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Now that BPZ Energy (AMEX: BZP) has received the certified reserve report for its Corvina field, one can estimate forward-looking metrics for FD&A, recycle ratios, and capital efficiency.

As detailed below, BPZ's field-level recycle ratio for Corvina (oil only, 2P reserves, $100 WTI) is projected to be approximately 7.6x, or roughly triple the recent world average on a company-wide basis. In simple terms, this means an undiscounted, pre-tax cash return of more than seven dollars for each dollar of invested capital. As used worldwide in the upstream oil & gas industry, the recycle ratio (a non-GAAP metric) compares operating cash flows (also called field netbacks) to all-in FD&A (finding, development, and acquisition) costs. It is most commonly specified for a period of time (e.g., a year) for the company as a whole. As used here, it is the estimated undiscounted pre-tax operating cash flows from the production of Corvina's 2P oil reserves divided by the field FD&A to fully produce those reserves.

For a company operating as a going concern with multiple fields in various stages of development and production (as opposed to a company operating in blow-down production mode) the company-wide recycle ratio is a composite of field-level ratios, with similar trends over time as fields are developed, produced, etc., subject to inflation and escalation in costs and revenues (which can each go in either direction), discounting (which reduces the value of future cash flows relative to current cash flows), cash flow timing, and the ability of the company to replicate its performance at subsequent fields.

With the caveat that recycle ratios typically represent multiple fields for a specific period of time (rather than a specific field over time) a recent study of 13 U.S. companies by Calyon Securities showed a 2007 recycle ratio of 1.7x. (

For major Canadian oil & gas trusts, a recent presentation by Vermillion Energy Trust showed a three-year average ratio of 1.8x. ( [pdf file] (Slide 29).

Finally, a Bank of Montreal study showed a 2001-2006 worldwide average of about 2.5x, with relatively little variation from year to year. [pdf file] (Chart 8).

The rough similarity of these ratios across companies and countries over comparable time periods should be no surprise since capital seeks the highest risk-adjusted returns. Recycle ratios much above the world average may indicate unusually high oil & gas prices (which are invariably followed by increasing operating costs, increasing FD&A costs, and lower recycle ratios) or omit factors that neutralize the apparent high returns, e.g., very high income taxes or security or political risks. Recycle ratios much below these levels invariably lead to disinvestment and ultimately higher ratios. In only a very few cases – like Corvina - are unusually high returns associated with a world-class resource in terms of cost structure, net revenues, operating conditions, political stability, and so on.

At $100 WTI and expected production rates, BPZ estimates that the 1P oil reserves at Corvina will yield a recycle ratio of 11.6x. On a 2P basis, including full build-out of the second platform, the recycle ratio is estimated at 7.6x. ( (slide 16)

These ratios are the result of outstanding operating cash flows and exceptionally low FD&A. BPZ's cost structure at Corvina is very low. At $100 WTI, BPZ's total costs for lease operations, royalties, G&A, transportation, and a refiner quality discount are about $20/barrel, leaving $80/barrel of operating cash flow. (

With BPZ finally authorized to resume shipments to the refinery and WTI well above $100/barrel, BPZ will enjoy operating cash flows substantially in excess of $80/barrel. (

On the FD&A side, BPZ's costs are very low because Corvina is in shallow water, near the coast, and at easily accessible drilling depths with low-cost rigs. There are no hurricanes. The geology is well understood, the sands have high porosity, high permeability, natural aquifer drive, and high recovery rates. The refinery is less than 100 miles away by ship. Prior operators drilled the structures in the 1970s and 1980s and provided a large amount of valuable data and a functional platform, departing only when they found too much then-stranded gas and not enough oil at then-current world prices with then-current technologies. BPZ's proficiency at identifying where and how to drill and complete the wells as oil producers or dual producers and vast changes in world oil markets have transformed the economics of the field. Corvina capex to date is $124M for 18 million barrels of 1P oil reserves, or less than $7 per barrel. To develop and produce the 2P reserves, including full platform buildouts, BPZ expects to spend $400M for 38 million barrels, or less than $11 per barrel.

This exceptional capital efficiency is not an artifact of factors omitted from the simple ratio, e.g., extreme income taxes or high political or security risk. Peru is a stable, investment-grade country and corporate income taxes are below U.S. levels.

Of course, one of the essential elements of top-level capital efficiency is knowing where, when, and how to allocate capital and having an accurate expectation of what that capital will generate. Earlier this year, BPZ published internal estimates of 150 million barrels of original oil in place [OOIP] at Corvina (thus far). In May, BPZ received its first Corvina reserve report, establishing 147 million barrels of OOIP, thereby confirming the company's geologic models. ( [pdf file] (slide 6).

Later this year, BPZ will shift its drilling campaign to the second of its 50 mapped structures, the Albacora field. Albacora has similar geologic characteristics to Corvina, similar 1970s and 1980s drilling results (too much stranded gas, not enough oil at then-current prices and technologies), an existing and functional platform, existing wellbores (including one that tested at 5,000 b/d), and so on. It also has a higher grade of oil, eliminating Corvina's roughly $8/barrel refiner quality discount. Using the same methodology it used to accurately estimate Corvina's OOIP, BPZ estimates Albacora's OOIP at 540 million barrels – 3.6x more than Corvina. ( (slide 16).

BPZ's enterprise value is about $2.0B, against an oil-only Corvina PV10 of about $1B (1P), $1.5B (2P), and $1.9B (3P) based on $90/barrel WTI. In other words, BPZ is valued at more-or-less the value of the Corvina oil, with a little extra for high oil prices. Clearly, the Albacora field is not part of the valuation, let alone the additional fields in the Corvina complex or any of the other mapped structures. In short, and with the usual caveats about forward-looking statements and BPZ's ability to reproduce its Corvina results at Albacora and subsequent fields, this makes BPZ an extremely interesting long-term investment.

The recycle ratio measures capital efficiency at the field level. Metrics such as return on average capital employed and return on invested capital (also non-GAAP metrics) measure capital efficiency at the corporate level, e.g., typically comparing after-tax net corporate income (not field operating income) to capital invested in the company (not capital invested by the company).

The present analysis discusses the recycle ratio at Corvina as an oil producer only. Including gas, which is planned for pipeline sales in 2010, increases the recycle ratios. In very round numbers, BPZ estimates gas realizations starting in 2010 at about $13/boe. Assuming incremental costs for LOE, G&A, and royalties at about $3/boe (no refiner discounts, minimal incremental G&A or LOE, and less than $1/boe in incremental gas-related royalties), this leaves $10/boe of operating cash flow. Gas sales are forecast at 40,000 mcf/d, or about 6,700 boe/d. Assuming 8,000 b/d of oil sales and 6,700 boe/d of gas sales and operating cash flows of $80/bbl and $10/boe, respectively, the weighted-average operating cash flow is about $48/boe. Incremental gas-related FD&A at Corvina is likely to be near zero, as almost all production capex is already allocated to oil and any gas processing or transport capex will be part of the gas-to-power project, not the Corvina field. Adding the proven gas reserves to the oil reserves (for which the FD&A is already allocated) increases Corvina to 35MBoe from 18 MBbl (1P) and 75 Mboe from 38MBbl (2P). Field FD&A declines to about $3.50/boe (1P) and $5.30/boe (2P), with undiscounted recycle ratios increasing to about 13.7x (1P) and 9.0x (2P).

Disclosure: Long BZP

Source: Outstanding Capital Efficiency at BPZ Resources