Nonstandard reserves estimates lead to resource underestimation

James G. Ross
Gaffney, Cline & Associates Ltd.
Alton, U.K.

The U.S. practice, under Securities & Exchange Commission (SEC) rules, of publishing only proved reserves estimates, and the practice of under-emphasizing probable and possible estimates-for example by referring to them collectively as unproved-have led to a discrepancy between the reporting habits of the U.S. industry and much of the rest of the world.

Outside the U.S., increases in estimates of proved reserves for a specific asset are seen as merely a reflection of growing certainty with regard to the field and have no bearing on true reserves growth.

An increase in the proved reserves estimate for a field reflects merely decreasing uncertainty, while an increase in the proved plus probable estimate represents true reserves growth.

The practice, common in the U.S., of reporting only proved reserves results in underestimation of reserves and understatement of the true value of most companies.

Terminology

A recent Oil & Gas Journal article concluded that world reserves growth reflects both "a pattern of underestimation and the rewards of ever-advancing technology" (OGJ, Nov. 17, 1997, p. 49). The authors' frequent references to reserves, however, belie the fact that, throughout the article, they use only proved reserves figures. Although they clearly acknowledge this fact, it is symptomatic of a problem in the U.S. petroleum industry.

The term "reserves" often is treated as if it were synonymous with "proved reserves." This practice completely ignores the fact that any prudent operator also will have, internally at least, estimates of probable and possible reserves.

To avoid confusion, it is useful to define a few key terms when discussing reserves.

Reserves are, under most definitions, discovered, recoverable, commercial, and remaining. All reserves, not just those classified as proved, must fulfill these criteria. Thus, by definition, reserves are "remaining."

The generally accepted term for estimated total recoverable volumes-that is, reserves plus past production-is "ultimate recovery." This term will be used in this article to describe what are often called "initial reserves."

Discussions of reserves growth should reflect growth in ultimate recovery, because reserves will decline through production. Comparisons of reserves estimates, therefore, are not meaningful without compensating for this.

Somewhat more problematic are the definitions of risk and uncertainty.

Although a wide range of usages is seen for these terms, the authors define risk as the chance of failure or loss. It reflects an either/or situation in that only two outcomes are possible: success or failure.

The term "uncertainty" refers to a range of possible outcomes in an estimate-in other words, the potential error in the estimate.

In an undrilled exploration prospect, for example, there is a risk that the wildcat well will be unsuccessful-a dry hole. But there is uncertainty in the volume of recoverable hydrocarbons that may be present, should the well be successful.

The SEC's reserves definitions are unusual, in an international context, in that they cover only proved reserves. Most definitions in use around the world include the probable and possible categories, which together provide a basis for describing uncertainty. This is true for the widely used joint definition of the Society of Petroleum Engineers (SPE) and World Petroleum Congress (WPC), approved in March 1997.

Despite the wide usage and similarity of most definitions, two basic but different philosophies have emerged in their interpretation. One, largely reflecting North American practice, is based on risk; the other, common elsewhere in the world, is based on uncertainty.

An understanding of these two philosophies is useful in discussions of reserves growth.

Risk-based estimates

The risk-based assessment ap- proach reflects the extensive experience in the onshore U.S. environment.

Because of the way the industry has developed there, it focuses on individual well performance for reserves estimation and commonly bases estimates on a decline-curve analysis. Proved reserves, or at least proved developed reserves, are based on the decline-curve extrapolation of existing well production to some economic limit.

Continuing with this simplistic overview, proved undeveloped reserves are those in adjacent areas that are also reasonably certain to be recovered but require additional work, such as drilling more wells, to produce the hydrocarbon volumes. Probable reserves are, for example, extensions to the accumulation that are less certain than proved reserves but more likely than not to be recovered. Possible reserves are less likely to be recovered than probable reserves.

This incremental approach has led to the concept of "risked" reserves, in which probable reserves should not be added to proved reserves unless discounted for risk. A similar approach is applied to possible reserves.

