Why Reserve Reports Matter in Oil & Gas

Editor?s Note: Its the season for reading a steady stream of reserve reports released by oil and gas companies. Today I am sharing with you a piece written by my colleague Keith Schaefer that explains why investors should pay attention to reserve reports.

What do all oil and gas companies have in common?

At the end of each year ? On December 31st ? every oil and gas producer is required to file whats called a ?Reserve Report.?

In short, its a snapshot of the value of their inventory of oil and gas in the ground as of the last day of the year. Its intended to be an estimate of the remaining reserves the company expects to recover.

Now heres why the Reserve Report is so important ? and how it can impact a companys stock price:

Oil and gas companies produce away their main asset each year ?- reserves ? and have to replace them or eventually go out of business. It?s a fact of life. Valuations, debt lines and ultimately stock prices flow from this single piece of paper, which is how you figure out profitability.

Keep in mind, the oil and gas business is not about how fast you can get it out of the ground. Big IP rates can give a stock a quick pop, but the real money wants big reserves that they can rely on to provide LONG-TERM cash flow that provides funds for reinvestment.

Important point: The market will pay more for bigger, less profitable reserves than it will for smaller, highly profitable reserves.

This is important for a few reasons, but especially because it gives a glimpse into a company?s finding and development costs (or what the industry refers to as ?F&D.?

This measures a company?s ability to replace production at low cost. How good is management at finding oil or gas?? And how good are they at getting it out cheaply, so there?s lots of profit left for shareholders?

The reserve report is also the first clue into a key valuation tool called the Recycle Ratio ? which is profit per barrel (the industry calls this the ?netback?) divided by costs per barrel ? the F&D.

If you spend $20 to get a barrel of oil out of the ground, and get $60 profit for that barrel after all costs, then you are recycling your money 3:1 ? hence the name ?recycle ratio.?

The Recycle Ratio is only easy to find if you know where to look.? It?s usually in the middle of the quarterly financial document called the MD&A ? Management Discussion and Analysis.

Most junior producers in Canada are gas-weighted, so right now, there?s a lot to chew on. The release of year-end reserve reports will highlight the growing chasm between the oily haves and the gassy have-nots, especially considering the free-fall in natural gas prices.

Lower gas prices means that several gas-weighted juniors will see their reserves reduced.? Reserves by definition have to be economic at a certain gas price, and obviously reserves will be less with a lower gas price.

Another important point: Energy producers use a lot of debt, and the banks will lend them money against their assets ? their reserves.? Lower reserves will mean a lower credit line ? but what if their debt is already above their newly reduced credit line?

It?s like having the value of your home be worth less than the mortgage ? your asset value is less than your debt.? Then the bank forces you get enough collateral by selling assets or raising equity to pay down debt (which dilutes net asset value per share) or go out of business.

Because the reserves value is calculated at year-end, which just happens to be the coldest part of the winter heating season, the gas guys have been lucky the past couple years. But that was not the case for 2012? the going rate for gas at Dec. 31 was barely three bucks and change.

This only serves to highlight what a tough game the gas business has become. At the end of the day, abundant cheap supplies are definitely good for consumers, and probably the economy as a whole.

But for producers, it?s a tough way to make a living.

Some of the most gas-levered names in the business?are desperately trying to shift to oil prospects, and rightly so. The oil industry is a fashion industry for investors, after all. But it?s tough to turn on a dime and by the time the gas market breaks it might be too late to prevent these guys from being bought out ? cheap.

We say pay close attention, because these are the names that are going to be the prey for consolidators. Encana?s multi-billion dollar deal with PetroChina last year shows even dry gas assets still have substantial long-term value, but markets can stay irrational longer than you can stay solvent.

This is a nice way of saying that any gas-levered company operating in Western Canada is ripe for takeover, especially for deep pocketed majors with time ? and money ? on their side.

As always, timing is the key for investors trying to get ahead of a company sale/buy-out. Get it right and you could be looking at some attractive capital gains relative to (the newly reduced) net asset values when the predators start looking for some easy pickings. But beware. Jump in too early and you could be riding a slippery slope to the downside; wait too long and you could miss out all together.

But the first clue? The Reserve Report.

– Keith Schaefer
Publisher, the?Oil & Gas Investments Bulletin