29th July 2016
Before answering that question, are you sure you know what Reserves are? People have been arguing about that for decades, and have yet to reach complete agreement on a definition. Part of the problem is that estimates of Reserves and Resources are required for various different purposes, including company management, raising finance (either publicly or privately), national planning and more. Finding a single definition that is fit for all these purposes is not straightforward.
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Historically, reserves definition has been driven by North American practices, initially for Stock Exchange purposes by the United States Securities and Exchange Commission (SEC) and later also by the Society of Petroleum Engineers (SPE) and other professional societies, for broader application. Today, three main sets of standards defining Reserves and Resources are currently in common use internationally:
- The SPE Petroleum Resource Management System (SPE-PRMS), published in 2007 and supplemented by Application Guidelines in 2011, also endorsed by the WPC, APPG, SPEE and SEG, which has no regulatory authority but is widely recognized internationally and accepted by many Stock Exchanges including the LSE;
- The Canadian Oil and Gas Evaluation Handbook (COGEH), which is applicable to all companies listed on a Stock Exchange in Canada; and
- The SEC Rules, updated in 2009, which are applicable to all companies listed on a Stock Exchange in the USA.
The first two of these address all classes of Reserves and Resources, and are almost but not quite identical in terms of their definitions. The SEC Rules address Reserves only, with an emphasis on Proved Reserves, and use definitions that are similar to those of PRMS/COGEH but with some important differences.
In other parts of the world, notably the former Soviet Union and China, different systems have historically been used, while many oil producing countries, including Norway, Nigeria and India, use their own systems to keep track of the development of their domestic oil and gas resources. While there has been a move in recent years to harmonize all of these different systems, it is a slow process.
As defined by the SPE PRMS, Reserves are “… quantities of petroleum anticipated to be commercially recoverable by application of development projects to known accumulations from a given date forward under defined conditions.” Therefore, Reserves must be discovered (by drilling), recoverable (with current technology), remaining in the subsurface (at the effective date of the evaluation) and “commercial” based on the development project proposed.
Note that Reserves are associated with development projects. To be considered as “commercial”, there must be a firm intention to proceed with the project in a reasonable time frame (typically 5 years), and such intention must be based upon all of the following criteria:
- A reasonable assessment of the future economics of the development project meeting defined investment and operating criteria;
- A reasonable expectation that there will be a market for all or at least the expected sales quantities of production required to justify development;
- Evidence that the necessary production and transportation facilities are available or can be made available; and
- Evidence that legal, contractual, environmental and other social and economic concerns will allow for the actual implementation of the recovery project being evaluated.
Under the SPE PRMS, the generic term “resources” is used to describe all quantities of petroleum (recoverable and unrecoverable) naturally occurring on or within the Earth’s crust, discovered and undiscovered, plus those quantities already produced. Two specific classes of resources other than reserves are recognized:
- Contingent Resources: potentially recoverable volumes associated with a development plan that targets discovered volumes but is not (yet) commercial (as defined above); and
- Prospective Resources: potentially recoverable volumes associated with a development plan that targets as yet undiscovered volumes.
There is inherent uncertainty in the estimation of Reserves and Resources, simply because the oil and gas exists deep underground and the volumes present must be inferred from interpretation of data that are sparse, noisy and/or incomplete. During the life of a project, the uncertainty is likely to reduce, but the exact volume of Reserves associated with any particular project is not known until the time of final abandonment.
In recognition of this uncertainty, the framework used in the SPE PRMS to classify and categorize resources is a two-dimensional one, as shown in the following figure.
The vertical (classification) axis represents the project maturity. The life cycle of any oil or gas field starts with exploration. Geologists seek areas where oil and gas may exist and, on the basis of seismic and other data, may eventually drill an exploration well to see if any oil or gas can be found. At this stage, all potentially recoverable volumes are classified as Prospective Resources. If a discovery is made, the volumes potentially recoverable from that discovery are classified as Contingent Resources until a development plan has been defined and progressed to the point where it can be shown to be commercial, as defined above, at which point they would be reclassified as Reserves.
