O&G - Production and Reserves Flashcards
How do we measure Production and Reserves?
For oil & gas it’s easy: everything is measured in barrels (1 barrel = 42 gallons) on the oil, natural gas liquids, synthetic oil, and bitumen side and everything is measured in thousand cubic feet for natural gas.
Yes, even in countries that use the metric system these units are still common though you may see slight variations elsewhere.
For mining, the situation is more complicated because there are so many different types of minerals – but common units are tons or tonnes (1 metric ton = 1,000 kg), ounces, and carats. Here’s a chart that summarizes the key units:
Oil, Natural Gas Liquids, Synthetic Oil
and Bitume > Thousands of Barrels (MBbls) > Millions of Barrels (MMBbls) or Billions of Barrels (BBbls)
Natural Gas > Millions of Cubic Feet (MMcf) > Billions of Cubic Feet (Bcf) or Trillions of Cubic Feet (Tcf)
How do you convert between different types of energy, such as oil, gas, and natural gas liquids? Why do we need to convert units in the first place?
You convert based on how much energy a barrel of oil (or natural gas liquids, or synthetic oil, and so on) produces and how much energy 1,000 cubic feet of natural gas produces.
Since 1 barrel of oil produces 5.8 million British Thermal Units of energy (5.8MMBtu) and 1,000 cubic feet of gas produces 1 MMBtu, you round the 5.8 to 6 and assume that:
- 1 Bbl of Oil = 6 Mcf of Natural Gas
- 1 MBbl of Oil = 6 MMcf of Natural Gas
- 1 MMBbl of Oil = 6 Bcf of Natural Gas
- 1 BBbl of Oil = 6 Tcf of Natural Gas
If you convert to oil units, you get Barrels of Oil Equivalent (BOE) and if you convert to gas units, you get Thousand Cubic Feet Equivalent (Mcfe).
It’s super-important to get this conversion right because you pick comps based on Proved Reserves and Daily Production – if one company’s reserves are in BOE and another’s are in Mcfe, they are not comparable and you need to convert everything to either BOE or Mcfe.
What are the different types of Reserves, and why do we care about them in a model?
The 3 main types of reserves are Proved, Probable, and Possible.
Proved Reserves have at least a 90% chance of being extracted, Probable is at least a 50% chance, and Possible is less than 50%.
In natural resource-lingo, 1P refers to the Proved Reserves, 2P is Proved + Probable, and 3P is Proved + Probable + Possible.
You can further divide Proved Reserves into Proved Developed and Proved Undeveloped, and then Proved Developed Producing and Proved Developed Non-Producing.
In finance you care mostly about the Proved Reserves because you use it as a valuation multiple (EV / Proved Reserves) and because you select comps based on Proved Reserves.
Proved Reserves are also one of the key inputs for the Net Asset Value (NAV) model and the operating model.
The other reserve types are less important, but if you wanted to be more aggressive you could use them as inputs to a NAV model and get a higher valuation since the 2P and 3P numbers are always higher than 1P.
Why can’t we just use Revenue and EBITDA to select comps? Is there a reason that metrics like Proved Reserves or Production are fundamentally better?
If you used revenue or EBITDA, the numbers would shift around too much because of changes in commodity prices. For example, if the price of oil suddenly fell by 50% then oil companies’ revenue would also fall by 50%.
So you’d have to constantly re-adjust the selection criteria based on commodity prices. That’s not practical, so you use Proved Reserves or Production to measure the “size” of companies instead.
What are the key metrics you can use to analyze Production and Reserves?
We listed a few of these key metrics in the previous section: the Oil Mix % (for O&G companies), the R / P Ratio or Reserve Life Ratio, and EBITDAX.
Several additional metrics you use:
- Production Costs per Unit: Annual Production Expense / Annual Production Volume
- Finding & Development (F&D) Costs – All Sources (per Unit): Net Reserve Additions / (Acquisition + Development + Exploration Expenses)
- Finding & Development (F&D) Costs – Excluding Purchases and Sales (per Unit): Net Reserve Additions Excluding Purchases and Sales / (Development + Exploration Expenses)
- Production Replacement Ratio – All Sources: Net Reserve Additions / Annual Production
- Production Replacement Ratio – Excluding Purchases and Sales: Net Reserve Additions Excluding Purchases and Sales / Annual Production
Most of these are straightforward – Production Expenses per Unit gives you a rough idea of the “cost of goods sold” on each unit of energy/minerals produced.
Finding & Development Costs indicate how expensive it is to acquire, find, and develop additional reserves. The one excluding purchases and sales tells you how expensive it is organically. Lower is better here – if the number exceeds the average realized price per unit of resources, the company’s profit won’t look so good.
The Production Replacement Ratio tells you how much of the company’s depleted reserves are replaced each year. If this falls below 100%, the company is in trouble.
This ratio is more of a concern for huge companies like Exxon Mobil that have genuine difficulty replacing more than 100% each year.
How do you move from Production and Reserves to a full 3-statement model for a company?
Most revenue and expense items are directly linked to Production, or to Revenue, which is in turn linked to Production. For Total Revenue you just multiply the Annual Production of each commodity by the Average Realized Price for each commodity and sum up everything.
On the expense side, normally you link Production, Sales Taxes, Transportation, DD&A, and Accretion of Asset Retirement Obligation to Annual Production; other expenses such as G&A, CapEx, and Exploration also generally follow Annual Production even if they’re not directly linked.
Once you have the revenue and expenses in place, it’s just a standard 3-statement model that links together as you would expect.
