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.