U.S. E&Ps’ dramatic strategic shift from prioritizing growth to focusing on cash flow generation and shareholder returns has resulted in more earnings-call talk about dividends and share buybacks and less discussion about efforts to replenish and build their proven oil and gas reserves — a critically important factor in establishing company value. The emphasis on financial results has largely masked a sizable increase in the costs E&Ps are incurring to organically replace their reserves and a significant decrease in the volumes replaced. In today’s RBN blog, we’ll analyze the weakening in reserve replacement metrics over the last two years, a trend that has led many producers to grow their reserves through M&A.
First, let’s define oil and gas reserves and review how they are reported by producers. As we explained in an earlier blog on reserve replacement, proved reserves are quantities of crude oil, natural gas and NGLs assumed to have at least a 90% chance of eventual recovery under existing economic and operating conditions. Oil and gas companies are mandated to report their proved reserves annually in their 10-Ks. The changes result from several factors:
- Extensions and discoveries, the most impactful, are reserves unlocked through the development of existing fields and successful exploration of new properties. These additions are funded by the company’s annual organic — or “finding and development” — capital spending. The level and effectiveness of this investment is critical to the long-term sustainability of an E&P.
- Revisions of previous estimates primarily result from changes in commodity prices — lower prices can make certain volumes uneconomic to produce, while higher realizations nudge volumes into the proved category. Poor well performance can also reduce estimates of future recoverable volumes from a field.
- Purchases and divestitures reflect the net result of M&A activity.
- Production volumes are subtracted from beginning-of-year reserves and current-year reserve additions to arrive at current year-end reserves.
Tracking total reserve replacement volumes on a year-by-year basis can be misleading. Since reserves are contingent on commodity prices to make eventual extraction economic, results can be badly skewed by years in which oil and gas realizations plummet or soar, leading to significant swings in the economic viability of reserves. For example, proven reserves for the 40-odd E&Ps we monitor fell by a staggering 8.9 billion barrels of oil equivalent (boe) in 2020 when the onset of the pandemic depressed commodity prices, then soared by 3.8 billion boe of positive revisions with the strong oil price recovery in 2021.
As a result, the key measures of the quality of a company’s acreage and the E&P’s long-term sustainability are the costs incurred in organically replacing reserves through extensions and discoveries — see the first bullet above. These include development activities, including drilling and completing wells, adding infrastructure such as roads and processing facilities, water handling and disposal, and other expenses. They also include exploration costs for finding new oil and gas reserves. What producers call the finding and development (F&D) replacement rate is calculated by dividing their total organic reserve additions by their total production. The reserve replacement costs are calculated by dividing the total development and exploration costs by the volume of reserve additions.
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