The Importance of Oil and Gas Reserves to the Valuation of an Oil and Gas Company

Reserves of oil and natural gas usually comprise the most valuable asset of most oil and gas firms. "Upstream" activities -- exploration and development of oil and gas reserves generally comprise the highest percentage of profits for almost all integrated majors, in comparison with "downstream" activities -- refining, marketing and pipeline transport of oil and gas. For example, in 2005, exploration and production accounted for 83% of Chrevon's operating profit, 80% of BP PLC's operating profit, and 65% of Exxon Mobil's 2005 operating profit.

To paraphrase Willie Sutton (who was asked why he robbed banks): "Oil and Gas Reserves are where the money is."

A note on separate types of energy firms that exist within the energy world:

- First, there are intregrated majors, which concentrate on both upstream and downstream activities. The largest public integrated major by market capitalization in the world is Exxon Mobile.
- Second, there are independents, which focus almost entirely on upstream activities, with nearly 100% of profits from exploration and production of oil and gas. The largest US independant is Devon Corporation, ticker DVN.
- Third there are downstream and "midstream" firms which focus on refining, pipeline operation, LNG facility operation, and marketing.
- Fourth, in the energy sphere there are service firms such as Halburton, which provide well optimization services.
- And Fifth, Oil Sands firms, as they have economics and technology that do not closely resemble traditional upsteam oil and gas firms (oil sands are the subject of another post).

This investment blog concerns itself with catagories 1 and 2 above -- as well as 5 -- I believe every intregrated and independant above a market capitalization of $100M listed in the three major US exchanges is represented in this investment blog, which to my knowledge, has only been completed by the firm John S. Herold Inc in Greenwich, Conn -- but the charge upwards of $15K per year for acess to their data :).

There are a number of methods to analyze an oil and gas firm's reserves. The first (and most obvious) is to observe the total amount, listed by law in the Company's SEC filings. Generally, most companies will have this information on their website or company description as well. The total amount will be generally be listed in barrels for oil, or more rarely, in tons. Large firms will report billions of barrels -- Exxon Mobile reported approximately 13.37 billion total reserves of oil equivalant in 2005, while smaller companies will generally report millions of barrels of oil equivalent. Reserves of natural gas are generally listed in millions of cubic feet equivalent. Reserves of natural gas can be expressed as "barrels of oil equivalent" by energy -- an online calculator to convert from oil barrels to tons and from gas to barrels of oil equivalent can be found at http://www.questoffshore.com/Home/ConversionCalculator/

Note also, at this point in time, oil is more valuable per energy equivalent than natural gas -- although last year after the hurricane natural gas was more valuable per unit of energy -- so currently it pays to know the percentage of the company's reserves that are in oil verses natural gas (as oil is more valuable currently).

The second method to measure the reserves is through a reserve to production ratio --or R/P for short. This number measures how long, at current production rates, a firm can produce oil and gas with existing proven reserves. Typically the number ranges from 6 years to 15 years, with a higher number indicative of higher reserves.

The third method to find the discounted prsent value of the companies oil reserves, called the Standardized Measure. This measure is explained in the second post of this blog. This is a very important measure for investors interested in Oil and Natural Gas Firms -- and for readers not familiar with this measure, I stress that it would be valuable for the reader to learn about it, reading my post on the Standardized Measure would be a good starting point, as there is not a tremendous amount of information out there concerning it.

All three of these above methods could (ideally, should) be used in conjuction with each other for the investor to gain an understanding of the energy company's reserves.

