Oil Reserves

Oil reserves are the estimated quantity of crude oil that can be commercially recovered from known accumulations. Think of it as the oil in the ground that a company or country is confident it can pump out and sell at a profit, using today's technology and at current prices. For investors, particularly those analyzing energy companies, oil reserves are a fundamental measure of a company's core assets and future earning potential. This isn't just a geological guess; it's a dynamic economic calculation. A massive oil field is worthless if the cost of extraction exceeds the market price of oil. These reserves are critically categorized based on the level of certainty of their recovery—proved, probable, and possible—with 'proved' reserves being the gold standard for valuation. Understanding a company's reserves, how they are changing over time, and where they are located is crucial to assessing its long-term viability and value.

When you read an oil company's annual report, you'll see reserves classified into three main categories. This “P” system is all about probability and is essential for an investor to understand. Don't treat all reserves as equal!

This is the most important number. Proved Reserves (1P) are the quantities of oil that geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions. “Reasonable certainty” is a high bar, typically interpreted as a 90% or greater probability that the oil will be recovered. Value investors and conservative analysts focus almost exclusively on 1P reserves because they are the most reliable indicator of a company's tangible, bankable assets. They are the foundation of nearly all oil and gas company valuations.

Here's where things get more speculative.

• Probable Reserves: These are reserves that are less likely to be recovered than proved reserves but more certain than possible reserves. They typically have a 50% probability of being recovered. When you add Probable to Proved reserves, you get a figure known as Probable Reserves (2P).
• Possible Reserves: This is the most speculative category, with a low probability of recovery (typically 10%). While exciting, these are more like lottery tickets than reliable assets. The sum of Proved, Probable, and Possible reserves is called Possible Reserves (3P).

For a cautious investor, 2P and 3P figures should be viewed with healthy skepticism. They depend on future technological breakthroughs or significant price increases to become economically viable.

For a value investor, analyzing a company's balance sheet and future earnings power is paramount. In the energy sector, reserves are the ultimate asset that drives both.

An oil company's reserves are its inventory and its lifeline. A company's primary goal is to find or acquire more oil than it produces each year. This is measured by the Reserve Replacement Ratio (RRR), calculated as: (New Reserves Added / Oil Produced). A ratio consistently below 100% is a major red flag, indicating that the company is slowly liquidating itself. A healthy RRR, achieved at a reasonable cost, is a sign of a sustainable and well-managed operation.

Reserves are the cornerstone for valuing an energy company. Analysts often use metrics like Enterprise Value / Proved Reserves (EV/1P) to compare the relative cheapness of different companies. This ratio tells you how much you are paying for each barrel of a company's most certain reserves. If a stable, well-run company is trading at a significant discount to its peers on this metric, it might present a margin of safety for a value investor. You are, in essence, buying barrels in the ground for less than the market values them elsewhere.

Reserves aren't just numbers on a spreadsheet; they exist in the real world, with all its political complexities. A million barrels in a stable democracy like Norway or Canada carry a different risk profile than a million barrels in a politically volatile region. National reserve levels influence global power dynamics, trade balances, and even the value of currencies through mechanisms like the petrodollar system. A savvy investor must always ask: Where are the reserves? The geographical distribution of a company's reserves is a critical, and often overlooked, component of risk analysis.

Before you rush off to buy shares in the company with the biggest reserve number, keep a few things in mind.

• Reserves are estimates, not facts. They can be, and often are, revised up or down based on new drilling data, technological advances, and, most importantly, the price of oil. A drop in oil prices can wipe out billions of barrels from the 'proved' category overnight, as they may no longer be economical to extract.
• Quality over quantity. Not all oil is created equal. A barrel of light, sweet crude that is easy to extract and refine is far more valuable than a barrel of heavy, sour crude that is trapped in deep-sea rock. Dig into the details of the reserve quality.
• Stick with Proved (1P). When in doubt, focus on the 1P reserves. They are the most conservative and reliable figure for making investment decisions.

Think of an oil company's proved reserves as its savings account for future earnings. Your job as an investor is to figure out if you're paying a fair price for that account and to be sure it's being refilled faster than it's being spent.