Reserves and Resources

Reserves and Resources are two of the most critical—and often confused—terms in the world of mining, oil, and gas investing. They describe the amount of a `Commodity` a company has in the ground, but they are not interchangeable. Think of it like an apple orchard. Resources are all the apples on all the trees, including the green ones, the ones on the highest branches you can't reach, and those that are a bit rotten. They represent the total estimated quantity. Reserves, on the other hand, are only the ripe, perfect apples you can currently reach with your ladder and sell at the market for a profit. They are the subset of resources that are economically and technically feasible to extract with today's technology and at current prices. For an investor, this distinction is everything; it's the difference between a pipe dream and a bankable asset.

The journey from a “resource” to a “reserve” is one of increasing certainty. Geologists and engineers use seismic data, drill samples, and sophisticated modeling to estimate what's underground. As they gather more data and confirm that the commodity can be extracted profitably, a resource gets upgraded. The key takeaway is that reserves have a high degree of commercial certainty, while resources have a much lower one. A company's `Valuation` should be heavily weighted toward its proven, profitable reserves, not its vast, unproven resources.

To help investors understand this certainty, reserves are typically classified into three categories, often called the “P” system. Understanding this hierarchy is essential for assessing risk.

• Proved Reserves (1P): This is the gold standard. Proved reserves have a very high degree of accuracy, with at least a 90% probability that the quantities recovered will equal or exceed the estimate. When you see “1P” reserves, you can be reasonably confident they exist and can be extracted profitably under current conditions. Value investors focus heavily on 1P reserves as they form the bedrock of a company's value.
• Probable Reserves (2P): These are less certain than proved reserves, with a probability closer to 50%. A company might have good data, but there are still technical or economic uncertainties to resolve. The term “2P” refers to the sum of Proved plus Probable reserves (1P + Probable = 2P). While valuable, they carry more risk than 1P reserves.
• Possible Reserves (3P): This is the most speculative category, with a low probability of being recovered (typically around 10%). “3P” refers to the sum of Proved, Probable, and Possible. Be very wary of companies that heavily promote their possible reserves. They are often a sign of promotional management rather than solid operational reality.

For a value investor, scrutinizing a company's reserves is non-negotiable. It's about separating fact from fiction and paying for predictable `free cash flow`, not just geological potential.

• Predictable Earnings: Only reserves can be turned into production, revenue, and profit. A company with a large and growing base of `Proved Reserves` has a more predictable future than one sitting on a pile of speculative resources.
• Spotting Red Flags: Overly promotional companies often blur the line between reserves and resources. They might boast about their “multi-billion-barrel resource potential” to inflate their stock price. A savvy investor digs into the official reports to find the 1P reserve figures, which tell the real story.
• Assessing Longevity: A key metric derived from this data is the `Reserve Life Index` (Reserves / Annual Production). This tells you how many years a company can maintain its current production rate before running out of reserves. A stable or growing reserve life is a sign of a healthy, sustainable business.

Remember, even proved reserves are still estimates. They are not money in the bank. Their economic viability is directly tied to the price of the underlying commodity. If the price of oil plummets from $80 to $40 per barrel, a significant portion of a company's “proved reserves” might suddenly become unprofitable to extract, effectively demoting them back to being simple resources. Always check the price assumptions a company uses in its reserve reports. A company using an unrealistically high commodity price to calculate its reserves is waving a massive red flag.