Why aren't more U.S. companies replacing oil and gas reserves?

March 3, 1997
Jerry Paul Brashear The Brashear Group LLC Potomac, Md. Alan B. Becker Modern Energy Concepts Jefferson City, Mo. Michael L. Godec, Peter M. Crawford ICF Resources Inc. Fairfax, Va. Success in oil and gas exploration and production sounds deceptively simple: Produce and replace reserves so as to maximize the wealth of the company. Recent performance of the U.S. industry, however, demonstrates a tension between replacing reserves and maximizing profits.
Jerry Paul Brashear
The Brashear Group LLC
Potomac, Md.

Alan B. Becker
Modern Energy Concepts
Jefferson City, Mo.

Michael L. Godec, Peter M. Crawford
ICF Resources Inc.
Fairfax, Va.

Success in oil and gas exploration and production sounds deceptively simple: Produce and replace reserves so as to maximize the wealth of the company. Recent performance of the U.S. industry, however, demonstrates a tension between replacing reserves and maximizing profits.

For the 15 years ended in 1995, the U.S. industry replaced only 87% of the liquids (crude oil and natural gas liquids) and natural gas it produced.1 The 10 largest U.S.-based companies have replaced only 61% of their U.S. production the past 5 years but were substantially more profitable than the next largest 72 companies, per barrel of oil-equivalent (BOE).

In general, the smaller the company, the more of its production it replaced with new reserves but the lower its profitability per BOE. Wide variations in reserves replacement and profitability were noted among companies of all sizes.2

These results underscore the difficulties and complexity involved in developing optimal reserves replacement strategies. Companies may have vast numbers of potential reservoir and prospect options, each with varied technology and ownership alternatives, and subject to project-level and global risks. These options need to be defined and comprehensively assessed on a comparable basis for optimal strategic decisionmaking.

The complexity of data and options associated with this process necessitates simplification, such as suboptimizing by region or function (e.g., exploration versus development), narrowly searching for options, limiting technology choices, pro-active purchase options, or minimal risk or scenario assessments.

Such simplifications can reduce the quality of evaluation and planning for reserves replacement, but new analytical tools-models, databases, and approaches-have been devised to meet the difficulties in reserves replacement planning. To the extent they are applied, reserves replacement planning will be more comprehensive, systematic, responsive to risk, and subject to optimization. Such approaches can eliminate the apparent choice between full reserves replacement and profitability-to the greater success of a company and the industry.

This is the first of a three-part article. The first part reviews briefly the reserves replacement and E&P profitability of the larger U.S.-based oil and gas companies. The second considers the analytical difficulties and simplifications in more detail. The third part describes new analytical tools that can help overcome these constraints.

A review of U.S. reserves replacement

Reserves replacement is a critical requirement for companies that wish to remain in the E&P business.

Many companies, as policy, seek annually to replace their production, to add at least as much to the inventory of reserves as removed through production. Some try to grow by adding reserves faster than depleting them. Increasingly, however, others appear to be pursuing strategies that would maximize profits at the expense of reserves, essentially liquidating their assets as their total reserves decrease.

The oil and gas industry in the U.S. has been unable to replace the reserves it produced over the recent past. For the 15 years ending in 1995, reserves of liquids and natural gas have each declined by 18%-liquids from 36.5 billion to 29.8 billion bbl; natural gas from 202 tcf to 165 tcf.

Oil & Gas Journal Energy Database's Top Oil and Gas Company Benchmark Report 1991-1995 of the 100 largest publicly traded U.S.-based oil and gas companies was used to examine reserves replacement strategies and performance in detail. Collectively, the OGJ 100 own almost 60% of U.S. reserves. Of the 100, 82 were analyzed. (Twelve were omitted due to non-U.S. ownership or relative inactivity during the 5 year period, and six were omitted due to noncomparable reporting.)

Over the past 15 years, the 82 companies analyzed were considerably more successful, in terms of reserves replacement, than the industry as a whole, with average annual reserves replacement ratios of 97% each for liquids and gas. Over the last 5 years, however, the ratio for U.S. liquids fell sharply (to 69%) while the ratio for gas rose to 101%.

In fact, liquids reserve additions exceeded production only five times in the past 15 years, the last time in 1988 (Fig. 1 [35481 bytes]). Gas reserve additions exceeded production in only 8 years out of 15. The massive negative revisions reflect the write-down of Alaska North Slope (ANS) gas reserves (for lack of a market) by ARCO in 1985 and Exxon in 1987. (British Petroleum also took large negative revisions for this reason but is not included since it is not based in the U.S.)

