Virtual Reserves - And Other Measures Designed To Confuse the Investing Public
- J.C. Tobin (Applied Planning Assocs.)
- Document ID
- Society of Petroleum Engineers
- SPE Reservoir Engineering
- Publication Date
- February 1996
- Document Type
- Journal Paper
- 34 - 36
- 1996. Society of Petroleum Engineers
- 6.1.5 Human Resources, Competence and Training, 7.2.3 Decision-making Processes, 4.3.4 Scale, 5.7 Reserves Evaluation, 1.6.9 Coring, Fishing
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Norman Augustine, CEO of Martin Marietta, in his book Augustine's Laws,1 observed that, "Cost estimating is the first professional activity to make practical use of the mathematics of a complex number. It is easy to see the imaginary component in these estimations. The difficulty is in finding the real part."
Over the years, I believe we have seen this form of math creep into reserve estimation. In that we are once again dealing with numbers that have no resemblance to reality, I think that the appropriate label for such reserves, in keeping with the terminology of modern technology such as virtual imaging and virtual memory, is to call them "virtual reserves."
Security & Exchange Commission (SEC) Regulation S-X 4 forced many firms that use the calendar year for their fiscal year to delete much of the proven reserves from their books at the end of 1993 because of abnormally low prices. While this fact did not compromise the SEC's desire for consistency in reporting, it did add to the confusion of investors who look to reserves for underlying value.
The promotional aspect of our industry has regularly dealt in virtual reserves reflecting the speculative nature of asset and property transactions. The hoped-for or imaginary components in these estimations are well recognized and, in many cases, well documented in the court system of our land. Therefore, I will address the more current forms of virtual reserves.
The SEC had two purposes in mind when creating their modern definitions of reserves.
1. One purpose is to come up with a common way of measurement so that various governmental agencies could assess changes in year to year macro reserve levels.
2. The other objective was to give investors a common way of comparing reserves for various E&P companies.
The SEC techniques require the categorization of reserves based on their economic merits reflecting the price seen on Dec. 31 of each year or the end of the firm's fiscal year. These classifications are laid out in SEC Practice, Regulation S-X, Chap. 20 and fall into proved, probable, and possible major groups, with developed producing, developed nonproducing and undeveloped subgroups for the proven category.
Most investors have not read S-X nor would they understand it if they did read it, therefore creating the additional need for accountants and lawyers. This, of course, is part of the job creation side benefit of regulation. But I digress. Even a major oil company, which offered the definitions below, realizes how useless these definitions are in the investment decision process. This firm noted how reserves are like fish.
Proved Developed. The fish is in the boat. You have weighed him. You can smell him and you will eat him.
Proved Undeveloped. The fish is on your hook in the water by the boat and you are ready to net him. You can tell how big he looks (they always look bigger in the water).
Probable. There are fish in the lake. You may have caught some yesterday. You may even be able to see them, but you have not caught any today.
Possible. There is water in the lake. Someone may have told you there are fish in the lake. You have your boat on the trailer but you may go play golf instead.
However, these humorous definitions do not recognize the impact of the price of fish. This SEC approach could be of some value if prices were fairly stable over time. However, as seen in Fig. 1, oil prices have been still quite volatile even since the price collapse in 1986.
In the 1984 Arthur Andersen, World Oil Trends, entitled "The Perils of Prophesy," it was noted that "Oil price forecasters make a herd of sheep look like independent thinkers." Perhaps it is this fear of "consistency" that has caused the SEC to use year-end prices for the valuation of reserves.
The spot price of WTI was $14.15 on Dec. 31, 1993. Fig. 2 shows that at this price level there was only 8.6% of the time when prices were lower over this 9-year period. The Dec. 31, 1993, price level does not represent the long-term economic viability of any physical reserves.
Therefore, revisions to these reserve estimations required by this low price took truly proved developed reserves off the "SEC books." This resulted in a new regressive classification called proven undiscovered reserves (see Fig. 3).
After this process is complete, virtual reserves are then translated into an equally "useful" single discounted cash flow value. This computation is made using "best engineering judgment" estimations for production constrained by year-end price, operating cost assumptions, etc., and a 10% discount rate. While this process attempts to ensure consistency, there is no recognition of variations in any of these parameters.
In the search for ways to assess the relative merits of one firm compared with others, the investor's never-ending task goes on.
Financial reports use physical proven SEC reserves. However, revenues are determined from actual prices received rather than year-end levels. The investor still must question whether current or future production decisions reflect those year-end prices or revenues received in the past. Of course, there is no guarantee that even proven reserves will ever be produced in the future.
Reports of proven reserves tend to be revised upward year to year from extensions, new recovery techniques, new discoveries and "predictive clarification or correction." Uncontrollable (and assumed to be unpredictable) economic forces such as prices and taxes also drive revisions of past estimates. In addition, general initial conservatism and corporate objectives and culture may tend to bias these estimations. Year end 1993 was a rare time where prices forced potential downward revisions to reserve projections.
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