Reserve Report Dirty Secrets

Do you ever read the introductory pages to a reserve report?  You should – because virtually every report contains some shocking wording.  Here is one from a report by a respected, certified reserves estimator:

“The reserve estimates were based on interpretations of factual data furnished by [Client]. Oil and gas prices, pricing differentials, expense data, capital investments, plug and abandonment costs, tax values were supplied by [Client]. Ownership interests were supplied by [Client] and were accepted as furnished.”

Then he adds, “To some extent, information from public records has been used to check and/or supplement this data.”  But this sentence just highlights the problem – even a conscientious reserves estimator has limited public data for a reasonableness check.  It would be cost-prohibitive to test most of the data supplied by the client.  Even worse, not every reserves estimator is conscientious.  The dirty secret – even independent reserves reports are of necessity built on a foundation that is sometimes nothing but sand.

The US Securities and Exchange Commission (SEC) has tried to alleviate this problem by regulating the parameters for a reserves report used by a publicly-listed company in the US.  To a certain extent, this has been helpful, especially by providing clarity and consistency on pricing and by establishing clear parameters for the physical limits of the reservoir.  But while providing clarity, sometimes these SEC-mandated assumptions are far from realistic.  And there is still a lot of wiggle room.  Even so, it is a good start if you see that a reserve report was based on SEC assumptions.

In reaction to the SEC requirements, the Society for Petroleum Engineers, in conjunction with several other groups, has released its Petroleum Resources Management System.  Conceptually they are a great improvement over the one-size-fits-all approach of the SEC because they have more flexibility.  But on the downside, they have more flexibility than the SEC mandates.  So the user of an SPE reserves report cannot know whether the report is really better or worse than an SEC reserves report unless he digs into the details.

Banks that lend on oil and gas reserves often provide their own assumptions in creating reserve reports for bank use.  But banks are notoriously reactive – when prices are low and assets are cheap, the banks usually use tight assumptions that make almost any project uneconomic.  When prices are high and times are good, banks loosen their assumptions and lend on anything.  At least that is the oil patch lore, and there seems to be a lot of truth to it.  So the impression is left that bank reserve reports are more geared to protecting the hide of the energy lending department rather than coming up with a real valuation.

What is a creator or user of reserves reports and economic analyses to do?  Fortunately, there is a lot that can be done to unpack the assumptions used and to determine if they are realistic.  In following blog posts, we will turn our spotlight on the more common problems.  Read on and you will become an expert user of reserves and economics reports.