oil reserves 101

When a company reports it’s reserves, unless otherwise noted, it is talking about something called proved reserves.  This is the quantity of oil that has been identified in the ground, which they have the legal ownership off, that are deemed to have at least a 90% chance of being extracted with current prices and technology.  In order to report something as proved reserves their data must be audited by an independent reservoir engineering firm, just as the financial reports of a company must be audited by an accounting firm.  Typically most proved reserves will already have the producing infrastructure in place, but sometimes the infrastructure is not fully in place.  Because of this, proved reserves may be divided into proved-developed (PD) and proved-undeveloped (PUD).   In the event of a sudden decline in prices PUD reserves are much more at risk of being written off by the company.  This happened several years ago for PUD gas reserves in the Haynesville shale when the price of gas plummeted.  Proved-developed reserves are rarely written off because the money has already been spent to get the wells to production, and the operating cost of maintaining production is usually very low.  Proved undeveloped reserves can only be counted as reserves if the company has a reasonable expectation that they will be developed within 5 years (sometimes called the 5 year rule).  Because of the amount of work involved in doing  a survey of reserves, in companies make an annual “reserve report”, which states reserves typically as of calendar year end.

Other types of reserves:

Historically, the SEC only allowed oil companies to report proved reserves to investors.  This may have been to prevent companies from confusing investors and exaggerating their prospects to them.  But at the end of 2008 a rule change was proposed and later adopted, allowing companies to report “probable” and “possible” reserves.

Probable Reserves- These have been shown to have at least a 50% chance of being produced with current technology and at current prices.

Possible Reserves- These have at least a 10% chance of being produced with current technology and at current prices.

Sometimes reserves are also discussed in terms of 1P, 2P, 3P reserves.  1P is proved only.  2P is proved + Possible.  3P is proved + possible + probable.

Another change that the SEC has made recently was that certain catagories of oil were prohibited as being reported as reserves, including oil sands and shale oils.  This change was also proposed in 2008.

One area of confusion among people not familiar with the industry, is that sometimes they hear the term reserves, and think that this is a best guess for how much more oil can be produced.  This is not the case at all.  Reserves are oil that has been proven to be extractable.  Even if a quantity of oil is known to exist, it cannot be considered a reserve unless a company owns the right to extract it, and has demonstrated the technical and financial feasibility of extraction. 

OPEC stated reserves: Countries like Saudi Arabia have long reported the same exact proved reserve figure (260 billion barrels in that case).  This has led some to accuse them of just cooking their books.  They produce 3.5 billion a year and yet the number never goes down!  While they may indeed be adjusting the number for political reasons, they could possibly be adding reserves through engineering work to compensate for the produced barrels.  It is difficult to say, but if we look at OPEC proved  reserve charts, the chart for many countries look very suspicious.  Starting in 1986 OPEC began trying to use a formula system to set production quotas for each member country.  Reserves were a factor, and if a country had large reserves, it would help get it a higher quota.  For this reason many countries increased their stated reserves massively, as shown in the chart below.  Their reserves are not independently audited, like they are for a private-sector company.  It is not possible that these revisions were all the result of some overnight engineering.  Either the reserves were deliberately understated prior to 1986 or they were deliberately overstated after that point.  Also note the huge increase for Canada- this is when they started counting the oil sands as reserves.

Article is from http://www.theoildrum.com/node/7363

after the brutal sell-off, are E&P stocks a buy?

The 10% selloff in energy in the past three weeks doesn't seem so bad in comparison to the 7.5% decline in oil prices, but of course the equities had been declining faster than oil in the last weeks of September.  The Marcellus gas producers have held up particularly well, but that may be partly because of the Chesapeake sale to Southwestern of their southern Marcellus assets, which went for a nice price.  Oil producers in the unconventional plays need a relatively high price to make money.  Marcellus gas producers don't, or they'd be out of business.

If the oil price was going to stay where it is there are a number of decent buys out there, but why can't it fall further?  Supply has to come off the market or demand has to increase.  The market must be balanced.  The US seems to be doing its part on the demand side if booming SUV and pickup truck sales are any indication, but the auto industry on the whole is moving towards more and more efficient vehicles, and that doesn't seem to be changing.  China, the source of the biggest demand growth, appears to be slowing. Demand in oil tends to be very inelastic in the short term, so it is hard to see demand increasing and balancing the market in the short term.

