Unproven reserves

What Are Unproven Reserves?

Unproven reserves are estimated quantities of hydrocarbons, such as crude oil and natural gas, that are not yet considered "proven" but are anticipated to be commercially recoverable from known accumulations through future development projects. These estimates fall under the broader category of energy finance and represent a spectrum of geological and engineering uncertainty. Unlike proved reserves, which have a high degree of certainty of recovery, unproven reserves require additional data, technological advancements, or changes in economic conditions to become commercially viable.

Within the oil and gas industry, unproven reserves are typically classified into two subcategories: probable reserves and possible reserves. Probable reserves have a higher likelihood of being recovered than possible reserves. The accurate assessment of these reserves is crucial for strategic planning, capital expenditures, and resource management within the energy sector.

History and Origin

The classification and estimation of petroleum resources have evolved significantly over time, driven by technological advancements and the need for standardized financial reporting. Early industry practices for reserve estimation were often less rigorous, leading to inconsistencies and, at times, overstatements. The need for a common language and methodology became evident as the oil and gas industry grew globally and public companies began reporting their reserves to investors.

A pivotal development in standardizing definitions was the creation of the Petroleum Resources Management System (PRMS) by the Society of Petroleum Engineers (SPE) in collaboration with other industry bodies. Initiated in the 1930s, international efforts to standardize petroleum resource definitions led to the SPE publishing reserves categories in 1987. The PRMS, issued in 2007 and subsequently updated, provides a comprehensive framework for classifying petroleum resources, including unproven reserves, based on their commerciality and the associated level of uncertainty. This framework has become a global standard, adopted widely by companies and regulatory bodies.⁵ In the United States, the Securities and Exchange Commission (SEC) also modernized its oil and gas reporting rules, effective January 1, 2010. These revisions aimed to align SEC disclosure requirements with current industry practices and technological changes, permitting, but not requiring, the disclosure of probable and possible reserves in SEC filings, provided they meet specific definitions largely consistent with the PRMS.⁴

Key Takeaways

• Unproven reserves represent estimated quantities of hydrocarbons that are not yet classified as "proven" due to lower certainty of commercial recovery.
• They are categorized as probable reserves (more likely to be recovered than possible) and possible reserves (less likely than probable).
• Estimation relies on geological and engineering data, but involves a greater degree of uncertainty and reliance on future conditions compared to proven reserves.
• Unproven reserves are critical for long-term strategic planning, resource management, and potential capital allocation for oil and gas companies.
• Industry standards like the SPE-PRMS and regulatory guidelines (e.g., SEC rules) provide frameworks for their classification and disclosure.

Interpreting Unproven Reserves

Interpreting unproven reserves involves understanding the inherent uncertainties and the conditional nature of their potential recovery. These reserves are not guaranteed, and their conversion to proved reserves depends on several factors, including successful exploration and development activities, sustained economic viability, technological advancements, and a supportive regulatory environment.

When evaluating an oil and gas company's portfolio, unproven reserves provide insight into its future growth potential and long-term resource base. Probable reserves are considered more prospective, often requiring less extensive further work or a lower improvement in economic conditions to become proven. Possible reserves, on the other hand, represent the outermost fringes of the resource base and are highly speculative. Investors and analysts use unproven reserve estimates, alongside proved reserves, to assess a company's total resource potential, but they apply significant discount factors due to the associated risk assessment. A company with substantial unproven reserves might indicate significant upside potential, but also carries higher geological and commercial risks compared to one heavily reliant on already proven fields.

Hypothetical Example

Consider "Horizon Energy," an oil and gas company operating in an emerging energy market. Horizon Energy has a block where initial exploration drilling and seismic data suggest a significant accumulation of natural gas.

Based on initial geological and engineering analysis:

• Proved Reserves: Horizon Energy has identified a portion of the gas field that can be developed immediately with existing technology and current market prices, yielding 500 billion cubic feet (Bcf) of proved reserves.
• Probable Reserves: Adjacent to the proved area, there's another section of the reservoir that, with additional infill drilling and a modest improvement in gas prices, is deemed to have a 50% chance of being commercially recoverable. Engineers estimate this section contains an additional 700 Bcf of probable reserves. The probability that the combined proved plus probable reserves (2P) will be recovered is at least 50%.
• Possible Reserves: Further out, on the flanks of the structure, geological models suggest an even larger volume, but its recoverability hinges on much higher gas prices, significant technological breakthroughs, and extensive future capital expenditures for new production infrastructure. This area is estimated to hold 1,000 Bcf of possible reserves, meaning there is at least a 10% probability that the sum of proved, probable, and possible reserves (3P) will be recovered.

