Natural gas reserves may rapidly disappear (and later reappear)

Michael Giberson

At Toronto’s The Globe and Mail, Nathan Vanderklippe reported, “Low natural gas price casts doubt on ‘proven’ reserves.”

He explains how rapidly falling natural gas prices can cause reserves to disappear. And, by the way, with higher prices reserves can just as quickly reappear. It isn’t magic. But the nature of oil and gas reserves is not well understood, often not even within the energy policy community, so it is worth looking at this relationship between prices and reserves.

Frequently in public policy discussions of oil and gas, reserve amounts get talked about as if they are estimates of all of the remaining oil and gas that will be developed. Reserves are actually just estimates of the currently discovered petroleum resource that is technically recoverable using current technology and anticipated to be profitable to develop at expected prices.

It is the last part of the description – “anticipated to be profitable to develop at expected prices” – that may be responsible for the disappearance of natural gas reserves this Spring. As Vanderklippe discusses, prices expected for this year and the next few were somewhat higher last year while reserve reports were being prepared (in the $3.50 to $4 range). Looking at the same set of resources at today’s much lower price (current futures prices for May are just over $2 an mmBTU) and a perhaps sizable fraction of reserves reported last year may no longer be profitable to develop. And if some of today’s reserves are no longer profitable to develop, the natural gas is no longer countable as a reserve. Experts quoted in the article suggest drops of from 20 percent to 40 percent of proved reserves due to lower prices.

But of course the natural gas resource doesn’t disappear when the reserve numbers fall, the gas just gets reclassified into a sub-commercial category, “contingent resources.” When prices rise again (or the cost of developing resources falls), the natural gas resource can just as suddenly reappear as a reserve.

One other reserve definition note: the reserve numbers most frequently mentioned in policy reports and news articles are “proved reserves.” As described in the Petroleum Resources Management System, the industry standard reserves definitions, proved reserves are a  fairly conservative estimate of the discovered resource anticipated to be profitable to develop at expected prices. Nine times out of ten you actually expect to produce more than the proved reserve estimate.

(Note that Vanderklippe’s article refers to Canadian reserve reporting practices, in the United States the Securities and Exchange Commission determines reserve reporting requirements which may vary from Canadian practice.)

Can we count on cheap natural gas for decades to come?

Michael Giberson

The new U.S. gas triumphalists say the gas resource supply picture has changed, shale gas has saved us from importing lots of expensive LNG, we’ve got tons and tons of gas now and for years to come, and public policy ideas based on the idea of diminishing supplies of ever more costly gas need to be replaced.

Not so fast, a few analysts are saying. A few recent examples:

Both suggest, among other things, that gas may be cheap now but it won’t be cheap later, so don’t let your public policy (or your private long term investments) get hooked on cheap gas.

The Our Finite World piece is the less-sound of the two. It seems to add up to a claim that gas is so cheap that it doesn’t pay to invest in more production capacity, and if no one invests in more production capacity supplies will run down, and then gas will not be cheap anymore. So watch out! There are many informative charts in the post.

The Financial Times column essential comes down to a view that shale gas resources won’t yield as much gas as proponents believe, and ultimately the U.S. is going to find itself back on the tail end of a very expensive LNG supply chain. The story ends on an ominous note, suggesting that if we don’t hurry to line up LNG supply contracts now at twice the current price of gas in the U.S., then China might grab those supplies first.

I guess I’m still more in the gas triumphalist camp. My evidence is rather weak, admittedly: a combination of observing current market conditions (have you compared the price of gas to the price of oil lately?), reading about gas reserves and technology, some general understanding of economics, and a tendency toward “cornucopian” rather than “Malthusian” sentiments on long-run resource issues. (I can be convinced otherwise, but it will probably take a few years more of data from shale gas wells to make much a dent in my current beliefs.)

Does anyone care about oil and gas reserves reports included in year-end financial statements?

