This is the first of multiple posts discussing the most important information contained in a reserve report, the assumptions used to create it, and what factors should be changed to arrive at Fair Value^[1] or Fair Market Value^[2].

Why Is a Reserve Report Important?

A reserve report is a fascinating disclosure of information. This is, in part, because the disclosures reveal the strategies and financial confidence an E&P company believes about itself in the near future. Strategies include capital budgeting decisions, future investment decisions, and cash flow expectations.

For investors, these disclosures assist in comparing projects across different reserve plays and perhaps where the economics are better for returns on investment than others.

However, not all the information in a reserve report is forward-looking, nor is it representative of Fair Value  or Fair Market Value. For a public company, disclosures are made under a certain set of reporting parameters to promote comparability across different reserve reports. Disclosures do not take into account certain important future expectations that many investors would consider to estimate Fair Value or Fair Market Value.

What Is a Reserve Report?

Simply put, a reserve report is a reporting of remaining quantities of minerals which can be recoverable over a period of time. The current rules define these remaining quantities of mineral as reserves. The calculation of reserves can be very subjective, therefore the SEC has provided, among these rules, the following definitions, rules and guidance for estimating oil and gas reserves:

1. Reserves are “the estimated remaining quantities of oil and gas and related substances anticipated to be economically producible;
2. The estimate is “as of a given date”; and
3. The reserve “is formed by application of development projects to known accumulations”. In other words, production must exist in or around the current project.
4. “In addition, there must exist, or there must be a reasonable expectation that there will exist, the legal right to produce or a revenue interest in the production of oil and gas”
5. There also must be “installed means of delivering oil and gas or related substances to market, and all permits and financing required to implement the project.”
6. Therefore, a reserve report details the information and assumptions used to calculate a company’s cash flow from specific projects which extract minerals from the ground and deliver to the market in a legal manner.

In short, for an E&P company, a reserve report is a project-specific forecast. If the project is large enough, it can, for all intents and purposes, become a company forecast.

What Is the Purpose of a Reserve Report?

Many companies create forecasts. Forecasts create an internal vision, a plan for the near future and a goal for employees to strive to obtain. Internal reserve reports are no different from forecasts in most respects, except they are focused on specific projects.

Externally, reserve reports are primarily done to satisfy disclosure requirements related to financial transactions. These would include capital financing, due diligence requirements, public disclosure requirements, etc.

Publicly traded companies generally hire an independent petroleum engineering firm to update their reserve reports each year and are generally included as part of an annual report. Like an audit report for GAAP financial statements, independent petroleum engineers provide certification reserve reports.

Investors can learn much about the outlook for the future production and development plans based upon the details contained in reserve reports. Remember, these reserve reports are project-specific forecasts. Forecasts are used to plan and encourage a company goal.

How Are Reserve Reports Prepared?

Reserve reports can be prepared many different ways. However, for the reports to be deemed certified, they must be prepared in a certain manner. Similar to generally accepted accounting principles (GAAP) for financial statements, the SEC has prepared reporting guidance for reserve reports with the intended purpose of providing “investors with a more meaningful and comprehensive understanding of oil and gas reserves, which should help investors evaluate the relative value of oil and gas companies.” Therefore, the purpose of SEC reporting guidelines is to assist with project comparability between oil and gas companies.

What Is in a Reserve Report?

Reserve reports contain the predictable and reasonably estimable revenue, expense, and capital investment factors that impact cash flow for a given project. This includes the following:

1. Current well production: Wells currently producing reserves.
2. Future well production: Wells that will be drilled and have a high degree of certainty that they will be producing within five years.
3. Working interest assumption: The ownership percentage the Company has within each well and project.
4. Royalty interest assumptions: The royalty interest paid to the land owner to produce on their property.
5. Five-year production plan: All the wells the Company plans to drill and have the financial capacity to drill in the next five years.
6. Production decline rates: The rate of decline in producing minerals as time passes. Minerals are a depleting asset when producing them and over time the production rate declines without reinvestment to stimulate more production. This is also known as a decline curve.
7. Mineral price deck: The price at which the minerals are assumed to be sold in the market place. SEC rules state companies should use the average of the first day of the month price for the previous 12 months. Essentially, reserve reports use historical prices to project future revenue.
8. Production taxes: Some states charge taxes for the production of minerals. The rates vary based on the state and county, as well as the type of mineral produced.
9. Operating expenses for the wells: This includes all expenses anticipated to operate the project. This does not include corporate overhead expenses. Generally, this is asset-specific operating expenses.
10. Capital expenditures: Cash that will be needed to fund new wells, stimulate or repair existing wells, infrastructure builds to move minerals to market and cost of plugging and abandoning wells that are not economical.
11. Pre-tax cash flow: After calculating the projected revenues and subtracting the projected expenses and capital expenditures, the result is a pre-tax cash flow, by year, for the project.
12. Present value factor: The annual pre-tax cash flows are then adjusted to present dollars through a present value calculation. The discount rate used in the calculation is 10%. This discount rate is an SEC rule, commonly known as PV 10.

The overall assumption in preparing a reserve report is that the company has the financial ability to execute the plan presented in the reserve report. They have the approval of company executives, they have secured the talent and capabilities to operate the project, and have the financial capacity to complete it. Without the existence of these expectations, a reserve report could not be certified by an independent reserve engineer.

A Plug for Mercer Capital

Mercer Capital has significant experience valuing assets and companies in the energy industry. Because drilling economics vary by region it is imperative that your valuation specialist understands the local economics faced by your E&P company.  Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

Endnotes

^[1] “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” – FASB Glossary

^[2] “The price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts” – U.S. Treasury regulations 26 C.F.R. sec. 20.2031-1(b)