In this scenario, while Horizon Energy has 500 Bcf of proved reserves, its unproven reserves (700 Bcf probable + 1,000 Bcf possible = 1,700 Bcf) indicate a much larger long-term potential, albeit with varying degrees of uncertainty and requiring future investment and favorable market conditions.

Practical Applications

Unproven reserves play a vital role across various aspects of the oil and gas industry, from strategic planning to financial analysis and regulatory oversight.

• Strategic Planning and Investment: Companies use unproven reserves to plan future exploration and development projects. These estimates guide decisions on where to allocate capital, identify potential new sources of hydrocarbons, and forecast long-term production profiles. While immediate investment decisions are often based on proved reserves, unproven categories inform long-range portfolio management and growth strategies.
• Asset Valuation: In financial markets, unproven reserves contribute to a company's overall valuation, though typically at a significant discount compared to proved reserves. Analysts often apply different valuation methodologies, such as discounted cash flow analysis, to different reserve categories, reflecting their varied risk profiles.
• Mergers and Acquisitions: During mergers and acquisitions, the assessment of a target company's unproven reserves is crucial. The potential for converting these into proved reserves can significantly influence the deal's terms and the perceived long-term value of the acquisition.
• Regulatory Disclosure: While regulatory bodies like the SEC primarily mandate disclosure of proved reserves for publicly traded companies, the option to disclose unproven reserves, provided they meet specific criteria, offers investors a more complete picture of a company's total resource base. The SEC's modernization of oil and gas reporting allows for such disclosures, aiming to provide a more comprehensive understanding for investors.³ This aligns with the aim of greater transparency in financial reporting within the energy markets.

Limitations and Criticisms

Despite their utility, unproven reserves come with significant limitations and criticisms, primarily stemming from their inherent uncertainty.

• Subjectivity and Uncertainty: Estimating unproven reserves involves a high degree of subjective judgment and relies on projections about future geological, technological, and economic conditions. This can lead to variability in estimates between different evaluators or over time. The process of reserve estimation is a challenge for the industry, often involving significant judgment and addressing inherent uncertainty and risk.²
• Risk of Non-Conversion: There is no guarantee that unproven reserves will ever be converted into proved reserves. Unforeseen geological complexities, sustained low commodity prices, changes in government regulations, or technological failures can render these reserves uneconomical or technically unrecoverable.
• Misleading Interpretations: If not properly understood or communicated, the reporting of large unproven reserves can potentially mislead investors into overestimating a company's near-term production capabilities or financial strength. The "unburnable carbon" concept, where some reported reserves may not be produced due to climate change goals, adds another layer of complexity to these estimates.¹
• Historical Overestimations: Historically, some companies have faced scrutiny for aggressive estimations or downward revisions of their reserves, leading to a lack of confidence in disclosures. Such incidents highlight the importance of robust internal controls and independent third-party audits in the reserve estimation process.

Unproven Reserves vs. Proven Reserves

The fundamental distinction between unproven reserves and proven reserves lies in the degree of certainty regarding their commercial recoverability.

While proven reserves represent the most reliable and immediate source of future production and revenue, unproven reserves provide a forward-looking perspective on a company's potential for long-term growth and resource management. Confusion can arise if stakeholders do not fully grasp the probabilistic nature of unproven reserves, treating them with the same certainty as proven reserves, which can lead to misjudgments in investment analysis.

FAQs

What is the difference between probable and possible reserves?

Probable reserves are unproven reserves that have at least a 50% probability that the quantities actually recovered will equal or exceed the sum of estimated proved plus probable reserves. Possible reserves have a lower probability, typically at least a 10% chance, that the quantities actually recovered will equal or exceed the sum of estimated proved plus probable plus possible reserves. They represent a higher level of geological and commercial uncertainty.

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

For companies reporting under U.S. SEC regulations, only proved reserves are typically reported in the primary financial statements. However, companies may disclose unproven reserves (probable and possible) as supplemental information in their regulatory filings, provided these estimates meet specific definitional and disclosure requirements. This helps provide a more complete picture of the company's total resource base for stakeholders and investors.

Why are unproven reserves important if they are not certain?

Unproven reserves are crucial for strategic planning, long-term resource management, and assessing a company's future growth potential. They guide exploration efforts, inform potential capital expenditures for future development, and provide a broader view of a company's assets beyond immediate production, influencing long-term valuation and investment decisions in the oil and gas industry.

How do commodity prices affect unproven reserves?

Commodity prices, such as the price of crude oil or natural gas, significantly impact the commercial viability of unproven reserves. If prices are high, reserves that were previously uneconomical to extract might become commercially recoverable, potentially leading to their reclassification as probable or even proved reserves. Conversely, sustained low prices can make certain unproven reserves less likely to be developed, or even lead to their reclassification to a lower category.