Michael Giberson

On December 23, 2008, I posted on “The forthcoming dramatic fall of reported oil reserves.” Now, as predicted, reports are showing up like this one from Warren Resources, Inc.:

Independent reserve engineers’ estimates of Warren’s proved oil and gas reserves as of December 31, 2008, were 129.3 Bcfe, compared to 356.4 Bcfe as of December 31, 2007, which represented a 64% decline. … This decrease in estimated proved reserves is largely due to the steep decline in year-end oil and gas prices.

(I don’t know anything in particular about Warren Resources, it just happened that they recently issued a news release with year-end results and it was readily found in a Google News search)

As the December 23 post noted, because SEC requirements required reserve estimates to be based upon single-day end-of-year prices, reserve estimates can be dramatically affected by price volatility. The Warren Resources post illustrates the point nicely.

SEC’s reserve reporting requirements were controversial, in part because they departed from industry standard approaches to reserve estimation. And, as mentioned in a December 30 follow up post, the SEC is changing its rules for reporting reserves. The SEC justifies revising their requirements “to help investors evaluate the value of their investments in these companies.”

But will the change help investors?

Richard Miller, a former president of the Society of Petroleum Evaluation Engineers (SPEE), addressed this question in a presentation at last year’s SPEE annual meeting. His article based on that presentation is contained in the new Journal of the Society of Petroleum Evaluation Engineers (pp. 32-39). He said:

Before expending time and effort to revise the SEC reserves reporting rules, perhaps it might be useful for the SEC, reporting companies, and energy company investors to consider this question:

Does the effort to report oil and gas reserves under the current or revised definitions provide information that is useful to investors? Put another way; is the oil and gas reserves information reported in SEC Form 10-K and 10-Q of real value to investors and, if so, what is the value of that information?

In short, Miller finds no support for the idea that the SEC-required reports are valuable to investors.

Miller takes two separate approaches to examine the issue. First he looks at whether stock prices and trading volumes appear to be affected by information announcements (both disclosures of SEC-required reserve reports, and other, more informal information releases). Second, he surveyed oil and gas industry analysis at major financial advisory firms. Neither approach suggested there was much value in the information.

His result is not too surprising. A number of energy industry companies devote significant effort to tracking petroleum reserves, constantly acquiring and digesting information more subtle and more substantial than that required by the SEC. By the time the official version of reserves estimates is issued it is old news. While it may be good for the SEC to revise its rules for other reasons, it won’t provide much in the way of “help to investors.”

UPDATE: The forthcoming dramatic fall of reported oil reserves

Michael Giberson

A week ago I wrote, “The forthcoming dramatic fall of reported oil reserves is due to falling prices and reporting requirements, not ‘peak oil’ or the manipulations of greedy industry executives.” However, as this Associated Press story reports, yesterday the Securities and Exchange Commission adopted proposed changes to reporting requirements that will have the effect of reducing the effects of price volatility on reserves reported.

An SEC press release is available, but as of Tuesday morning the full text of the new regulations were not available on the SEC website.

According to the AP article the new rules will:

  • Allow companies to use new technologies to determine proven oil and gas reserves provided the technologies have been shown to lead to reliable assessments.
  • Allow companies to disclose their probable and possible reserves to investors. Until now, SEC rules limited disclosure only to proved reserves.
  • Require companies to report oil and natural gas reserves using an average price based on the prior 12-month period rather than year-end prices.
  • Require companies to certify the independence of petroleum auditors that audit their assessments of reserves.

The third item is the key to reducing the effects of price volatility on officially reported reserves.

The effect of price volatility on reserves can be reduced, but not eliminated, because the price of oil is one factor that determines how much of the oil in the ground will likely be economically producible (cost of production being the other main factor).  A prior twelve-month average of prices is not necessarily the best estimate for a company to use in its own internal evaluation of expected reserves – the company may have reasons to believe it can do better in pulling oil from the ground (or will do worse) than the amount indicated by using the twelve-month average price. But for financial reporting purposes it is important to have a standard and not too volatile measure.