Proved Reserves

Proved Reserves (also known as 'P1 reserves' or '1P reserves') represent the quantity of oil, natural gas, or other mineral resources that geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions. Think of it as the cash in the bank for an energy company. The term “reasonable certainty” is key; in the investment world, this typically implies a high degree of confidence, often interpreted as at least a 90% probability that the quantities will be recovered. This calculation isn't just a geologist's best guess; it's a conservative estimate bound by current realities. It must factor in today's commodity prices, the current cost of extraction, and existing technology. If it's not profitable to pull out of the ground right now, it doesn't count as proved. This makes proved reserves the most reliable and scrutinized metric for valuing an energy company's core assets.

When analysts talk about a company's reserves, they're often referring to a family of estimates, each with a different level of certainty. It's like planning for future income: you have the salary that's guaranteed to hit your bank account, the bonus you're pretty sure you'll get, and the lottery ticket you bought. Proved reserves are the guaranteed salary.

• Proved Reserves (P1): The gold standard. As we've discussed, these are backed by solid evidence and are economically viable today. They form the bedrock of an energy company's valuation.
• Probable Reserves (P2): The likely bonus. These are reserves that are not yet “proved” but have a “more likely than not” chance of being commercially recoverable, typically defined as a 50% or greater probability. When you hear the term “2P,” it refers to the sum of Proved and Probable reserves (P1 + P2).
• Possible Reserves (P3): The lottery ticket. This is the most speculative category. There's a chance the resources are recoverable, but it's low—usually understood as at least a 10% probability. These are based on more tenuous geological data. “3P” refers to the sum of all three categories (P1 + P2 + P3).

For a value investor digging into an oil and gas company, proved reserves are not just a number on a page; they are the very essence of the business.

An energy company's primary asset is the oil and gas it has in the ground. Proved reserves are the most tangible part of that asset base, often recorded on the balance sheet. The company's entire enterprise value is fundamentally tied to the future cash flow that can be generated from producing and selling these reserves. Investors often use metrics like the reserve life index (total proved reserves divided by annual production) to see how many years a company can continue producing at its current rate. A long reserve life suggests a stable, enduring business.

A company is constantly using up (producing) its reserves. A key sign of a well-run operation is its ability to find or acquire new reserves to replace what it sells. This is measured by the reserve replacement ratio. A ratio consistently over 100% means the company is growing its asset base, which is a great sign. A ratio below 100% is a major red flag, suggesting the business is slowly liquidating itself. It's like a baker selling more bread than the dough he's making.

Here's a crucial lesson: Proved reserves are not static. Because they are defined by “existing economic conditions,” a sharp drop in oil or gas prices can wipe reserves off the books overnight. A field that was profitable to drill at $100/barrel might be a money-loser at $50/barrel. When this happens, the oil is still in the ground, but it no longer qualifies as “proved,” and the company must perform a “write-down,” reducing the value of its assets. This highlights the importance of understanding a company's cost of production. A low-cost producer can keep its reserves “proved” even in a low-price environment, giving it a significant competitive advantage.

Proved reserves are the most conservative and reliable measure of an energy company's wealth. For a value investor, they are the starting point for any analysis. However, it's vital to remember that this figure is a snapshot in time, heavily influenced by commodity prices. Always look beyond the headline number to understand the quality of the reserves, the company's ability to replace them, and its cost structure. In the cyclical world of energy, the companies that can protect their proved reserves during the downturns are the ones that truly thrive in the long run.