Proved and Probable Reserves

• The Bottom Line: Proved and Probable Reserves are an oil, gas, or mining company's core assets—the verifiable inventory it can profitably extract—and for a value investor, they are the bedrock of its intrinsic value.
• Key Takeaways:
• What it is: A classification system that ranks a resource company's underground assets based on the certainty of their existence and economic viability. Proved (1P) are the most certain; Probable are less so.
• Why it matters: It separates verifiable, bankable assets (Proved) from more speculative potential (Probable & Possible), which is the absolute foundation for applying a margin_of_safety.
• How to use it: By focusing on the value of Proved reserves and treating Probable reserves as a potential bonus, you can build a conservative valuation and avoid overpaying for hype.

Imagine you're not an investor, but an apple farmer. Your entire business—your wealth—is tied to the apples you can harvest and sell. How would you count your apples? You wouldn't just wave a hand at your entire property and say, “I have a million apples.” You'd be more precise, because your livelihood depends on it. This is exactly what Proved and Probable Reserves do for companies that extract resources like oil, natural gas, gold, or copper. They are a system for taking inventory of what's still in the ground, but with crucial layers of certainty. Let's walk through your apple orchard:

• Proved Reserves (often called “1P”): These are the apples hanging low on healthy trees in the main orchard. You can see them clearly. You have the ladders, baskets, and workers ready. The local market is paying a good price, well above your costs to pick them. Based on current technology, prices, and regulations, you are at least 90% certain you can profitably harvest and sell these apples. For a value investor, this is the hard, reliable asset.
• Probable Reserves: These are the apples on the higher, trickier branches, or perhaps in a patch of trees across a small stream. You're pretty sure you can get to them, but you might need a taller, more expensive ladder or to build a small bridge. The evidence is good, but not iron-clad. You are roughly 50% certain you can get these apples to market profitably. When combined with Proved reserves, the total is often called “2P” (Proved + Probable).
• Possible Reserves: You've seen some blossoms on a hill at the far end of your property. You think there might be a whole new grove of apple trees there, but you haven't done a full survey. It's too speculative to include in your main business plan. You are only about 10% certain of this potential. Value investors generally ignore “Possible” reserves, as they are closer to a lottery ticket than a tangible asset.

In short, Proved and Probable Reserves are an attempt to answer the most fundamental question for a resource company: “What do we actually own, and how sure are we that we can turn it into cash?”

“Risk comes from not knowing what you're doing.” - Warren Buffett

This quote is the essence of why understanding reserves is critical. Focusing on Proved reserves is how you know what you're doing; getting lured by Possible reserves is often how you court risk.

For a value investor, the distinction between Proved and Probable isn't just academic—it's the entire game. Our philosophy is built on buying businesses for less than their conservative intrinsic_value. In the resource sector, that value is overwhelmingly derived from the company's reserves.

A company like Coca-Cola has brand value, distribution networks, and secret formulas. An oil and gas company has… oil and gas in the ground. That's it. The value of the entire enterprise is the present value of the future cash flows it can generate from pulling those resources out and selling them. This is where the reserve categories become your most powerful tool:

• Anchoring to Reality: Proved (1P) reserves are your anchor. They are as close to a “sure thing” as you can get in this industry. A disciplined value investor starts by calculating the value of a company based only on its Proved reserves. This provides a hard floor for your valuation.
• Building a Margin of Safety: The core principle taught by Benjamin Graham is to buy an asset for significantly less than its intrinsic worth. If you can buy a company for a price that is justified by its Proved reserves alone, then any value derived from its Probable reserves is essentially free. This is a massive margin of safety. If the “Probable” projects work out, you get a handsome bonus. If they don't, your initial investment is still protected by the value of the “Proved” assets.
• Assessing Management Quality: How a company's management team talks about its reserves is a huge tell.
  • Conservative & Credible Management: They focus their presentations on Proved reserves, their low costs of extraction, and their track record of converting Probable reserves into Proved ones. They under-promise and over-deliver.
  • Promotional & Speculative Management: They constantly hype their “massive potential” and “huge resource upside,” drawing your attention to Possible reserves. They are selling a story, not a business. A value investor learns to tune out this noise and focus on the audited 1P numbers.

Ultimately, by focusing on what is proved, you are investing. By paying for what is merely probable or possible, you are speculating.

You don't need to be a geologist to use reserve data to make smarter investment decisions. You just need to know where to look and what questions to ask.