It is important to note that all public energy companies that file with the SEC MUST publish their proven oil reserves and their production figures and standardized measure, but are not required to publish their probable and possible reserves. Proven reserves are reserves that are known with 90% or more certainty -- probable reserves are known with 50% certainty, and possible, 10% certainty, as defined by the SEC. For more information see: http://energy.ihs.com/News/Press-Releases/2004/pr_012104-resreporting.htm

Also, it is important to note that not all reserves are equally accessable, or in other words, some reported reserves are difficult and expensive to withdraw and others are very expensive -- so the cost of development per barrel can vary widely between firms. Further, many firms can be more efficently and effectively run and therefore have a lower lifting costs and therefore profit per barrel. The standardized measure should, if properly calculated by the firm, should take this disparity of development costs into account. To double check, a diligent investor will check development costs of the firm.

Thoughts on Gazprom's Development of the Shtokman Gas Field

Gazprom appears to be aiming to develop Shotkman mainly on its own. Therefore Gazprom's access to financing is critical -- Gazprom almost certainly won't be able to finance Shtokman from internally generated cash flow.

Gazprom's forecasted budget is still up on the Russian version of the Moscow-based Institute of Energy Policy's website site. The budget is included on page 22 of the December 7, 2005 presentation here: (in Russian): http://www.energypolicy.ru/pv.php?id=1002396 (the English version of this presentation is not available)

There are three highlighted lines towards the bottom of the page, first (towards the top) reads: (translated from Russian): Total Revenues,
Second highlighted line reads: Total Spendings (ie costs), third reads: total debt. All numbers are in US dollar billons.

Summary: In 2012, Gazprom will have revenues of $US46.14 billion and spendings (costs) of $US 74.37Bn, leaving debt to increase from $21.0Bn in 2005 to $119.05Bn in 2012.

Assumptions of forecasted budget: 1. constant price domestically and in Europe and CIS of Gas (maybe reasonable, although likely the price will rise a bit), 2. slower internal Gazprom cost growth than historical, 3. Capex includes Yamal, NEP, Shtokman, but does not count oil, petrochemical, power capex at Gazprom 4. interest rate = 5.6%. 5. lower Russian gas production offset by higher Central Asian production (in which Gazprom collects a tariff) 6. Gas transportation tarrif increases from USD 0.82 per tcm to USD 2 per tcm by 2008 (likely to happen).

It seems to me that as soon as European banks realize the dire situation of the finances within Gazprom, -- if the projection above is accurate and the assumptions are reasonable -- they won't be willing to finance the Shtokman project. And/or the Russian government and Gazprom will have to become more flexible about revenue sharing and access to the project, which may or may not happen -- it depends on the political situation in Russia, which is the subject of another article.

I would lean towards more delays at this point as European banks worry about repayment -- and Russia is not extremely enthusiasic about pushing the project through as there is a saying in Russia: "Why not leave the oil for our grandchildren?" -- they acknowledge that oil and gas is non-renewable and also feel the price they get now is on the low side, so lower supply from less projects will encourage a higher price from their existing supply.

What is the Standardized Measure of an Oil and Gas Company?

The Standardized Measure is defined as the present value of the future cash flows from proven oil and natural gas reserves, minus development costs, income taxes and existing exploration costs, discounted at 10%. Note that all oil and gas firms that list on an US exchange must provide the Standardized Measure in their filings with the SEC, according to FASB 69. see: http://www.fasb.org/st/summary/stsum69.shtml

How is the Standardized Measure calculated according to FASB 69? In order to Calculate the Standardized Measure, the oil and gas firm will forecast production by year in future years of ONLY proven reserves -- not probable and possible reserves --and then will subtract certain costs and income taxes (at a constant income tax rate, which could change if the government decides to tax higher profits at oil and gas firms due to high prices). To the extent that the company has a strong exploration and development program, in which they find reserves at a higher rate than they produce them (in other words, a high "replacement ratio") the Standardized Measure will not reflect this potential.

The Standardized Measure is defined as the present value of the future cash flows from oil and natural gas reserves, minus development costs, income taxes and existing exploration costs, discounted at 10%. The result will be a number in dollars, for large companies, in the billions, and for smaller oil and gas firms, in the millions. The company, in order to calculate the Standardized Measure, assumes a constant price for natural gas and oil in future years -- unusually the year end price of oil and natural gas (but not always, I have indicated the exact price of gas utilized by the firms in my chart in this blog). In 2005 prices for natural gas utilized by companies range from $8.00 per mcfe to $11.00 per mcfe and prices for oil range from $45 to $65 per barrel.

