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From Fossil To Fuel™
From Fossil To Fuel™

Episode 19 · 2 years ago

Episode 18 - Reserves

ABOUT THIS EPISODE

What are reserves and why are they so darn important?

My name is Brennan McDougal and I'm a professional engineer. Or the last decade I've worked in many different facets of the oil and gas industry. While I have a pretty solid technical background in oil and gas, I don't really know a whole lot about the other non technical departments that help run an oiling gas company. Recently I took a course to help develop my business acumen and better understand how the financial side of the business works. What a novel concept to educate the technical people on the business and financial side. I thought it would be a really cool idea to return the favor and educate the non technical people on the technical side. This is how the concept from fossil to fuel was born. Through these twenty four episodes, we will take a journey from how oil and gas was formed millions of years ago how it is refined into the fuel that runs our cars and keeps our homes. Come join me on this adventure as we learn how the oiling gas industry operates. From fossil to a...

...few reserves are something that are absolutely crucial to the value of every oil and gas company. And when I say value, of course I'm talking about the stock market for sure, but generally reserves are not well understood unless you're a savvy investor or tied to some technical aspect of the business. Reserves are the amount of oil and gas that a company estimates they are able to reliably and economically recover. Reserves are further broken down into classifications based on the probability that they can be recovered. Let's make up an example for this specific podcast and...

...we'll use this example throughout the whole thing to keep it consistent. So let's say you have an oil reservoir that has a total of a hundred cubic meters of oil. This includes the oil that you can recover as well as the oil that you can't. This hundred cubic meters is referred to as the oil in place. Because reservoirs aren't perfect and because recovery is limited by the technology that we currently have, only a fraction of this hundred cubic meters can actually possibly be produced with today's technology. Let's say that only forty cubic meters can possibly be recovered. That means that we have reserves of forty cubic meters and our recovery factor is forty percent. However, the hundred cubic meters that we used for oil and place is just an estimate, and the forty cubic meters...

...that we think we can recover is also an estimate. So naturally there's quite a bit of uncertainty in all of this. That's why, when we talk about reserves, we break them down into three classifications of certainty, possible, probable and proven. Proven reserves doesn't mean they're guaranteed, but rather a ninety percent confidence that they are. If you remember your high school probability, this ninety percent confidence is referred to as p ninety, meaning you'll be able to do it ninety percent of the time. Proven reserves are then further divided into proven, developed and proven undeveloped. Proven developed means that wells are already in place and producing and accessing these reserves. Proven undeveloped means you know the reserve reserves are there, but you still need to develop that area and drill wells...

...to access the reserves. Generally speaking, it's these proven developed and proven undeveloped reserves, known as one P reserves, that investors look at when evaluating companies in their stock and that's because these reserves are the ones that have the most certainty. Probable and possible reserves are subcategories of unproven reserves. Probable reserves have a fifty percent confidence, or p fifty probability. So when we add proven, or one P reserves and the probable reserves together, the sum is known as two P reserves. Possible reserves are the least likely and have a ten percent confidence, or P ten probability. So when we add all three together, proven, probable and possible, we get three P reserves. There are...

...other ways to classify reserves and there have been changes in amendments, but I'll stick with this for simplicity's sake. As oil and gases produced out of the ground, the reserves become more and more depleted, because reserves are based on what is left. In the previous example, we started off with forty cubic meters of reserves. Traditionally, when we quote reserves, it is two P reserves that we talk about, or the sum of the proven and probable reserves. We don't count possible reserves when quoting these numbers. So if, after the few years that we've started, say a couple of years, we've produced ten cubic meters of oil. That means that we only have thirty cubic meters of reserves left and less. Of course, we've discovered a new technology, like fracking, that has allowed us to increase our estimate of recoverable oil.

Put yourself in the frame of mind of a public oil company that is traded on the stock market. Reserves are important to you because they're important to your investors. Remember, reserves are a very strong indicator of the health or the future of your company. Because oil companies are constantly producing oil, it means that they're also constantly depleting their reserves, which means there's only one way to keep your reserves up. You need to find more. You need to replace them. Ideally, you're making new discoveries or acquiring new land to add reserves in order to make up for the ones you're losing as you're producing oil and gas. Investors will look at your reserve replacement ratio. If this ratio is greater than one, it means that you've added more reserves to your portfolio than you've lost by production or other means. If it's less than one, it...

