DIFFERENT FISCAL SYSTEMS COMPLICATE RESERVE VALUES

Daniel Johnston
Daniel Johnston & Co. Inc.
Dallas

The value of hydrocarbon reserves (16381 bytes) in-the-ground varies dramatically worldwide because of the existence of numerous reserve categories and diverse fiscal systems.

For a company's survival in the petroleum industry, value replacement is more important than reserve replacement. But unfortunately, when it comes to international reserve values, nobody seems to speak the same language.

Discoveries are often measured in terms of gross recoverable reserves. But, reserve and financial transaction reporting differ widely.

TERM UNCERTAINTY

In the U.S. during 1994, $4.50/bbl was the average price paid for proved developed producing reserves. In other words, reserves in-the-ground were worth about $4.50/bbl. Unfortunately, some of the confusion begins right here.

Quoted U.S. reserve transaction values are based usually, but not always, on net-revenue-interest barrels. In fact, it is often impossible to determine from published sources whether working-interest barrels or net-revenue-interest barrels are quoted.

Some published U.S. reserve/production transaction data include working-interest barrels while others record net-revenue-interest barrels. Unless the terms are defined, uncertainty will exist.

The U.S. Security and Exchange Commission (SEC) 10-K reporting requires net-revenue-interest barrels. But unfortunately outside the U.S., this consistent treatment disappears. In fact, the net-revenue-interest concept is almost nonexistent in countries with contractual systems.

FISCAL SYSTEMS

Fig. 1 (72821 bytes) groups the world's petroleum fiscal systems.

• Under royalty/tax systems, oil companies take title to produced hydrocarbons at the wellhead and then pay the appropriate royalties and taxes. The royalties are paid either in cash or in kind.

• In contractual systems, oil companies receive a fee for exploration, development, and production operation services.

• With a production sharing contract (PSC), the fee is a share of production so that ultimately the oil company takes title to a share of hydrocarbons-usually at the point of export.

• Service or risk service agreements are similar to PSCs except the fee is in cash. The company does not take title to any hydrocarbons. This fact creates the confusion: How can a company book reserves it does not own?

RESERVE CLASSIFICATION

Exploration and development economics focus on gross recoverable reserves and to a lesser extent on working-interest reserves. Other concepts have less meaning when discussing exploration and development field size, field-size threshold, deliverability, and facility requirements.

A company's value of reserves in-the-ground is often based on its gross recoverable reserves or working-interest share of reserves. However, depending on the fiscal system, both reserve reporting and liftings will be based on either net-revenue-interest barrels or contractor entitlement.

The definition of reserves "booked" under a royalty/tax and a production sharing system are shown in the definition box.

In a PSC, part of the entitlement is cost recovery that depends on oil prices. Therefore, as prices fluctuate, the entitlement can change dramatically.

For example if the oil price drops, the entitlement will increase. This is because the contractor's entitlement equals the contractor's share of profit oil plus cost recovery. This points out a key weakness of reporting entitlement reserves. One example of this is found in Maxus Energy Corp.'s 1991 Annual Report, p. 47, footnote b, that says:

"The 1990 and 1991 changes reflect the impact of crude oil price fluctuation on the barrels to which the company is entitled to under the Indonesian production sharing contracts. In 1990, the impact of increasing prices reduced reserves by 20.7 million bbl. But, decreasing prices in 1991 resulted in an increase of 25.6 million bbl."

The ownership relationship under the Indonesian PSC forced Maxus to book the reserve changes to which it was entitled.

In its 1993 annual report, Maxus increased its Indonesian reserves another 24.3 million bbl because of lower crude prices. This revision outstripped the company's 1993 Indonesian production of 22.8 million bbl.

This kind of revision sounds "crazy" but it is not deceptive. It is standard reserve reporting consistent with SEC disclosure requirements. Unfortunately, the value of this information is limited.

Santa Fe Energy also has interests in Indonesia. Its 1994 Annual Report, p. 59, says:

"Indonesian reserves represent an entitlement to gross reserves in accordance with a production sharing contract. These reserves include estimated quantities allocable to the company for recovery of operating costs as well as quantities related to the company's net equity share after cost recovery. Accordingly, these quantities are subject to fluctuations with an inverse relationship to oil price. If oil prices increase, the reserves attributable to the recovery of operating costs decline. Although this reduction would be offset partially by an increase in the net equity share, the overall effect is to reduce the reserves attributed to the company."

