at a higher price can drop out of the reserves figure, and if the price rises, previously uneconomic oil can be added. This means reserves can change even if no oil is produced and nothing new is drilled.
Producers replace the oil they sell by discovering new fields, buying other companies' reserves, or revising their estimates as more data comes in. A common check is the reserve replacement ratio, which compares the reserves added in a year with the oil produced in that year.
A ratio below 100% means the company is shrinking its resource base. Another standard measure is the reserves-to-production ratio, which divides total reserves by annual output to show how many years the oil would last at the current rate.
A company with a very short life must keep investing heavily in exploration to stay in business. One with a very long life may have attractive assets but may also be tying up capital that is not producing yet.
Reserves are also reported in the financial statements and in separate disclosures. The rules for what counts differ between regulators, so numbers from two companies are not always directly comparable.
It is worth reading the notes to see which definitions each company has used.
In practice
Real-world examples.
Example
An investor compares two producers with similar share prices. One has 20 years of reserves and the other has 6 years, so the investor asks how the second plans to replace its oil. The answer shapes how much each company is worth.
Example
A bank reviewing a reserve-based loan lowers its oil price assumption by $10 a barrel. Part of the borrower's proved reserves no longer pass the economic test, so the borrowing limit falls. The company has to repay part of the loan.
Example
A mining and energy group announces a purchase of a small producer for $400 million. Most of the price is explained by the reserves acquired, which the buyer values per barrel and compares with the cost of finding the same oil itself.
Formula
Calculation
Reserves-to-production ratio (years) = proved reserves / annual production
Reserve replacement ratio = reserves added during the year / oil produced during the year
Suppose a company has 150 million barrels of proved reserves and produces 10 million barrels a year.
Reserves-to-production ratio = 150,000,000 / 10,000,000 = 15 years.
During the year it also adds 12 million barrels through drilling and revisions. Reserve replacement ratio = 12,000,000 / 10,000,000 = 1.2, or 120%.
A rough value at a net margin of $20 a barrel is 150,000,000 x 20 = $3,000,000,000 of undiscounted future margin, which must then be reduced for timing and risk.Case study
Seen in the real world.
Cedar Ridge Oil is an illustrative, fictional company that reported proved reserves of 80 million barrels at the start of the year and produced 8 million barrels during it. Management said the ratio of reserves to production was a comfortable 10 years.
At the year end the oil price had dropped, and the independent engineers removed 15 million barrels that were no longer profitable. Only 3.2 million barrels were added from new discoveries, so replacement on discoveries alone was 3.2 / 8 = 40%. After production and the removal, reserves stood at 80 - 8 - 15 + 3.2 = 60.2 million barrels, and the reserve life fell to about 7.5 years.
The board responded by cutting dividends to fund exploration and bought a stake in a nearby field. The illustrative lesson is that reserves are an estimate tied to price, and a healthy-looking figure can shrink quickly when conditions change.
Watch out
Common mistakes.
- Treating reserves as the total amount of oil in the ground, when they only include the portion that can be produced economically.
- Assuming reserves are fixed, when they move with oil prices, costs and the quality of the data.
- Comparing reserve figures across companies without checking the definitions, because different regulators and categories of certainty are not equivalent.
Questions
People also ask.
What are proved reserves?
They are the volumes that engineers are highly confident can be produced under current economic and operating conditions, and they are the main figure used for lending and valuation.
How do reserves differ from resources?
Resources include oil that may exist but is not yet confirmed as economic, while reserves are the part that meets the tests for profitable production.
Why does a low reserve replacement ratio worry investors?
It means the company is using up its stock of oil faster than it is finding more, so future production and cash flow are likely to fall.
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