On the supply side, we are now getting into earnings seasons, and it will be interesting if we hear about capex cuts in North America.  Due to the fast decline rates in unconventional, the production would certainly fall fast if they pulled back on capex in a significant way, but recently production has been growing with flat capex spending due to increasing efficiency by the drillers.  Many of these companies are hitting on all cylinders now, and I doubt we see them pull back unless the price goes down further.  They might talk up their willingness to cut capex in the event of a big price drop, but I bet most are taking a wait-and-see attitude for the moment.

We also have the November 27 Opec meeting.  Opec has a lot of competing interests now.  Nearly all the Opec countries are heavily reliant on oil revenues for their budgets.  But a few countries, like Venezuela, Iran, Libya, and Iraq, may be at risk of political collapse with prolonged oil price declines.  The situation in Algeria, Nigeria, Angola or Ecuador I don't even know enough to casually speculate about.  Russia (they are not an OPEC member) might be vulnerable to a severe economic collapse in a very big price drop scenario as well, especially given the western sanctions.  But many of the gulf states, like the Saudis, Kuwait, Qatar, UAE might be able to weather a rather long period of low prices, and if it derails US unconventional, Canadian oil sands, and deepwater to any extent, then that will put them in a stronger position for the long term.  If it causes a political crisis in Iran, then so much the better for the Gulf Arabs.  If I was in their position I might want to give the non-opec oil producers a good sweat, just like any prudent would-be monopolist, before balancing the market.  It will be interesting to see how they act.

weekly prices and other stuff

After a series of horrendous weeks in energy, last week was the worst yet.  The S&P was only down .75% for the week after Friday’s rally, but E&P stocks were down 5-6% on average.  Bakken companies were nearly totally correlated: down between 7, and 8.1%.  Whiting Petroleum now trades at 11x next years estimates and a 3.7x EV/EBITDA, and this for a company growing at a steady 30% CAGR for many years.  These estimates will likely come down with the retreating oil price, but the current $90 trading level for WTI certainly does not justify the fall in price over the past few weeks.  The declines are only rational if we believe the price will continue to fall, which unfortunately I do.

I find myself conflicted.  

The E&P companies I now own shares of, EOG and WLL, have both had phenomenal execution, and now trade at very low multiples.  On the other hand I have no confidence at all in the oil price.    But for now I am still resolved to hold these through earnings season. 

As a bit of an aside- on Thursday I also bought American Airlines stock amid panic selling that some attributed to the Ebola case in Texas.  In general, airlines have an inverse correlation with oil because fuel cost is over 30% of operating costs in a very thin margin business.  But this is only part of the reason I’ve bought AAL.  Along with E&P stocks, airlines are also extremely high beta, so they can become correlated with energy in the context of a general risk-off situation.  Airlines have also been selling off since July, and they tend to be extremely seasonal.  You never want to own shares in July and August, and they usually do very well in October through December.  Part of this may be because wall street tends to go on vacation in August, and it is hard to enjoy a vacation when you are holding airline shares.  The other reason to own them is that they are trading at 5.5x next year’s earnings estimates.  They might get to put a huge tax asset back on the balance sheet later this year.  I just mention this in passing, as I mentioned my CF fertilizer position earlier (which has not changed), because it is a trade that is energy related.

Saudi price cuts- the sell off continues

Saudi's sent a strong signal to the market by cutting their prices today.  An OPEC supply cut could make prices rebound strongly, but their meeting isn't until November 15.

Both US Crude and Gasoline inventories declined in the EIA report from yesterday but this has failed to slow the collapse in prices.  This is being compounded by the general market selloff and the failure of ECB to come to the rescue with QE.


Besides the shocking declines in the E&P stocks I would also call attention to the drill ships.  Both low and high quality drill ship companies are selling off as badly as the E&Ps or worse.  Transocean is down by over a third since its July peak.
 

Always volatile low-quality drill ship company Transocean (of BP-Horizon fame) is now selling at 1/2 book value.

 Higher quality Ensco is also dropping like a rock.

Schlumberger, the premium oil-service name has held up quite well, off only about 10% so far.

The oil majors have also pulled back by 10-20% off the highs.

I'm considering selling EOG, which is off by about 7% since I bought it only in August.  This would leave me with only WLL left.

With an OPEC rescue off the table for a little while at least, and inventory declines doing nothing to arrest the strong downward trend in prices, one last hope could be a short term rebound in the dollar, which has been strengthening for months now.  Lack of QE in europe might lead to mean-reversion for the dollar, and a weakening dollar is always supportive of oil prices.  The dollar has strengthened from about $1.39 to the Euro in May to about $1.26 today, an incredibly big move.