The 82 companies analyzed pursued all reserves replacement strategies in the database definitions: Extensions and discoveries, improved recovery, and purchases added to reserves, while production and sales reduced reserves. Revisions (not always a strategy) both added and subtracted reserves. Table 1 [13423 bytes] summarizes these data for the 15 year period and the last 5 years.

Notable differences can be seen between liquids and gas. Extensions and discoveries-largely due to improved exploration, reservoir description, and drilling technologies-replaced almost twice as much gas production as oil production, while improved recovery made essentially all its contribution in oil, as would be expected. Purchases contributed significantly to both.

Sales of reserves increased sharply for both oil and gas, perhaps signaling strategic consolidations or high grading to core businesses or regions by some companies.

Revisions were important for both resources but declined over time for liquids while rising for gas, perhaps reflecting the lesser maturity of the U.S. natural gas resource base.

Replacement in 1991-95

The companies were divided into four groups, based on the size of their mean reserves over the 1991-1995 period, to examine the effects of company size on reserves replacement (Table 2 [18803 bytes]).

U.S. companies, as a group, had greater success in replacing reserves abroad than in the U.S. Excluding purchases, the 82 companies replaced only 81% of the U.S. reserves they produced (through revisions, extensions and discoveries, and improved recovery) and only 85% when including net purchases. By contrast, their non-U.S. reserve additions exceeded production by 26% without purchases and by 27% including them. Worldwide, the companies overall more than replaced their production by slight amount.

But this overall trend belies the notable differences that are revealed when the companies are compared according to relative size (Fig. 2 [15507 bytes]).

The largest companies, Group A, replaced only 71% of their U.S. production through revisions, improved recovery, and extensions and discoveries and sold some reserves for a net U.S. reserves replacement ratio of 61%. Abroad, they added 22% more than the amount they produced, and sold some of that for a worldwide net replacement ratio of 86%. These companies were the only group with sales greater than purchases, both foreign and domestic.

By comparison, all three groups of the smaller companies more than replaced their U.S. reserves. Internationally the three smaller groups also increased their reserves. All also purchased more than they sold. Worldwide all three groups of the smaller companies more than replaced their reserves and, in general, the smaller the company, the higher the reserves replacement ratio.

Just as differences are notable between groups, they are also significant within groups. For Group A, U.S. reserves replacement ratios (including net purchases) ranged from 22% for Shell to 97% for Exxon and 161% for Burlington Resources; for Group B, from negative ratios for Oryx and Mesa to 186% for Sonat and 240% for Apache; in Group C, from 4% for Fina to 183% for Trans-Texas and 383% for Parker and Parsley; and, in Group D, from negative ratios for Fortune and Triton to 855% for Lomak, 924% for Harcor Energy, and 1,142% for Harken Energy.

Replacement strategies

To examine reserves replacement strategies, the data are further broken down for the U.S. in Fig. 3 [16572 bytes]. The upper portion shows the aggregate 5-year average changes in reserves, as measured in billion barrels of oil equivalent (BBOE). The lower portion displays the same data, but divides the respective elements by production to yield the components of the reserves replacement ratio, expressed as percentages.

All four groups of companies employed all the reserves replacement strategies, but in different proportions and with different results. In absolute terms, the Group A companies both produced the most and generated the most new reserves. But this was the only group that did not fully replace the U.S. reserves it produced. This was also the only group of companies to sell more reserves than they purchased. Both of these trends suggest a strategic focusing on core businesses by this group of companies.

Examination of the other groups shows that, in general, the smaller they are, the larger their reserves replacement ratio, the less they rely on improved recovery and the more on purchases as the preferred means for replacement.

All groups utilize extensions and discoveries as the dominant reserves replacement approach, and all actively purchased and sold reserves. In aggregate, these 82 companies purchased 844 million bbl and sold 698 million bbl over the 5 years, with the difference of 146 million bbl coming from companies outside the 82, most of which were smaller independents.

Reinvestment trends

These results may reflect differences in corporate effort. Fig. 4 [11608 bytes] displays the U.S. plowback, or reinvestment ratios, of the respective groups for 1991-95. This is the proportion of net oil and gas revenues (oil and gas revenues less production costs) that is reinvested in generating reserves. The lower portion of the bar represents the sum of exploration and development expenditures (divided by net oil and gas revenues), while the total bar also includes expenditures for purchases.

For the 82 companies as a whole, the reinvestment ratio was 48% of net oil and gas revenue for exploration and development and another 16% for purchases of reserves, for a total of 64%.

