Friday, 13 March 2015

Reserves - better not blink or they could be gone

By Ian McLelland

In a week of carnage among the UK listed E&P mid-caps, one of the more puzzling big fallers is Soco International. At the time of writing the stock is down nearly 40% from the start of the week as investors get to grips with a spectacular drop in 2P reserves, from 130mmboe to 41mmboe. However, this reeks of a potential over-reaction and a lack of understanding among much of the analyst community as to what reserves actually mean. We therefore think it is worth considering in this post what companies and independents auditors actually mean by the simple words “reserves”.

Reserves Definition
Although there are variations by jurisdiction, most reserves auditors follow or align their codes with the industry standard of the “Petroleum Resources Management System” as laid out by the Society of Petroleum Engineers (SPE). Anyone with even a passing interest in the E&P sector should bookmark both the guidelines and the PRMS on their web browser using the links below:

In here there are some magic words about what defines “reserves” over the other industry standards or contingent and prospective resources. The golden rules to define reserves (taken from 2.1.2 of the PRMS) are as follows:

·         “Evidence to support a reasonable timetable for development
·         A reasonable assessment of the future economics of such development projects meeting defined investment and operating criteria
·         A reasonable expectation that there will be a market for all or at least the expected sales quantities of production required to justify development
·         Evidence that the necessary production and transportation facilities are available or can be made available
·         Evidence that legal, contractual, environmental and other social and economic concerns will allow for the actual implementation of the recovery project being evaluated.”

Furthermore, there is a clause in there about internal and external approvals that is particularly relevant to Soco.
·         "There must be a reasonable expectation that all required internal and external approvals will be forthcoming, and there is evidence of firm intention to proceed with development within a reasonable time frame"

Implications for Soco

So what’s happening over at Soco? Like all companies Soco is assessing its options as it comes to grips with a different macro oil price and cost environment. At the same time, it's working through an optimised development plans to maximise recovery at its flagship TGT block in Vietnam - with its partners (PetroVietnam and PTTEP). This follows two years of work by ERC Equipoise to update reservoir models, work that continues to develop.

While none of this work necessarily points to a fundamental difference in understanding of the TGT reservoir where net 2P reserves were previously 117mmboe (including CNV), the fact that things are up for review and local partners are not yet aligned on development plans has triggered the criteria that has moved a large chunk of TGT out of reserves and into resources.

The oil is still there, the economics should remain sound (Soco quotes breakeven development economics of $55/bbl) – it’s just a case of recoverable oil (possibly temporarily) being moved out of the reserves categorisation. Soco’s TGT development plans for contingent resources (gross production for each of the reserves/ resources cases as below taken from 2014 results presentation) show the oil is still there.
Soco's TGT development plans for reserves/contingent resources
Source: Soco

Who else could be affected?
Investors are prone to treat reserves in a black and white manner when in fact their definition can often be far less clear. There are therefore investment opportunities for those who can anticipate reserves downgrades/upgrades due to any of the criteria above, even if there is little change in the underlying economics or development concept.

Where things get interesting is when considering operator and partner alignment for developments and how these can be affected by the current macro environment. Long term, we do not anticipate most reserves auditors to be changing economics for reserves classification – Canadian auditors generally use McDaniel & Associates price forecasts (McDaniel forecasts) and these indicated only a modest reduction of c $3-5/bbl in long range price outlook in its most recent forecasts (from January 2015 over 2014). We have plotted the last five quarters Brent outlooks from McDaniel to show how little long range forecasts are actually moving in the long term, even when short term prices are clearly well down.
McDaniel oil price forecasts over time
Source: MacDaniel

What investors need to ask though is - Are there are projects out there with evolving development plans, where reserves have been booked, funding is tight and/or where partners may not be in alignment over potential development plans? This could be the trigger to precipitate material downgrades in reserves, even if only temporarily.

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