Unproved reserves

Unproved Reserves

Unproved reserves represent estimated quantities of oil and natural gas that are less certain to be recovered than proved reserves. These estimations fall under the broader financial category of Resource valuation within the energy sector, playing a crucial role in a company's potential future outlook. While based on geological and engineering data, unproved reserves involve a higher degree of technical, contractual, economic, or regulatory uncertainty that prevents them from being classified as proved. These uncertainties are inherent in the complex process of Exploration and production within the energy industry.

History and Origin

The classification and reporting of petroleum reserves have evolved significantly over time, driven by the need for consistent and transparent disclosure to investors. Historically, reserve estimations were often less standardized, leading to inconsistencies across the Energy sector. A major milestone in modernizing these classifications occurred in 2008 when the U.S. Securities and Exchange Commission (SEC) revised its disclosure requirements for oil and gas companies. This update allowed, but did not mandate, the disclosure of probable and possible reserves, moving beyond the sole focus on proved reserves that had previously been in place⁵.

Concurrently, industry bodies like the Society of Petroleum Engineers (SPE) have played a pivotal role in establishing global standards. The SPE, in collaboration with other organizations such as the World Petroleum Council (WPC) and the American Association of Petroleum Geologists (AAPG), developed the Petroleum Resources Management System (PRMS). The PRMS provides a comprehensive framework and consistent definitions for classifying petroleum resources, including unproved reserves, which are further categorized into "probable" and "possible" based on decreasing levels of technical certainty⁴. These collaborative efforts aimed to provide a universal language for evaluating and reporting oil and gas quantities, enhancing clarity for investors and regulators alike.

Key Takeaways

Unproved reserves are estimated quantities of oil and gas with a lower certainty of recovery compared to proved reserves.
They are categorized into probable reserves and possible reserves, reflecting varying degrees of geological and engineering confidence.
These reserves are crucial for assessing a company's long-term growth potential and future Cash flow.
Estimation of unproved reserves involves significant judgment and is subject to technical, economic, and regulatory uncertainties.
Regulatory bodies like the SEC and industry standards such as the SPE-PRMS guide their classification and disclosure.

Interpreting Unproved Reserves

Interpreting unproved reserves requires an understanding of the inherent uncertainties associated with these estimates. Unlike proved reserves, which demonstrate reasonable certainty of economic producibility, unproved reserves carry a higher level of Risk assessment. They are typically categorized into:

Probable Reserves: These are unproved reserves that analysis of Geological data and engineering data suggests are more likely than not to be recoverable. This generally implies at least a 50% probability that the quantities actually recovered will equal or exceed the sum of estimated proved plus probable reserves.
Possible Reserves: These are unproved reserves that analysis suggests are less likely to be recoverable than probable reserves. They are based on less extensive data and involve higher risks. In probabilistic terms, there should be at least a 10% probability that the quantities recovered will equal or exceed the sum of estimated proved plus probable plus possible reserves.

Investors and analysts assess unproved reserves to gauge a company's future growth prospects, potential for reserve additions, and long-term Economic viability. However, it is important to recognize that their conversion into proved reserves is contingent on various factors, including future drilling success, commodity prices, and technological advancements.

Hypothetical Example

Consider "Horizon Energy Inc.," an oil and gas exploration company that has recently completed an initial exploratory well in a new geological formation. Based on the seismic data and core samples from this well, their geological and engineering team estimates that:

Proved Reserves: 50 million barrels of oil (highly certain based on existing well data and current economic conditions).
Probable Reserves (Unproved): An additional 30 million barrels, estimated to be recoverable from an adjacent, undrilled fault block that shows similar characteristics to the discovered area. There's a "more likely than not" chance these will be recovered if additional wells are drilled and prove successful.
Possible Reserves (Unproved): Another 20 million barrels from a deeper, less-explored zone within the same basin. The geological indicators are present, but there is less data, and recovery would depend on significant future Capital expenditure and favorable technological advancements.

Horizon Energy Inc. would report its 50 million barrels as proved reserves. The 30 million barrels of probable reserves and 20 million barrels of possible reserves would be disclosed as unproved reserves. While not immediately added to the company's "proved" inventory for standard Financial accounting and valuation models like Discounted cash flow, these unproved reserves signal potential future growth and are considered in strategic planning and long-term Investment decision making.

Practical Applications

Unproved reserves are integral to long-term strategic planning and capital allocation within the oil and gas industry. Companies utilize these estimates, particularly probable reserves, in their internal forecasting and business development strategies. While not typically included in a company's primary reported proved reserves for Regulatory reporting and financial statements in the same stringent manner as proved reserves, unproved reserves provide insight into potential future projects and resource expansion.

