It seems that the oil and gas industry is the favorite punching bag for many news outlets and the latest commodity price cycle has made the industry an easy target for a plethora of “I told you so” journalism.
Given that most of the individuals I know that work in the oil and gas industry are busy rolling up their sleeves, trying to figure out how they’re going to turn a profit in 2019, I thought I would take it upon myself to start a new blog series that examines some of the negative views expressed in the media about the industry.
The first article I have chosen to examine is a piece published by The Wall Street Journal on January 2, 2019, which can be found here. The article makes many bold claims including that the “practice of promoting [expected ultimate recoveries] became widespread after oil prices crashed in 2014 and producers, many in need of capital infusions from Wall Street, talked up their prospects.
Wall Street’s valuation of many shale companies, which had been closely tied to the value of their proven oil and gas reserves, began diverging.” To back-up their claims, the authors present a chart comparing publicly-traded reserve valuations against enterprise values from 2007 to 2017, the result being a growth in disparity from 1.7x in 2007 to 2.8x in 2017 and a conclusion that investors have been led astray by the industry’s propaganda.
In order to analyze the article, it is important to know some history about the SEC’s treatment of company reserves. On December 31, 2008, the SEC issued a final rule revising disclosure requirements relating to oil and gas reserves. The amendments were intended to modernize and update oil and gas disclosure requirements to align them with current industry practices and to adapt to changes in technology.
According to the SEC, these revisions were intended to provide investors with a more meaningful and comprehensive understanding of oil and gas reserves and to facilitate comparisons between companies. Critics of the rule, however, have argued that the SEC’s methodology may not accurately represent the fair market value of oil and gas reserves, particularly in light of the increasing significance of shale formations in U.S. energy supply since the rule was adopted.
Among other changes, the SEC Final Rule requires companies to estimate proved reserves using oil and natural gas prices based on the 12-month historical average of the beginning-of-month prices. Prior to the 2008 ruling, the SEC rules were less conservative and required that a single-day, fiscal year-end spot price be used to determine economic production and future cash flows of oil and gas reserves.
Turning to the article and applying this methodology, we know that the reserve numbers from 2007 would have used spot pricing from December 31, 2007 of $95.95 per barrel of oil and a less conservative methodology, which would have produced a much higher reserve valuation as compared to the reserve numbers from 2017, which would have used the 12-month historical NYMEX average for 2017 or SEC pricing of $51.34 per barrel of oil and a more conservative methodology.
Accordingly, the authors’ root cause analysis appears to be flawed as there are a number of reasons why the disparity in reserve report valuations and enterprise values grew significantly between 2007 and 2017 that don’t involve EUR projections including:
- Investors in 2007 believed that the methodology in reserve valuations more accurately reflected each company’s enterprise value while investors in 2017 believed the changes to reserve valuations resulting from the SEC’s Final Rule were too conservative.
- Investors in 2007 were less optimistic as to the market’s ability to sustain increased commodity prices while investors in 2017 were more confident that commodity prices would increase.
- Investors in 2007 were less confident in each company’s ability to continue to find and add reserves while investors in 2017 were more optimistic in each company’s ability to find and add reserves.
The authors of the article also cite Parsley Energy’s investor presentations from 2014 and 2015 claiming that the company overestimated its EURs in the Midland basin, increasing their projections from 690,000 barrels in 2014 to 1,050,000 barrels in 2015. The authors, however, failed to mention Parsley’s disclaimers in these same investor presentations which provide as follows:
“We may use the term “expected ultimate recoveries” (“EURs”) or other descriptions of volumes of reserves, which terms include quantities of oil and gas that may not meet the SEC’s definitions of proved, probable and possible reserves, and which the SEC's guidelines strictly prohibit Parsley from including in filings with the SEC. Unless otherwise stated in this presentation, such estimates have been prepared internally by our engineers and management without review by independent engineers. These estimates are by their nature more speculative than estimates of proved, probable and possible reserves and accordingly are subject to substantially greater risk of being actually realized, particularly in areas or zones where there has been limited or no drilling history. We include these estimates to demonstrate what we believe to be the potential for future drilling and production by the Company. Actual locations drilled and quantities that may be ultimately recovered from our properties will differ substantially.”
Improving the reliability of EUR calculations is a topic I will save for another day but I believe that the industry has done an excellent job of communicating the risks and uncertainties of EUR calculations to their investors, a fact that the authors fail to mention in their own cited EUR calculations.
Additionally, the figures cited by the authors were produced by Rystad Energy, a group that has produced controversial reports on both ends of the spectrum. As for the article’s grandstanding on the industry’s profitability, the shale revolution is still in its infancy and if history provides any indication, American ingenuity will always prevail.