What it means
A producer sells its oil and gas, but every barrel sold has to be replaced by finding new reserves. Finding and developing new reserves costs money, so the key question is whether the margin on each barrel is bigger than the cost of replacing it.
The recycle ratio puts those two figures side by side. The top of the ratio is the operating netback, which is the profit per barrel after the cost of operating and transporting it.
The bottom is the finding and development cost per barrel, which is what the company spent to add reserves. Both are normally stated per barrel of oil equivalent, a unit that converts gas into a barrel-like measure so oil and gas can be added together.
A ratio of 1 means that each dollar reinvested simply gets back one dollar of operating margin. Higher figures suggest the company can fund growth and still have cash left over, while a figure below 1 suggests that it is spending more to replace reserves than it earns from selling them.
Many investors look for ratios comfortably above 1 and treat very high figures as a sign of an efficient operator. The measure is easy to calculate but easy to misread.
Commodity prices change the netback quickly, and a sharp price rise can lift the ratio without any improvement in the company's skill. Finding and development costs also vary a lot from year to year, so a single year's result can mislead.
Analysts normally look at the ratio over several years and compare it with peers working in similar geology. It is a screening tool and not a complete valuation, because it ignores debt, overheads and the quality of the reserves added.
The ratio sits alongside other efficiency measures such as the reserve replacement ratio, which compares reserves added with reserves produced. Together they answer two separate questions, whether the company is replacing what it sells and whether it earns a good margin while doing so.
A producer can pass one test and fail the other, which is why serious analysts look at both.
In practice
Real-world examples.
Example
An equity analyst compares two mid-sized oil producers. One has a recycle ratio of 2.5 and the other 1.1, so she concludes the first is generating far more cash per dollar of drilling and gives it a higher rating.
Example
The finance team of a gas producer sees its netback fall from $24 to $16 per barrel while development costs stay at $14. The recycle ratio drops from about 1.7 to about 1.1, and management decides to slow its drilling schedule.
Example
A lender reviewing a reserve-based loan notes a recycle ratio below 1 for three years in a row. It asks the borrower to explain how it will fund the replacement of reserves without taking on more debt.
Formula
Calculation
Recycle ratio = operating netback per barrel / finding and development cost per barrel
Suppose a producer earns an operating netback of $30 per barrel after costs and spends $15 per barrel to find and develop new reserves. Recycle ratio = 30 / 15 = 2.0. This means each dollar spent on adding reserves brings back two dollars of operating margin when the barrel is eventually sold. Because the numerator and denominator are both stated per barrel of oil equivalent, the ratio is a pure number with no currency attached.Case study
Seen in the real world.
Cedar Ridge Petroleum is an illustrative, fictional producer that reported strong profits in a year of high commodity prices. Its operating netback was $42 per barrel and its development cost was $28 per barrel, giving a recycle ratio of 1.5.
The following year prices fell and the netback dropped to $20 per barrel while development costs stayed at $28. The recycle ratio fell to about 0.7, which showed that the company was now spending more to replace each barrel than it earned from selling one.
The board cut its drilling budget and focused on its cheapest prospects. The illustrative lesson is that a healthy ratio in a strong market does not guarantee one in a weak market. The new chief financial officer then added the recycle ratio to the monthly board pack, so that every drilling proposal was judged against it before money was committed.
Watch out
Common mistakes.
- Quoting a single year's ratio as if it described the company's lasting skill, when prices and costs shift from year to year.
- Mixing a netback per barrel with development costs per thousand cubic feet of gas, instead of putting both on the same barrel-equivalent basis.
- Treating a high ratio as proof of a good investment without checking debt levels and reserve quality.
Questions
People also ask.
What is a good recycle ratio?
Analysts generally want it above 1 and often prefer a figure well above that, but the right level depends on the sector and the stage of the price cycle.
Does the ratio include overheads?
Usually not, since it uses the operating netback and the finding and development cost, so general and administrative costs sit outside it.
Why does the ratio swing so much?
The netback moves with commodity prices, so a price change can alter the ratio even when the company has done nothing differently.
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