This is the second 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].

In our first post, we discussed the purpose of a reserve report, why they are important, how they are prepared and what is contained in the report. In this post, we discuss two of the most important inputs that go into every reserve report: production and pricing and why it may be appropriate to make adjustments to these inputs for purposes of Fair Value or Fair Market Value.

What Is a Reserve Report?

To recap, 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.”
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 must also 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.

Production

In our first post, we summarized 12 significant assumptions made in a reserve report. Production is an important input that goes into every reserve report. Production revolves around the estimate of current and future oil and gas removed from the resource play. To organize the certainty of future production forecasts, the SEC requires the use of three categories: (1) Proved, (2) Probable, and (3) Possible. These categories have the following definition:

• Proved: An estimate that is reasonably certain. There must be at least a 90% probability that the actual quantities recovered will equal or exceed the estimate. Therefore, economic producibility: proved oil and gas reserves are those quantities which can be estimated with reasonable certainty to be economically producible from a given date forward from known reservoirs and under existing economic conditions, operating methods and government regulations. Economic producibility must be based on existing economic conditions.
• Probable: An estimate that is as likely as not to be achieved and when using a probabilistic method, there must be at least a 50% probability that the actual quantities recovered will equal or exceed the estimate.
• Possible: An estimate that might be achieved, but only under more favorable circumstances than are likely and, when using a probabilistic method, there must be at least a 10% probability that the actual quantities recovered will equal or exceed the estimate.

The production assumptions might be the most important assumption within the reserve calculation. Careful attention should be utilized in the estimation of future production. Use of a certified reserve engineer is highly encouraged for this assumption.

If the production and decline curves are prepared in an appropriate manner, no adjustment to this input is needed for Fair Value or Fair Market Value, unless hypothetical conditions are to be applied. In which case, adjustments need to be made for matching the valuation date with the production forecast date.

Pricing

Reserve reports allow for two types of pricing assumptions for the future estimate at which the minerals are assumed to be sold in the market place. The first SEC rule states (1) companies should use the average of the first day of the month price for the previous 12 months; therefore, an average of the previous year (historical pricing); and (2) the SEC also allows for use of contract prices if future production is contractually guaranteed at certain pricing. This type is forward-looking.

For the most part, reserve reports use historical prices in their analysis. This assumption should be challenged for possible replacement in Fair Value or Fair Market Value analysis.

In these types of situations, future expectation is appropriate to utilize in the reserve calculation. Therefore, a forward-looking price assumption, frequently called a “price deck,” should be considered.

Forward-looking price assumptions come in the form of futures contracts which are based on certain amounts of crude oil/natural gas delivered in certain future months. These types of futures contracts are traded daily on various exchanges^[3] and include contracts for delivery as far out as 60 months or longer in some instances.

Therefore, with the available information and forward-looking purpose of Fair Value and Fair Market Value analyses, strong consideration should be made to replace a historical price deck with a forward-contract price deck. Additionally, incorporation of differentials and local pricing should also be considered when using a price deck based on futures contracts.

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)

^[3] Chicago Mercantile Exchange, New York Mercantile Exchange, Intercontinental Exchange