The Standardized Measure is highly sensitive to the price of oil and natural gas assumed in the calculation -- for example, several companies have used a price of $10 per mcfe for natural gas for the standardized measure at the end of 2005, compared to a price of under $6 in 2004 -- an increase of almost 70%! Oil prices also generally (but not always) have been assumed by companies at around $60, up from around $45 in in 2004, an increase of 33%. The increases in oil and gas prices contributes to a very large increase in the Standardized Measure. Further, two companies with similiar resource bases may use widely different price assumptions for oil and natural gas, leading to very different Standardized Measures.

What doesn't the Standardized Measure include that it should?

The Standardized Measure does not include effects from oil and natural gas price hedging, costs from interst on debt, general and administrative costs, and new exploration costs, and does not include special taxes in future years. To the extent that a Company has an effective or uneffective hedge program (read: has hedged gas production in the $9 range for years to come verses not doing so) the Standardized Measure will not reflect this. Also, if the company has a large debt load, and high administrative costs, and/or an uneffective exploration program, the Standardized Measure will be higher than it "should" be.

The question arises: does the Standardized Measure "overvalue" or "undervalue" the true value of the proven reserves in future years, notwithstanding oil and gas price changes and future exploration, due to the items that it does/does not include? There are arguments on both sides:

For those who say the Standardized Measure "overvalues" point to:

- Lack of inclusion of administrative costs
- Lack of inclusion of interest costs from debt
- No new exploration costs
- No inclusion of increased/special taxes

Those who state the Standardized Measure "undervalues" proven reserves point to:

- 10% discount rate is too high in an era of low interest rates

(again, this undervalued/overvalued debate above does not include the impact of probable and possible reserves -- reserves that will be discovered in future years -- the Standardized Measure excludes probable and possible reserves)

Why is the Standardized Measure important?

The Standardized Measure is one very important tool for investors to understand if the oil and gas firm is undervalued. All public oil and natural gas firms can be compared to a candle, in that as they produce oil and natural gas, they "burn" their resources. If an oil and gas firm does not find new resources -- "wax" -- in furture years -- they will "burn" through their resource base. Assuming an oil and gas company finds no new resources besides proven in future years (note a large assumption), and the assumptions of future development costs and income are accurate, the value of the company should be (in an efficient market) roughly equal to the Standardized Measure. Further, to the extent that the market value of the firm is above or below the Standardized Measure, the stock can be considered overvalued or undervalued, respectively.

An illustration is useful here to show the usefulness of the Standardized Measure. Let's say Candle Firm has a candle that will burn for ten years. Candle Firm has no plans to find or buy any new candles. Candle Firm knows that after ten years, the candle will be gone. Candle Firm knows that every year in the future, they will burn 1/10th of the candle, and every year their income from the candle will be equal to the amount they burn times the price of heat they produce, minus their costs and taxes. Candle Firm can forecast the income from their resource over the next ten years, and then discount it to the present using an appropriate discount rate. This should be the value of the Candle Firm.

In the chart of public companies in this website, 86 public companies listed on US exchanges have been analyzed, with standardized measure to enterprise value provided(enterprise value equals market capitalization minus debt plus cash). All other measures equal, a higher standardized measure to enterprise value indicates the oil and gas firm is more undervalued.

In practice, the standardized measure to enterprise value is a good starting point for analysis for investors, as the diligent investor will go further and analyze the quality of oil and gas reserves, the exploration program, cost control, forecast possible future price of oil and gas, analyze the company's hedging program, financial strength, access to drilling rigs, geographic regions and potential, political risk, possible acquisitions, and analyse the competitence and ability of the management team.