The horizontal (categorization) axis represents the uncertainty in the recoverable volumes associated with the project. At all stages of project maturity, this is captured by retaining low, best and high estimates, but it is only for Prospective Resources that those terms are explicitly used. For Reserves, the low estimate is referred to as the Proved (or 1P) Reserves, the best estimate as the Proved plus Probable (or 2P) Reserves and the high estimate as the Proved plus Probable plus Possible (or 3P) Reserves. By analogy, the low, best and high estimates of Contingent Resources are referred to as 1C, 2C and 3C estimates. In general, the range of uncertainty in recoverable volumes should decrease with increasing project maturity. Prospective Resources should have a much wider range of uncertainty than Reserves associated with a project that is on production.
Resources may be estimated deterministically or probabilistically. In a deterministic approach, the low, best and high estimates are derived from three defined scenarios, with the following levels of confidence:
- Low/1C/1P estimate: there should be reasonable certainty that volumes actually recovered will equal or exceed the estimate;
- Best/2C/2P estimate: there should be an equal likelihood of the actual volumes of petroleum being larger or smaller than the estimate; and
- High/3C/3P estimate: there is a low probability that the estimate will be exceeded.
In a probabilistic approach (usually based on a “Monte Carlo” simulation), the low, best and high estimates usually equate to the P90, P50 and P10 of the resulting probability distribution (subject to some specific additional constraints for Proved Reserves), i.e. there should be (at least) a 90%, 50% and 10% probability of the estimates being exceeded.
Commercial and economic considerations obviously play an important part in estimating Reserves. The final step in the calculations usually comprises two economice tests:
1. To determine whether the project being evaluated is economically attractive (on a forward basis): if it is not, then the project does not meet the test for commerciality and no Reserves may be attributed to it; and
2. The Economic Limit Test (ELT) to determine the economic limit for production, i.e. the production rate beyond which the net operating cash flows are negative; this is the point in time that defines the end of the project’s economic life.
Both of these clearly depend on the oil (and/or gas) price assumptions being used, amongst other factors. Reserves volumes do therefore depend on the oil price, as is discussed more fully in this separate article. Unlike the SEC, which requires companies to use specific commodity prices, any reasonable price forecast may be used when estimating Reserves under PRMS (or COGEH).
If a project meets all the criteria for commerciality, then the (gross) Reserves volumes associated with it are equal to the sum of the projected production from the effective date of the estimate until the economic limit (or the expiry of the production contract/license, if that is earlier and renewal is not reasonably certain) as illustrated in the figure below. Gross Reserves are 100% of the volumes estimated to be recovered by the project; the proportion that a company participating in the project is entitled to book depends on several factors, including the company’s percentage interest and the nature of the production contract. Further articles on this subject will follow.
Estimation of Reserves and Resources and preparation of reports involves a large number of people in the oil and gas industry. Most of the larger operators have dedicated reserves teams, as do some of the National Oil Companies. Smaller companies either compile Reserves and Resources reports themselves or outsource the work to consultants. In certain situations, including Stock Exchange listings and other transactions, an independent opinion from a third party is required (see our related article on the Competent Person's Report).
In conclusion, some of the important points to remember are that:
- Reserves and Resources are estimated rather than calculated: this is because there is inherent uncertainty in the estimation of subsurface volumes of oil and gas;
- The uncertainty generally decreases as a project becomes more mature, but the true reserve volume is never known until abandonment (when it is zero);
- Reserves and Resources are estimated for several different purposes and there are numerous different reporting standards (SEC, COGEH and PRMS being the most widely used internationally);
- Reserves must be discovered (by drilling), recoverable (with current technology), remaining in the subsurface (at the effective date) and “commercial”, based on the development project proposed;
- Contingent Resources are potentially recoverable volumes associated with a development plan that targets discovered (by drilling) volumes but is not (or not yet) “commercial”; and
- Prospective Resources are potentially recoverable volumes associated with a development plan that targets as yet undiscovered volumes.
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