1. Step 1: Locate the Data. The most reliable information is found in a company's Annual Report (Form 10-K for U.S. companies). Look for a section on “Reserves” or “Supplementary Information on Oil and Gas Producing Activities.” Investor presentations are also useful but always cross-reference with the official filings.
2. Step 2: Distinguish 1P, 2P, and 3P. The company will report its reserves in barrels of oil (bbl), or thousands of cubic feet of natural gas (Mcf). They will be broken down by category (Proved, Probable, Possible) and geography. Your primary focus should be on the Proved (1P) figures.
3. Step 3: Analyze Key Performance Indicators (KPIs). Looking at the total reserve number isn't enough. You need context. Three key metrics will give you that context:
   • Reserve Replacement Ratio (RRR): This measures the amount of new reserves a company adds in a year relative to what it produces. An RRR of 100% means it replaced every barrel it pumped. A value investor looks for companies that consistently maintain an RRR above 100% through drilling or smart acquisitions, not just from commodity price increases. This demonstrates sustainability.

`RRR = (Reserves Added in Year / Reserves Produced in Year) * 100%`

• Finding and Development (F&D) Costs: This is the cost to add one new barrel of oil (or equivalent) to its reserve base. A low F&D cost indicates an efficient operator. Comparing this cost to the current market price of oil reveals the company's underlying profitability. You want low and stable F&D costs.
• Reserve Life Index (RLI): This tells you how many years the company can sustain its current production rate before running out of its proved reserves. A higher number is generally better, indicating longevity and stability.

`RLI = (Total Proved Reserves / Annual Production)`

The numbers tell a story. A company with a high percentage of Proved reserves, a consistent RRR above 100%, low F&D costs, and a long reserve life is a durable, well-run business. It's a robust farming operation. Conversely, a company with stagnant Proved reserves, a low RRR, and a management team that constantly points to its “exciting” Possible reserves is often a sign of a business struggling to replace its core assets. It's a farm that is harvesting more than it's planting. This is a red flag. Always trust the audited Proved numbers over the promotional PowerPoint slides.

Let's compare two fictional oil producers, “Bedrock Oil Co.” and “Wildcatter Exploration Inc.” Both have the same market capitalization. Which one would a value investor prefer?

The Value Investor's Analysis: At first glance, Wildcatter Exploration seems to have more reserves (150M vs 120M BOE). But a value investor immediately sees the flashing red lights.

• Bedrock Oil is a fortress. Its value is built on a massive foundation of Proved reserves (83%). It is successfully replacing what it produces (RRR 115%) at a very low cost ($12/barrel), ensuring future profitability. Its long reserve life (12 years) means it's not in a desperate hurry to find the next “big one.” You can build a reliable DCF model on its Proved reserves and be confident in the output.
• Wildcatter Exploration is a house of cards. The vast majority of its “assets” are speculative. It is failing to replace its core Proved reserves (RRR 75%) and is spending a fortune to do so ($25/barrel). Its short reserve life (6 years) explains why management is so desperate to sell a story about future potential. To buy Wildcatter is to bet on a drilling success story, not to invest in a proven business.

The choice is clear. A value investor buys Bedrock Oil, confident in the assets they can see and measure, and lets the speculators gamble on Wildcatter.

• Grounds Valuation in Reality: Reserves are tangible assets. Analyzing them forces you to move beyond market sentiment and focus on the physical reality of the business.
• Standardized Framework: Reserve reporting standards (like those from the SEC in the US or NI 51-101 in Canada) provide a common language, allowing for a more direct comparison between companies.
• Indicator of Sustainability: Metrics like the RRR and RLI are excellent forward-looking indicators of a company's operational health and long-term viability.
• Reveals Management Discipline: A company's reserve report is a window into the mind of its management team—are they disciplined operators or speculative promoters?

• They are Estimates: Despite the “Proved” label, all reserve figures are complex geological and engineering estimates, not certainties. They can and do get revised. ¹⁾
• Highly Sensitive to Commodity Prices: A reserve is only a reserve if it is economically producible. A crash in oil prices can turn a multi-billion barrel Proved reserve into an economically worthless pile of rock overnight, as the cost of extraction now exceeds the selling price.
• “Proved” Doesn't Mean “Easy”: A reserve can be classified as Proved, but it might be in a geopolitically unstable region or face new environmental regulations that make extraction difficult or impossible. The context is crucial.
• Ignoring Production Costs: A company can have huge reserves, but if its cost to get them out of the ground is higher than its competitors, it will always be a second-rate investment. Reserves must be analyzed in conjunction with costs.

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