Estimating reserves from limited data is very challenging. Just because huge sums of money are involved doesn't mean that we can realistically from a technical and/or commercial perspective obtain the data to determine reserves with a high degree of accuracy.

Recently several companies have made major revisions to their reported reserves. To better understand the factors involved, I consulted my e-mail network.

Many people shared the sentiments of the expert who said, "Reserve estimates are guesses! Maybe educated guesses, but guesses none the less."

As a result, as another person warned, "No other issue in our profession is more controversial, political and involving of possible intrigue and collusion than reserves determinations."

Reserves reported in conformance with the SEC definitions are supposed to give investors information so that they can make informed decisions. "As far as Wall Street analysts are concerned, reserve replacement tells the Street something about a company's long-term health. Just replacing reserves means the company should be able to at least maintain its current production and earnings growth. Failing to replace reserves suggests to the Street that future earnings will be lower and company stock suffers."

The technical work involved in estimating reserves is dependent on professional judgment. As one engineer wrote, "Reservoirs are delineated by a couple of holes less than a foot in diameter, and the parameters from the core, if you get a core, are extrapolated to the entire humongous acreage."

A veteran analyst remarked, "You and I working independently with the same data and in good faith will probably not agree with each other's answer any closer than +/- 15% and more probably +/- 20 to 30%. And neither one of us would have added a fudge factor to the final answer to protect our job."

Another sage added, "There is a great deal of inherent uncertainty in the technical/engineering side of the calculations that go into reserve reporting, and although a lot of sound judgment goes into the process, it is possible to take advantage of this uncertainty and manipulate it for various purposes."

There are many reasons why technical folks are under pressure to skew reserves.

• "If asset teams are rewarded for reserve replacement or growth, they may compensate for less-than-successful investment programs by more optimistic assessment of their existing base. Conversely, if companies punish their management severely for downward revisions, initial bookings may be quite conservative and biased on the low side. Often these subtle biases are well within reasonable bounds of uncertainty and are easily rationalized with sound engineering, but are biased nevertheless."

• "If a buyer paid too high a price, he's going to pump up reserves to look good at least on a $/boe basis."

• "There are a number of projects that are marginal. No one wants to see their project die on the vine. There is pressure to make a project economic."

• "If a well drilling or recompletion project can be done relatively cheaply and a large productivity response is not needed, engineers working up the project might be very conservative in their reserve estimates."

• "I've experienced the pressure to provide a certain reserve figure to corporations trying to get bank loans when the facts said otherwise."

One person declared, "The fundamental problem is that investors do not understand uncertainty, the companies do not try to communicate it properly and the SEC provides a barrier between the two by not allowing full disclosure in direct contravention of its mandate."

The current SEC system of limiting official reserves reports to proven reserves combined with the intrinsic unknowns makes it just too tempting to select the most advantageous truth.

Eve Sprunt, evesprunt@aol.com, is an oil industry executive. Responses in quotes come from her broad network of contacts in the industry who respond to her e-mail surveys.

Comments