Probable and possible estimates are treated as discrete volumes-that is, they are either there or they are not, hence the risk element. Because probable reserves are defined as "more likely than not" to be produced, however, one can expect that, on average, probable reserves will eventually be recovered in at least 50% of the fields for which they are identified.

It should be clear therefore that, by definition, the proved estimate is meant to provide a conservative estimate of ultimate recovery. Proved reserves should, more often than not, understate ultimate recovery.

It is interesting to note that, given the requirement under some definitions that probable and possible reserves must be discounted for risk before they can be summed, it is unclear how an equivalent upside, or optimistic, outcome may be established with this philosophy.

Uncertainty-based estimates

A fundamental difference between the onshore U.S. environment and many other provinces is the size of the average license area.

Because U.S. landowners generally have mineral rights, the property for which reserves are being estimated is frequently smaller than the total accumulation or field. In contrast elsewhere, it is more common for the field to be smaller than the license area, which is defined by the relevant government authority without particular reference to surface ownership rights, if any.

As a result, evaluation tends to be based on the entire accumulation, with an optimum field development program being the objective. This leads to the need to make, first, a best estimate of the ultimate recovery for the field and, second, an estimate of downside and upside cases to ensure that adequate flexibility is built into the development plan. Alternatively, further appraisal is undertaken to reduce the uncertainty before a commitment to develop is made.

It is standard industry practice in many parts of the world to equate this best estimate with proved plus probable, or unrisked, reserves. The downside case is defined, in accordance with relevant definitions, as proved, while the upside case is proved plus probable plus possible, again without being discounted for risk.

This philosophy has clear advantages over the risk-based approach. It is intrinsic to the probabilistic methodology used by many international companies but it also can be applied using a deterministic, three-outcome-scenario approach. Thus, the two methods are comparable, at least in theory.

Also, the uncertainty-based philosophy may be applied to any resource estimate, including undrilled prospects. Since the term "reserves" must not be used for undiscovered volumes, the proved, probable, and possible categories should not be applied either. In such cases, the terms "low estimate," "best estimate," and "high estimate" may be used.

These resource uncertainty categories can be correlated, as shown in the table [64,381 bytes] on p. 40. Note that the term "scenario method" is used rather than the more commonly applied term "deterministic method" because it is thought to better reflect actual practice.

Tracking uncertainty

The use of consistent definitions for resource uncertainty categories, based on the uncertainty philosophy, provides a powerful tool for tracking estimates of ultimate recovery (see chart [75,727 bytes], p. 39).

The theoretical relationship shown in the chart often is not seen in practice. This indicates a failure in the industry's ability to assess uncertainty correctly.

It is therefore possible to learn from this relationship. The theory is quite clear: More information-for example, production data-should lead to reduced uncertainty. Uncertainty is only zero when a field is abandoned.

It is evident from the chart that an increase in the low, or proved, estimate of ultimate recovery merely reflects decreasing uncertainty. And an increase in the best, or proved plus probable, estimate represents true reserves growth.

Conclusions

Interpreted sensibly and in the context of definitions for probable and possible reserves, proved reserves must represent a downside case for a field. Reporting proved reserves only, as is done under SEC regulations, will result in an understatement of the true value of most companies.

An increase in estimates of proved ultimate recovery over time does not constitute reserves growth; rather, it represents declining uncertainty. An increase in estimates of proved plus probable ultimate recovery does represent reserves growth.

Because the high and low estimates do not represent absolute minimum and maximum values (proved reserves are not guaranteed), the actual recovery can be expected to fall outside of this range occasionally, even when everything in the evaluation is done correctly.

It has been shown that this occurs roughly 10% of the time,1 which is what would be expected if the proved estimate has a probability of 90%.

In practice, what is shown in the decreasing uncertainty chart is representative of many cases: the best estimate declines during appraisal, as the field turns out to be more complicated than was assumed. The estimate then grows as more is learned through production performance and as improved technology is applied and efforts are focused on extending the field's life.

This is true reserves growth.

Reference

1. Capen, E.C., "A Consistent Probabilistic Definition of Reserves," SPE Reservoir Engineering, February 1996, p. 26.

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