For instance, the U.S. Energy Information Administration (EIA) relies on various data, including company disclosures, to develop national and regional estimates of proved reserves. While the SEC primarily focuses on proved reserves for public company filings, the EIA also acknowledges the role of probable reserves in calculating taxes for companies owning or producing oil and gas, underscoring their relevance in broader government energy policy decisions³. The recognition of unproved reserves allows companies to showcase their full resource potential to stakeholders, even if the pathway to commerciality involves more uncertainty. Effective Asset valuation in the energy sector often involves considering the spectrum of reserves, including those unproved, to project future revenue streams and justify long-term investments in exploration and development.

Limitations and Criticisms

Despite their utility, unproved reserves come with significant limitations and are often a source of criticism due to their inherent uncertainty. The estimation process for unproved reserves involves a notable degree of judgment and reliance on assumptions about future economic conditions, technological advancements, and regulatory environments². This subjectivity can lead to variability in estimates across different companies or even within the same company over time, making direct comparisons challenging.

A primary critique is the potential for overestimation. Since unproved reserves are speculative, there is a risk that the actual quantities recovered may fall short of initial estimates. This can be influenced by fluctuating commodity prices, which can render previously economic unproved reserves uneconomic, or by unforeseen technical challenges during development. The lack of a fully standardized, uniform reserves estimation procedure across the entire industry, despite efforts by bodies like the SPE, means that methodologies can vary, compounding the uncertainty¹. For investors, relying heavily on unproved reserves for short-term valuation can be risky, as the conversion to proved status often requires substantial additional investment and is not guaranteed. Companies face challenges in accurately predicting the timelines and success rates for converting unproved reserves into producing assets, which can impact their long-term Depletion rates and overall profitability.

Unproved Reserves vs. Proved Reserves

The fundamental distinction between unproved reserves and Proved reserves lies in the level of certainty regarding their economic recoverability.

Proved Reserves are those quantities of oil and gas that, by analysis of geological and engineering data, can be estimated with reasonable certainty (typically a 90% or greater probability) to be economically producible from a given date forward, from known reservoirs, and under existing economic conditions, operating methods, and government regulations. These are the most reliable and are the primary focus of external financial reporting for publicly traded companies.

Unproved Reserves encompass those estimated quantities where the likelihood of extraction is less certain than for proved reserves. They are further subdivided into:

Probable Reserves: Have a higher probability of being recovered than possible reserves, but still lack the certainty of proved reserves (typically at least a 50% probability that the sum of proved plus probable will be recovered).
Possible Reserves: Have the lowest degree of certainty, based on less complete data and more speculative assumptions (typically at least a 10% probability that the sum of proved plus probable plus possible will be recovered).

While both categories are derived from geological and engineering assessments, unproved reserves often factor in assumptions about future economic conditions or technological advancements that are not considered for proved reserves. Proved reserves represent a company's current, high-confidence asset base, whereas unproved reserves represent future potential and opportunities for growth.

FAQs

What is the primary difference between proved and unproved reserves?

The main difference is the level of certainty of recovery. Proved reserves have a high degree of certainty (at least 90% probability) of being economically producible under current conditions, while unproved reserves (probable and possible) have lower certainty and may depend on future factors.

Why do companies estimate unproved reserves if they are uncertain?

Companies estimate unproved reserves for internal planning, to assess long-term growth potential, and to inform strategic Investment decision processes. While not as certain, they provide a valuable indication of future opportunities and asset potential beyond current proved quantities.

Are unproved reserves included in a company's financial statements?

Typically, only proved reserves are formally included in a company's primary financial statements for regulatory purposes, such as filings with the SEC. Unproved reserves may be disclosed in supplemental reports or footnotes, providing additional context for investors regarding a company's total resource base.

What factors can impact the conversion of unproved reserves to proved reserves?

The conversion of unproved reserves to proved reserves depends on several factors, including successful drilling results, favorable commodity prices, technological advancements that improve extraction efficiency, and obtaining necessary regulatory approvals. Changes in any of these areas can affect their eventual reclassification.

How do regulatory bodies view unproved reserves?

Regulatory bodies like the SEC provide guidelines for disclosing unproved reserves, allowing companies to provide this information to investors. However, they generally maintain stricter requirements for the reporting of proved reserves due to their higher certainty, ensuring a conservative and reliable basis for financial disclosures.