If you've checked out any of the new reserve reports being released by oil and gas producers, you've probably noticed that the new SEC rules make comparisons to prior-year reports virtually meaningless. Fortunately for us, companies are explaining the effects in great detail and presenting their numbers both according to the old rules and the new rules. This exercise is revealing a lot of useful information for energy investors.
What's new, wildcat?
To review quickly, here are a few major changes in the rules, which went into effect on Jan. 1, 2010:
- Reserve calculations now use the average oil and gas price for the first day of each month of the prior year, instead of the year-end price. Of the 65 comment letters the SEC received from folks like Chevron (NYSE: CVX) and Apache (NYSE: APA) in response to the agency's proposals, the CFA Institute appears to be the only party to oppose the principle behind this popular measure, which is intended to smooth out volatility and seasonality effects.
- The definition of "oil and gas activities" now includes unconventional sources like bitumen from oil sands. This allowed Marathon Oil (NYSE: MRO) to add 603 million barrels of proved synthetic crude reserves in Canada (nearly 90% of total net reserve additions) to its ledger.
- Companies are permitted to disclose probable and possible reserves in SEC filings. A December 2009 Ernst & Young survey found that 83% of operators would not include these figures in their upcoming 10-Ks, however.
- Operators can book more proved undeveloped reserves (i.e. on planned future drilling sites in the vicinity of existing wells), as long as reliable technology exists to conclude that these locations are reasonably certain to be developed economically. Picture an X in the center of a tic-tac-toe board, representing the drilled location. All the O's you plunk down around it would be your proved undeveloped [PUD] locations. Range Resources (NYSE: RRC) has booked 1.2 PUD locations for every proved developed well in the Marcellus shale, while Petrohawk Energy (NYSE: HK) has booked Eagle Ford PUDs at a roughly 5:1 ratio.
- With certain exceptions, PUDs should only be recognized if there is a plan to develop them within five years of the original booking date.
And you thought Avatar had crazy effects
We looked at the impact of some of these rule changes on Petrohawk last week. The firm's PUD bookings exploded by 227%, leaving them to account for two-thirds of total proved reserves. As a result of drawing so many O's onto the tic-tac-toe board, finding costs were cut in half. Meanwhile, because Petrohawk's reserves are 98% natural gas, the firm's estimate of future cash flows (PV-10) was decimated by the low average annual price of $3.87 per million BTU.
In its press release, Petrohawk did a decent job of explaining the effects of the new SEC rules, but not a great one. For an exemplary report, check out Forest Oil (NYSE: FST), which clearly laid out the following effects on its reserves, in billions of cubic feet equivalent (Bcfe):
Addition (Reduction) to Reserves, in Bcfe
Average pricing vs. year-end pricing
More permissive PUD bookings
Five-year time limit on PUDs
Data from company press release.
The pricing impact to Forest's reserves equates to a 15% drop in proved reserves. Compared to a drop of 11% for Petrohawk and just 6% for Range Resources, this suggests that Forest's assets are a bit less robust at very low commodity prices. Still, you could do a lot worse.
Take this company, for example
As I argued last year, GMX Resources (NYSE: GMXR) has historically been aggressive with its reserve assumptions, and this fact was highlighted, double-underlined, and starred in last week's press release. The firm lost a big pile of reserves both to steeper production decline assumptions and to PUDs that got pulled. In total, proved reserves dropped 24% from last year.
By also using average prices instead of the $5.79 per million BTU year-end gas price, GMX had to drop 22% of its reserves from its report. What's more interesting is where those reserves drop off. Haynesville / Bossier PUDs get vaporized, while legacy Cotton Valley reserves (93% of the total) are virtually untouched. Considering that GMX dropped its Cotton Valley program in 2009 and isn't planning on picking it up again until 2011, are we really to believe that this play is impervious to price declines?
Of all the wacky reserve reports you're likely to see this year, I think this one will trump them all. And it has nothing to do with the new SEC rules, which in this case illuminated a lot more than they obscured.
Disclosure: Author does not have a position in any company mentioned.