...means that you weren't able to add enough new reserves to make up for your producing assets. Ultimately, it's an endless game of finding, adding or adjusting your reserves to make your company's portfolio attractive to investors and to ensure the future success and life line of the company. Finding new reserves is probably the hardest way to replace reserves because a lot of the oil and gas reservoirs have already been identified, so making a big find isn't as common nowadays. However, if you're able to find a new area that was previously unrecorded, you can now add those reserves to your books and substantially increase your proven reserves. Adding or acquiring reserves can be a lot easier if you've got money to spend. Land Wells and companies are always being bought, sold and traded. This is...

...another way to add reserves, because once you acquire land or wells, you also acquire the associated reserves. Your engineers will of course, have to verify how the reserves were estimated by the other company, and don't be surprised if they were a little bit over inflated to make the sale look a little more attractive. Another option is to adjust your reserve. A company is constantly reviewing and revising their reserves numbers. Sometimes we overestimate and sometimes we underestimate. Perhaps a new variable like technology or government regulations has come into play which will enable you to increase your initial estimate of proven reserves, and sometimes the opposite is true. Either way, preserved numbers are constantly changing, but they are a good indication of the state of the company's potential. So how our reserves calculated?...

Well, it's an extremely complex process that is impossible to explain in a matter of minutes and most companies will have their own kind of specialty recipe on how they do it. So, as usual, I'll try and simplify a few the key concepts. Think of the reservoir as a giant sponge. So sponge is composed of sponge material and a bunch of holes inside it. If we use that analogy to talk about reservoir and the rocks in the reservoir, in rocks these holes are called pores. Like water sits in the holes of the sponge in your kitchen, boiling gas sits in the pores of the Rock. If the volume of the reservoir that we're using from the example we've been talking about, the whole time here is a thousand cubic meters, and so...

...that includes the pores, the rock. That's everything's a thousand cubic meters, and the volume that just the rock occupies is nine hundred cubic meters. That means what is left over, or the hundred cubic meters, is purse or poor space. If these pores are all filled entirely with oil, then that means that the oil in place is a hundred cubic meters. So if we drill a well in this thousand cubic meter conventional reservoir, and we'll assume that the geology is the same across the reservoir, your best place to drill the well is right in the middle. There are many different ways to calculate reserves, like I talked about, but a simple example goes like this. If you drew a small circle right around the rock nearest to the well, that would be your p one reserves, if you drew a slightly bigger circle further...

...out, that would be your p two reserves, and if you drew an even bigger circle, everything in that biggest circle would be your pthree reserves. However, even the biggest circle won't cover all of the volume of the reservoir. So your pthree reserves will never, or almost will never, match the hundred cubic meters of oil in place that we have. This is why oil and gas companies have to drill more than one well. You can't just drill one well and drain all of the oil out of the reservoir. It'll only access a portion of the oil in place. So in order to keep producing oil and accessing more of your reserves, you need to drill more wells. You might have a situation where we now have reason to believe that some of the oil will be harder to get at, and so, as a result,...

...you have to shrink some of the circles around the well, which then lowers the volumes of reserves that were calculating. This is how you get from a thousand cubic meter reservoir to a hundred cubic meters of oil in place, to forty cubic meters of possible or pthree reserves, and perhaps only twenty cubic meters of that is proven reserves, which works out to only be two percent of the volume you started off with. There's a lot of uncertainty when talking about reserves, because everybody kind of has their own way of doing it and nobody is sure one hundred percent of what they actually can recover. So it becomes a bit of a game or strategy in terms of how you manage your reserves, because, remember, this is a really important number that investors are looking at and whether it's technology or regulations or just the daytoday operations, your...

...reserves are always going to be changing and so whatever number you're reporting for your reserves, generally you you want that number to at least stay the same or increase, because if, for whatever reason, you have to cut your reserves, that is going to be a bit of a PR nightmare with the investor, because nobody wants to see your reserves decrease because effectively, what you're saying is well, the lifeline or the future the company is in doubt because we're not able to resent replace the reserves that we're currently producing. At the end of the day, investors will always pay attention to how many reserves you have, but they should also be paying attention to how those reserves are calculated.

Hey, guys, if you like today's episode, make sure you subscribe to the podcast. Unlike most podcasts that release an episode every week or two, I did all twenty four at once, Netflix style, so you can listen to them all right now if you just hit subscribe. If you like today's episode, make sure you leave me a comment or thumbs up, or you can email me at from fossil to fuel at GMAILCOM, or look me up on Linkedin. I'm Brendan McDougall.

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