Not All Barrels Are Created Equal
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Volumes of oil and gas that have been discovered, but yet to be produced are referred to as reserves*. One barrel in the ground is not necessary equal in value to another. In an earlier entry I discussed the hazards of using simple yardsticks such as $ per barrel in the ground as a means of valuing an asset, and this is why.
Risk is the main differentiating factor between the types of reserve categories and their associated values. SPE (Society of Petroleum Engineers) categorizes reserves as follows:
- Proved
- Probable
- Possible
- Contingent Resources (not actually a reserve category since a contingent resource doesn't meet the criteria of a reserve)
The above list is in order of increasing risk, or decreasing chance of occurrence. Since the value of an asset is a function of it's projected future cash flow, the lower the chance of occurrence (actual production) the less valuable the barrel. So this list is also in order of decreasing value to the investor.
Proved reserves are considered to have reasonable certainty or a high degree of confidence of being recovered. Often this is determined by a 90% probability of occurrence (P90). Probable reserves are less certain than Proved, and Possible are even less than Probable. Probable reserves are often referred to in combination with Proved reserves as Proved + Probable (or 2P), and typically represent a 50% probability of occurrence (2P=P50). In other words, we have an equal chance of recovering more, or less, barrels than our Proved plus Probable reserves. Possible reserves when added to the Proved + Probable reserves make up what is referred to as 3P reserves, and these represent only a 10% probability of occurrence (P10). So you can understand the investor's attraction to Proved reserves, and to a lesser extent Probable reserves, and often skepticism of Possible reserves.
When evaluating an asset we break these categories down further into their stages of development.. The Proved category is broken down into:
- Proved Developed Producing (PDP)
- Proved Developed Non-Producing (PDNP)
- Proved Un-Developed (PUD)
This list is again in order of increasing risk and decreasing value to the investor. While all three of these categories are Proved reserves, and therefore have a high degree of confidence, there is increasing risk of occurrence and decreasing value simply due to their degree of development. PDP reserves are already developed and are currently being produced, while PDNP reserves have had most of the capital necessary to develop spent, but are not currently producing and may require some additional capital to get producing, or may be waiting for a future event to occur before they can be produced. The PUD category typically represents future drill wells where significant capital must be spent to recover these reserves which makes them less valuable compared to reserves that have already been developed.
The degree to which an investor is willing to pay for these different reserve categories varies widely and is determined by the risk tolerance of the individual investor. It is very important for any investor to understand the risks associated with the reserves they are buying and to rely on an experienced and trusted evaluator to determine the associated risks.
* This of course is an over simplification and not all hydrocarbons in the ground meet the criteria to be called "Reserves." For a more detailed discussion please refer to the SPE PMRS definitions. Natural gas is often referred to in terms of barrels of oil equivalent, BOE, and the conversion is 6 MCF of gas = 1 BOE
