22nd June 2016
This is the second of three articles originating with GCA's "The Impact of Lower Commodity Prices on the E&P Sector" event, held in May 2016 at the Royal Institution.
The Impact of Lower Commodity Prices on the E&P Sector – Company Reserves and Resources Reporting
The impact on the E&P industry of sustained low petroleum commodity prices can be significant. Obviously it would be expected that low commodity prices would impact a company’s reserves and resources which in turn would reflect on a company’s asset values.
Reserves and resources are widely reported through standardised classification systems which allows like for like comparison between different assets; internationally recognised systems include the Canadian COGEH, US’ SEC and international PRMS (Petroleum Resources Management System). Reserves and Resources can be classified according to specific project technical and commercial maturity criteria into Reserves, Contingent Resources and/or Prospective Resources.
We should remind ourselves of the requirements for the respective classification:
- Reserves: as per the PRMS/COGEH definition, (SEC definition is similar), must be Discovered, Recoverable, Remaining (as of the evaluation date) and Commercial, based on the development project(s) applied
- Contingent Resources: Development plan targets discovered volumes but is not (yet) commercial, they carry a commercial risk.
- Prospective Resources: Not yet discovered and carry both a commercial and technical (geological) risk.
Furthermore, Reserves and Resource estimates are used for numerous reasons, they are not only reported in a company’s annual financial statements required to comply with regulatory and governmental authorities, they are used for internal business decision making and externally by investors and lenders in support of raising public funding and project financing.
Therefore what does a fall in oil price mean to these estimates? In fact, dependent on the regulatory and fiscal regime, low commodity prices can either: reduce Reserves; have no effect on Reserves; or increase Reserves. But in all cases, lower commodity prices will reduce the value of the Reserves.
A specific asset can move from one resource classification to another during its lifecycle.
A project not yet on production but which reasonably meets all commercial criteria needed to be classified as Reserves can likely have Reserves allocated to it. In a low price environment, there may be delays or reduced scope. If the project goes ahead with a reduced scope, only those reserves that are commercial can remain classified as Reserves, with the remainder being reclassified as Contingent Resources. Delays in a project could force Reserves to Contingent Resources unless strong intent to develop remains and will be executed within a reasonable time, typically five years. If any project still goes ahead but is no longer economic, no Reserves can be allocated to it.
It is also worth noting that the economic limit for projects with a short life will be far more affected by the low prices than those with a long life. The economics of a project with a lifespan of greater than about 10 years may not be so affected as a project with a shorter remaining life.
Impact of Oil Price – A Theoretical Example in a Typical Tax Royalty Environment
As already mentioned above, commodity prices have a large impact on the classification of Reserves and Resources, as it is a key element in the economics and viability of a project. If a project is not economic then the recoverable Resources cannot be classified as Reserves.
For illustration purposes, consider a theoretical oil field that was initially discovered by an exploration well, the discovery well was tested and flowed oil. The Resources associated with the project were moved from Prospective Resources to Contingent Resources upon discovery. Following a detailed planning phase and relevant approvals being made, the Contingent Resources moved into the Reserves class based on a relatively high oil price (~$100/bbl) given the development had all necessary approvals and the project was commercial. The field then moved to production.
If the operator needs to re-estimate Reserves for the field today, they would have to use a lower oil price. As a result the volume of Reserves (by definition, must be remaining) is likely to be reduced (perhaps significantly) depending on the operating cost of the field (see Figure 1).
Figure 1: Economic Limit of a Typical Oil Asset
Based on a relatively high oil price when the field development was sanctioned, the economic limit was at 15 years (point at which revenue from sales of produced oil is less than the cost to operate the field). Based on the oil price in 2016, the economic limit is at 11 years in this example. A large part of this would be due to the revenue of oil sales being much less at the 2016 market value. It should be noted that this effect also depends on the CAPEX and OPEX; many operators are cutting costs wherever possible in order to extend field life and reduce the impact on Reserves reductions.
A company may choose to move part of the Resources associated with this project that were previously classified as Reserves under the higher oil price to Contingent Resources under the lower oil price based on economic viability. If the oil price were to rise again, then these Contingent Resources could be reclassified as Reserves.
Impact of Oil Price – A Theoretical Example in a Production Sharing Contract (PSC) Environment
For an asset in a Production Sharing Contract (PSC) or Technical Services Contract (TSC) environment a drop in the oil price can have a beneficial effect for the Oil Company’s (Contractor) Reserves.
Contractor revenue in such a contract comprises Cost Recovery and Profit Share which means that if the oil price is lower, more barrels are required to recover the same amount of costs. The Contractor Profit Share, however, will be reduced in a PSC, but this is usually outweighed by the increase in the Cost Recovery barrels entitlement. In the typical TSC, the Contractor Profit Share would be unaffected by a change in oil price, but Cost Recovery barrels would still result in increased Net Entitlement.
An example represented in Figure 2 shows the impact of an oil price drop from $100 to $50 for a field with Gross Reserves of 100 MMBbls, costs of $1.1 Bn and a 15/85 profit share split.
Figure 2: Impact of Lower Oil Price in PSCs
From the theoretical examples above, it is clear that even though Reserves volumes can increase, decrease or stay the same, at a lower oil price, the overall fiscal value of the assets is eroded.
In a sustained low oil price environment, there is downward pressure on both CAPEX and OPEX also, which may soften the impact on potential Reserves changes and possibly mitigate the effect on economic field life in the Tax Royalty situation.
Therefore to conclude we can say that:
1) The effect of a lower Oil Price does not necessarily reduce the Reserves, but in all cases, it will reduce the Present Value of the Reserves
2) In PSC situations, a lower Oil Price can increase the Reserves yet the Present Value of the asset still decreases.
3) We should be diligent when assigning Contingent Resources and Reserves, particularly in a volatile pricing environment; e.g. we must ensure that all approvals are in place, the economics are robust and the company and any JV are truly committed to go ahead. It should be noted that the reporting system applied may also impact the reported Resources as they use differing pricing approaches.
4) Cost reductions can extend the field life and/or allow a project to be economic, by partially offsetting any lower oil price impact; therefore we should effectively consider cost expectations in cash flow estimates.
5) Remember that Reserves must be economic and if the economic evaluation indicates that the project is uneconomic, volumes must be classified as Contingent Resources
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