Oil and Gas Reserves

Oil and gas reserves are the estimated quantity of crude oil and natural gas that can be commercially recovered from underground reservoirs. Think of them as the lifeblood and primary asset of an exploration and production (E&P) company. Unlike a factory that can be rebuilt, these reserves are finite. Their size, quality, and the cost to extract them are the most critical factors in determining an oil and gas company's value. For an investor, understanding reserves isn't just an academic exercise; it's the key to separating a gusher from a dry hole. Because these are estimates based on geological and engineering data, they are classified by their level of certainty, a crucial detail for any prudent investor. A company's future revenue, profits, and very existence depend on its ability to accurately estimate, develop, and replenish these vital underground assets.

The oil and gas industry classifies reserves into three main categories based on their probability of being recovered. This system, often called the “3P” system, is fundamental to assessing a company's health and future prospects. Investors should focus most of their attention on the most certain category.

This is the gold standard. `Proved Reserves`, also known as 1P, are those with a “reasonable certainty” of being recovered under existing economic and operating conditions. The industry standard for “reasonable certainty” is typically a 90% or higher probability that the oil or gas is actually there and can be produced. Public companies must report these reserves in their financial filings to regulators like the U.S. `Securities and Exchange Commission (SEC)`. For a `Value Investing` approach, Proved Reserves are the most reliable asset on which to base a company's valuation.

These are a step down in certainty from Proved Reserves. `Probable Reserves` are quantities that are not yet proved but are estimated to have at least a 50% probability of being successfully recovered. When added to Proved reserves, the total is known as 2P (Proved + Probable). While not as bankable as 1P, these reserves give an investor a sense of a company's potential upside and future growth.

This is the most speculative category. `Possible Reserves` have a low chance of being recovered, typically estimated at 10%. These are reserves that might be recovered with future technological advancements or a significant rise in `Commodity Prices`. The total of all three categories is known as 3P (Proved + Probable + Possible). Value investors should be extremely cautious with this category, treating it as a potential bonus rather than a core part of the valuation.

For an oil and gas company, reserves are everything. They are the inventory that will be sold to generate future cash flow. Understanding them is non-negotiable for serious analysis.

• Valuation Bedrock: The value of an E&P company is primarily derived from the present value of its future production. Analysts often build a `Discounted Cash Flow (DCF)` model based on the production schedule of the company's 1P reserves. The more high-quality, low-cost reserves a company has, the higher its intrinsic value is likely to be.
• A Ticking Clock: An oil company is constantly depleting its main asset. Every barrel produced is one less barrel in the ground. Therefore, a company must continuously find or acquire new reserves to avoid slowly liquidating itself. This makes the ability to replace production a critical indicator of long-term sustainability.
• Quality Over Quantity: Not all barrels are created equal. A million barrels of oil that cost $80 to extract are far less valuable than a million barrels that cost $30. Investors must look beyond the headline reserve number and consider the costs of extraction, the political risk of the host country, and the quality of the oil or gas itself.

To move beyond a surface-level understanding, investors can use a few simple ratios to analyze a company's reserves.

This metric estimates how long a company's reserves will last at its current production rate.

• Formula: RLI = Proved Reserves / Annual Production
• Insight: A company with 1 billion barrels of proved reserves producing 100 million barrels per year has a `Reserve Life Index` of 10 years. A consistently falling RLI is a major red flag, suggesting the company isn't replacing what it produces.

This is arguably the most important operational metric for an E&P company. It shows whether the company is finding more oil than it's pumping out of the ground.

• Formula: RRR = (Total Reserve Additions in a Year / Total Production in a Year) x 100%
• Insight: An `Reserve Replacement Ratio` consistently over 100% shows a healthy, growing company. A ratio below 100% signals that the company is shrinking and may face long-term trouble unless it can reverse the trend.