Prospective Resources

Prospective Resources are the energy sector's equivalent of a treasure map—they represent estimated quantities of oil and gas that could potentially be recovered from undiscovered accumulations. This is the most speculative category of petroleum resources. Unlike Reserves, which have been discovered and are commercially viable, prospective resources are purely conceptual. They are identified through indirect evidence like geological surveys and seismic data, which suggest that oil or gas might exist in a particular location, known as a 'prospect'. Think of it as an educated guess. The crucial word here is undiscovered. No well has been drilled to confirm their existence. According to the industry-standard Petroleum Resources Management System (PRMS), they sit at the very bottom of the resource hierarchy, carrying the highest risk and the highest potential reward. An investment thesis built on these is a bet on successful exploration, a high-stakes game where many players walk away with nothing but expensive holes in the ground.

To understand the immense risk associated with Prospective Resources, it's helpful to visualize the hierarchy of petroleum assets as a pyramid. The higher you go, the lower the risk and the more certain the value.

• Level 1 (The Base): Prospective Resources

This is the wide, uncertain base of the pyramid. It represents all the potential oil and gas that might be found in undrilled prospects. The volumes can be enormous on paper, but the probability of ever converting them into cash flow is very low. This is the land of “what ifs” and geological dreams.

• Level 2 (The Middle): Contingent Resources

Once a company drills an exploration well and makes a discovery, the resource moves up the pyramid to the “Contingent” category. The oil or gas is now proven to exist! However, a significant hurdle remains: commercial viability. The company has not yet committed to developing the project. This could be due to low oil prices, high development costs, political instability, or the need for new technology. The treasure is found, but it's not yet clear if you can afford to get it home.

• Level 3 (The Peak): Reserves

This is the pinnacle of the pyramid and what investors should prize most. Reserves are resources that are not only discovered but are also deemed commercially and technically recoverable. A firm commitment has been made to produce them. Reserves are often broken down by their level of certainty:

1. Proven Reserves (1P): The highest confidence. The oil-in-the-bank.
2. Probable Reserves (2P): Less certain but still likely.
3. Possible Reserves (3P): The most speculative of the reserves categories.

Prospective Resources are the feedstock for future reserves, but the journey from base to peak is long, expensive, and fraught with failure.

For a value investing purist, a business whose valuation is propped up by Prospective Resources is a flashing red light. It's speculation, not investment. However, a savvy investor can find value in companies that hold these assets, provided they approach it with extreme caution and a healthy dose of skepticism.

The allure is undeniable. A successful exploration well that proves a large prospective resource can cause a company's stock to multiply in value overnight. These “ten-bagger” stories attract speculators like moths to a flame. The danger, however, is that for every spectacular success, there are dozens of “dusters,” or dry holes, where companies spend hundreds of millions of dollars and find nothing. Relying on a successful drill bit for your investment returns is a gamble, not a strategy. It violates the core principle of margin of safety.

Instead of betting on the drill bit, a value investor looks for situations where Prospective Resources are a “free call option” on top of an already sound business. Here’s what to ask when evaluating a company with exploration upside:

• What am I paying for? Does the company’s market price reflect only its existing production and proven reserves? If so, any exploration success is pure upside. If the share price is already factoring in a big discovery, you are paying for hope, and the risk is skewed heavily against you.
• What are the chances? Management should provide a geological Chance of Discovery (CoD). A 15% CoD sounds low, but it also means an 85% chance of complete failure. You also need to assess the Chance of Development (CoD), which is the probability that a discovery will be commercially viable.
• Who is taking the risk? How is the exploration being funded? Is the company using its own cash flow, or has it “farmed out” the project to a partner who will carry the cost in exchange for a stake in the discovery? A financially prudent company will try to minimize its own capital at risk.
• What is the management's track record? Does the leadership team have a history of converting prospects into producing assets, or are they serial promoters of high-risk ventures? A proven team of geologists and engineers is your best—though still imperfect—guide.