The Moving Parts within a Natural Resource Company's Reserve Calculation
Many investors I talk with seem confused by a company's "reserve calculation" and the impact lower commodity prices have on total reserves and the related balance sheet, income statement and cash flow effects. I have discussed at length the natural gas market in my "Bullish Case for Natural Gas as a Transportation Fuel".
In the coming months several natural gas producers will need to write-down their assets (some companies already started in Q1 of 2012). This balance sheet, asset write-down is a direct result of lower natural gas prices and is an attempt to calculate the new asset value based on the current natural gas pricing reality. Companies like Chesapeake Energy (CHK), Devon Energy (DVN), Apache Corporation (APA), EOG Resources (EOG), EnCana Corporation (ECA), Range Resources (RRC) and many others will all be required to review their reserve calculation taking into account the new pricing reality, and make adjustments if required.
The chart below graphically illustrates the many different moving parts within this "reserve calculation".
Let us start with some generic definitions of the more significant items illustrated.
· Proven Reserves -are those reserves claimed to have a reasonable certainty of being recoverable under existing economic and political conditions, with existing technology.
· Probable Reserves -are based on geological and/or engineering data similar to that used in estimates of proven reserves, but technical, contractual, or regulatory uncertainties preclude such reserves being classified as proven.
· Possible Reserves -have a lesser chance of being recovered than probable reserves. Reasons for classifying reserves as possible include varying interpretations of geology, based on future (yet perfected) recovery methods.
Note: Many times statistics are used to differentiate between proven (at least 90% confidence interval), probable (at least 50% confidence interval) and possible (10% confidence interval).
· Economic -the current market price of the resource is high enough to generate a profit.
· Borderline Economic -the current market price of the resource is not high enough to generate a profit, but is high enough to cover variable costs.
· No Economic Value -the current market price does not cover fixed or variable costs to develop.
Moving parts of the reserve calculation
As you can see from the above illustration, reserves can move up and down the "economic" left side, based on factors like - lower/higher selling price or a lower/higher cost of production. Reserves can also move right to left and vice-versa, based on factors such as geological reports, new production methods and uncertainties.
Internal factors like professional judgments, statistical conclusions, and geological assessments combined with external factors like resource demand, political outlook and new technologies all come together to calculate a "reserve".
To say this calculation is "complicated" … Would be an understatement.
Why will the reserve revisions be downward?
The most important factor to a reserve calculation is PRICE. Natural gas prices are down about 50% over the last 12 months and about 30% since January. These are huge near-term declines. As you can see below from the companies' 10-Ks, they use a rolling 12-month average in their reserve calculations - an SEC requirement. As the above chart indicates a reserve could move from economic to border-line-economic to non-economic all as a result of price changes.
From CHK 10-K, Page 12 footnote (D)
Estimated future net revenue represents the estimated future gross revenue to be generated from the production of proved reserves, net of estimated production and future development costs, using prices and costs under existing economic conditions as of December 31, 2011. For the purpose of determining "prices", we used the unweighted arithmetic average of the prices on the first day of each month within the 12-month period ended December 31, 2011. The prices used in our reserve reports were $4.12 per mcf of natural gas
From APA 10-K, Page F-61
Future cash inflows as of December 31, 2011 and 2010 were calculated using an unweighted arithmetic average of oil and gas prices in effect on the first day of each month in the respective year, except where prices are defined by contractual arrangements. Operating costs, production and ad valorem taxes and future development costs are based on current costs with no escalation.
With current natural gas prices (see chart above), you can see prices are lower than $4.12 currently and a technical recovery beyond $3.30 - $3.50 looks unlikely. This pretty much guarantees the reserve calculations will change dramatically in the coming months as economic reserves become non-economic as a result of lower commodity prices.
Big headlines but no cash impact
The last time natural gas prices got clobbered many companies had to write down their reserves. The following is a quote from CHK Q1 of 2009 press release -
The results included $6.01 billion non-cash, after-tax impairment charge to first-quarter earnings, capturing a 36% drop in natural-gas futures since the end of the fourth quarter.
And from APA February 19, 2009 press release
APA today reported net income of $706 million or $2.09 per diluted common share for the year ended Dec. 31, 2008. Apache's results include $3.6-billion non-cash, after-tax reduction in the carrying value of its oil and gas properties stemming from significantly lower commodity prices at year-end 2008.
The numbers are just enormous.
The smart money already is aware of the reserve issue - but I guarantee the "dumb money press" will have monstrous-sized headlines about the reserve adjustments and impairment charges. Usually when the reserve adjustments make "front page news" you should be looking to buy - not sell (there are always exceptions). For the most part these are non-cash charges. The reserves are still in the ground - and are just waiting for a favorable pricing environment.
I will warn you that in some cases loan covenants are tied to things like asset values, income and total reserves. Large write-downs can sometimes create loan covenant problems (defaults), which can greatly affect equity prices.
It's time to get your "value buy" list ready as we are doing at RulingTheMarkets.com - just don't pull the trigger. Remember not every natural gas producer will survive the next 12-24 months - put money to work over time, do not be in a hurry to invest.
Disclaimer: This work is based on public filings, public events, interviews, corporate press releases, and what I have learned as financial journalists. It may contain errors and you shouldn't make any investment decision based solely on what you read here. It's your money and your responsibility.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.