The Group A companies reinvested 42 cents per dollar of net oil and gas revenues in exploration and development, with another 2 cents per dollar on purchases. For the other groups, the smaller the company, the higher its plowback ratio. The Group C companies invested more than they generated from oil and gas operations in total, a net increase in investment. Group D reinvested effectively dollar-per-dollar on exploration and development alone and an additional 86 cents per dollar for purchasing reserves.

These reinvestment rates are entirely consistent with the reserves replacement noted earlier: the greater the plowback, the higher the relative reserves replacement.

To examine the extent to which differences in costs affect reinvestment and reserves replacement, the 5-year mean cost of developing reserves is displayed in Fig. 5 [13885 bytes] for the four groups. The left bar in each set represents the mean cost per BOE of internal generation of reserves, i.e., expenditures for exploration and development divided by the reserves added through extensions and discoveries, improved recovery, and net positive revisions.

The middle bar is the mean cost/BOE of purchased reserves; the right bar is the weighted average cost/BOE. While there is some variation across groups (e.g., $4.68/ BOE for Group A companies internal reserves generation versus $5.53/BOE for the Group D companies or $3.86/BOE for Group D companies purchases versus $5.43/BOE for Group B companies purchases), the resulting range of worldwide reserves replacement costs is quite narrow-all fall within a 3.6% range of $4.81/BOE. All the groups would appear to spend about the same amount per barrel to replace in the U.S. reserves.

E&P profitability

If the strategies and results are so very different and the gross expenditures per unit of reserves added are so similar, the question emerges as to whether other factors, such as reorganizations, consolidations, improved operational efficiencies, etc., cause one strategy to result in greater profitability than the others.

The variable, results of operations, is a suitable indicator of profitability because it is conveniently reported for the U.S. and worldwide separately. Results of operations is defined as oil and gas revenues less the sum of production costs; exploration expenses; depreciation, depletion, and amortization; and income tax. Results of operations measure profitability excluding interest expense and corporate overhead, which can be allocated by various procedures.

While this measure fails to perfectly match income and expense over time, averaging across companies and years permits a reasonable indication of profitability.

For all 82 companies, the 5-year mean value of the results of operations was $1.91/BOE worldwide, $1.87/BOE in the U.S. and $1.99/BOE from non-U.S. operations. Group A companies are more profitable than the others by this measure and are, themselves, more profitable abroad than in the U.S. for a worldwide mean of more than $2.07/BOE (Fig. 6 [15261 bytes]). Perhaps this reflects their concentration on core assets and the shift to less mature non-U.S. resources.

Within this group the variation of the largest companies was also notable. Of the top ten companies, four had more profitable U.S. than non-U.S. operations. The high U.S. 5-year mean was $2.90/BOE by Amoco; the U.S. low, 88¢/BOE by Mobil. By contrast, the non-U.S. high was $2.92/BOE by Mobil; the low 31¢/BOE by ARCO. The worldwide high for the 5 years was $2.44/ BOE by Exxon, with Burlington Resources the low of this group at $1.49/BOE.

For the other three groups, U.S. activities were consistently more profitable than non-U.S. operations by this measure. For Group D, non-U.S. operations showed a loss for the 5 year mean. In the U.S., the larger companies (Groups A and B) seem notably more profitable, at $1.94/BOE and $2/BOE respectively, in contrast to $1.13/BOE and $1.25/BOE, respectively, for Groups C and D. (Differences in interest expense and corporate overhead, if course, could reduce these differentials.)

These financial results seem inconsistent with the finding that all groups (except Group D) were more successful in replacing reserves abroad than in the U.S. Perhaps the smaller companies will recognize greater profits in the future as current reserves replacement yields greater production and profitability.

As in Group A, each group was marked by wide variation: In Group B, Oryx was high at $2.95/BOE worldwide, while Mesa was low, at zero; Group C was bounded by Trans-Texas ($3.17/BOE) and Cabot (negative 78¢/BOE); and Group D's boundaries were Tesoro ($6.50/BOE) and Fortune (negative $11.50/BOE).

This review reveals a wide range of strategies being employed with an even wider range of results. It may suggest an unpleasant choice between long-term viability through reserves replacement and profit maximization. The time focus of this review, 1991-95, was, perhaps, an atypical period of flat, relatively low prices, which could have contributed to the appearance of this devils dilemma.

The review is unambiguous in pointing out, however, that replacing production with new reserves has become an increasingly difficult challenge-one that, in aggregate, has not been fully met in liquids and only barely met in gas, and has been met by some companies but not by others, perhaps by design.

Next: The second part of this article examines some of the difficulties associated with meeting this challenge, describes corporate coping strategies and the problems they introduce, and the third part suggests analytical approaches to overcome these problems.

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