Here are some ways to do it:
- Generally, a number of estimation methods are allowed: decline curve analysis (DCA), analogy, reservoir modelling, volumetric, pressure, or some combination of those methods, etc. You can cherry pick among those methods to choose the one that yields outlier numbers. The least time-consuming method is to use DCA, with Arps equations, with a high b-factor and with a low Dmin value.
- For DCA, you can use the analogy method for the underlying assumptions to “supplement” your wells’ production data with historical data that goes further back. Like #1, the optionality in methods allow you to cherry pick.
- You could use the analogy method on wells that have undergone significant capex/opex spending on enhanced oil recovery techniques. However, because you likely do not have access to those wells’ capex+opex figures, you could over/underestimate the economics of your own wells.
- In Canada, you are allowed to use commodity price forecasts that are well above the futures curve. (*Things were very different in the early 2000s.)
- You could book reserves for non-producing wells, e.g. wells that are shut-in and wells that were not completed due to poor economics. Theoretically, these wells could be NPV positive with higher commodity prices.
Now I’m not saying that any particular company is necessarily deflating or inflating its reserves. But these are all ways in which charlatans could potentially manipulate reserves.
Here are some places to get ideas from
#1 – Slide 19 (the last slide) of a Parsley Energy presentation.
#2 – Pages 9-14 of Chesapeake’s response to SEC inquiries about its reserve estimates.
The current situation in Canada is that 3 major firms handle almost all of the reserve estimates for publicly-traded companies. You can find the information about the companies’ reserve estimates in their Annual Information Forms, such as the commodity price forecasts used. The three firms are fairly close in their forecasts, though there are small differences.
Things weren’t always like this. In the early 2000s, Canadian companies would provide much greater technical disclosure in their technical reports. You would also find engineers using commodity price forecasts below the futures curve.
Who is responsible for reserve estimates?
Technically, “independent” reserve engineers are responsible for reserve estimates. However, there are practical problems that affect their independence:
- They rely on the publicly-traded company for economic data on the wells. A lot of their economic data does not come from an independent source.
- A publicly-traded company can shop around for optimistic engineers. Conversely, engineers may become more optimistic/pessimistic to generate future business, positive referrals, and a track record of optimistic/pessimistic estimates.
A SEC press release highlights some practices that could be problematic:
Knoxville-based Miller Energy paid $2.25 million and assumed certain liabilities to purchase the Alaska properties. It later reported them at a value of $480 million, according to the SEC’s Division of Enforcement. While accounting standards required the company to record the properties at “fair value,” then-CFO Paul W. Boyd allegedly relied on a reserve report that did not reflect fair value for the assets, and he also is alleged to have double-counted $110 million of fixed assets already included in the reserve report. The report by a petroleum engineering firm allegedly contained expense numbers that were knowingly understated by David M. Hall, the CEO of Miller Energy’s Alaska subsidiary and Miller Energy’s chief operating officer since July 2013. Hall, of Anchorage, Alaska, also is alleged to have altered a second report to make it appear as though it reflected an outside party’s estimate of value.
I haven’t been following the SEC case so I don’t know if the SEC’s allegations have been proven in court. The company is currently in the bankruptcy process. Miller Energy is a company I wrote about and was shorting in August 14, 2013. I guess my cynicism paid off.
Do I care about accurate reserve estimates?
In practice, I put minor importance on it on the short side. Reserve estimates don’t actually affect cash flow and don’t cause companies to go bankrupt. I care mainly about negative cash flow, which is the #1 cause of bankruptcy.
The reserve estimates can tell you something about the integrity of the people involved. However, if somebody is continually destroying shareholder value, their integrity does not necessarily matter to me. A lack of integrity (or a lot of it) will not cause a company to go bankrupt.
In some cases, integrity can be a great screen for stocks. People with low integrity are much more likely to create situations where money-bleeding businesses are overpriced, potentially creating great short positions. But for oil and gas stocks, I don’t put much time and effort into figuring out insiders’ integrity based on the reserve estimates (at least on the short side). I care about negative cash flow the most, then I care about integrity, and then I place little importance on the accuracy of reserve estimates.
*Disclosure: No current positions in the stocks mentioned, long or short.
**I may be wrong about what is and isn’t allowed. I just assume that current practices are allowed by the relevant rules and regulations.