Comment

Leonard Le Blanc

Reserves and reality

Reserves reporting is one of the most sensitive and difficult issues in the oil and gas business. Recoverable reserve volumes are dependent on so many factors that most planners believe high and low estimations simply average out over the long run. They do - sometimes.

Ironically, now that newer technologies provide a much more accurate estimation of recoverable reserves, there are more "political" reasons to skew the estimations.

For example:

Production replacement has become a high profile measurement tool for equity analysts. The difficulty with applying this measurement annually is that the random rate of discoveries tends to produce negative reserve replacement numbers 70% of most years and exceed it drastically in the remaining 30%. Are producers smoothing out the reserve bookings roller coaster curve to protect equity values? Is there is a tendency to fudge reserve bookings to meet or exceed the annual 100% target? Perhaps.
Producers strive to improve accountability in reserves estimation. One of the goals in developing life-cycle asset management teams was to accurately predict recoveries. However, personnel in reservoir evaluation groups often turn over completely during the life of a field. The result is that personnel promotions depend more on booked reserves and early production rates, not on cumulative volumes.
Reserves are too-often booked as if recovery costs are straight line, allowing asset management teams to book maximum recoverable volumes. Capital and operating costs climb when enhanced recovery kicks in, but that is a problem for asset teams later in the life cycle.
Small- and medium-sized producers tend to be far more sensitive to equity values, hence the tendency to present recoverable reserves in the best light possible. While debt providers insist on unbiased third-party recoverable reserve estimates, equity investors tend to be moved more by smoke than fire.
Until recently, OPEC members' allocations were determined by reserves reported. The problem is that the OPEC secretariat finds it difficult politically to insist on third-party estimations, so OPEC members (national oil companies) tend to be very liberal about reporting volumes.

All of these possibilities influence reserves reporting. Many analysts account for the tendency to inflate reserve numbers by applying a 5-15% discount to reported numbers. On the other hand, producers say that if anything, reserve volumes are under-estimated.

So, where are we? Who do we believe? The tendency is to apply a high discount to OPEC member reserves, a lower discount to fields without third-party estimation, and none at all to fields where there is unitization, partnerships, or third-party estimation. This leaves us with a discount averaging 8-11%, which may over time produce the most accurate numbers.

Merger tendencies

An observer walking through oil and gas producers' offices today would be stunned by the assortment of outside contractor personnel working there. In recent years, producers have found technical skills among outside contractors to replace the people lost during the great layoff, but the internal structure to manage these contractors was not as easily replaced.

Producers took the only avenue available - grouping separate functions under one contract or finding outside contractors to manage all the functions.

Thus began the push by outside contractors to package internal services and products and reach out for those they did not have. The merging of service companies now taking place is the extension of that trend. There are two additional factors:

Individual service and supply costs - especially for drilling functions - are escalating too quickly for producers to plan properly. Package bidding is one way to contain some of this volatility.
The shortage of petroleum engineers and geoscience specialists has forced producers into a salary-plus-bonus bidding war with each other and with service companies. Producers are finding they can obtain the needed expertise without salary escalation by contracting for it.

Until cost escalation catches up with package bidding, or service and supply functions fulfill demand, mergers among service companies are likely to continue. Don't count on low oil and gas prices to drive down costs - consumers always find a way to use more cheap crude, and thus begin sowing the seeds for the next product demand and cost escalation cycle.