The difficulty of reporting reserves under a service agreement is illustrated by the reserves disclosure in Maxus Energy's 1993 Annual Report, p. 55, footnote c, on its interests in Venezuela and Ecuador, that says:

"Venezuelan reserves attributable to an operating service agreement under which all hydrocarbons are owned by the Venezuelan government have not been included."

However, Maxus does book reserves for its Ecuador risk service contract.

These examples highlight some weaknesses and inconsistencies in reserve disclosure despite the fact that the U.S. has some of the most extensive reporting requirements in the world.

RESERVE VALUES

Table 1 (17018 bytes) illustrates a company's reserve position in a field with 100 million bbl of recoverable reserves. Depending on the fiscal system, three different kinds of reserves exist in addition to working interest barrels.

Under a concessionary system 90 million bbl would be booked as net-revenue-interest barrels. Under a PSC a 64 million bbl entitlement would normally be booked because the company actually takes title to these reserves. If the same field were governed by a service agreement (such as Maxus Energy's service agreement in Venezuela) it is possible that no reserves would be booked.

Under different oil price assumptions, the entitlement would change but the net-revenue interest would probably remain the same.

Also, reserve values are significantly affected by a country's fiscal systems. The most characteristic feature of any fiscal system is contractor take, the percentage of profits to which the contractor is entitled. Government take is the complement of contractor take.

Contractor take impacts directly the value of reserves, as shown in Fig. 2.(48891 bytes) If there were reserve/production transactions in these countries as in the U.S., Fig. 2 (48891 bytes) shows how the reserve values would be distributed. The distribution is based on discounted cash flow analysis for a hypothetical 100 million bbl field in the later stages of production after capital costs have been recovered. Reserve values are subject to other factors, but Fig. 2 (48891 bytes) shows the effect of fiscal terms alone.

It is often pointed out that it can be unfair to characterize a country's fiscal system with a single-point comparison such as in Fig. 2.(48891 bytes) This is especially true for exploration economics but not so much for proved developed producing reserves. A key assumption in Fig. 2 (48891 bytes) is that there are no sunk costs associated with the reserves.

Sunk costs that will be recovered through cost recovery or are available as deductions have a significant impact, as shown in Fig. 3.(60801 bytes) Reserve values change from the time of discovery to the time at which most of the development capital has been recovered .

The range of values in Fig. 3 (60801 bytes) is based on a 100 million bbl field in a country with a 33% (world average) contractor take. Four separate cash flow projections were made beginning with the exploration perspective. Additional assumptions in the cash flow analysis are outlined in Table 2.(25090 bytes)

All values in Fig. 3 (60801 bytes) are unrisked. With appropriate risking, the values from both perspectives would be lower. However, as reserves are delineated, developed, and come on-stream, the risk diminishes.

From a contractor's perspective, the value of reserves in-the-ground is greatest at the time production starts because sunk costs have a positive impact on cash flow. From the government's perspective, reserves continue to increase in value as production progresses. The value to the government is the discounted cash flow from royalties, government share of production, and taxes.

STANDARDIZED MEASURE

Maxus Energy's 1993 Annual Report shows that it booked 180 million bbl of Indonesian oil reserves with another 13 million bbl of oil equivalent in gas and natural gas liquids (price equivalency). Of the 180 million bbl of Indonesian oil reserves, 90% are classed as proved developed, the remainder are proved undeveloped. The associated SEC value (standardized measure) discounted at 10% for these reserves is $335 million.

The SEC value/bbl is therefore $1.74/bbl of oil equivalent. Yet, some analysts have valued the reserves at $6.00/bbl or more. Values this high are nearly impossible in a country where the contractor's profit share is less than 15%.

Part of the confusion is because entitlement reserves are booked. Fortunately, there is sufficient information in the 10-K disclosures to estimate the actual working interest barrels if basic information about the production sharing contract is known.

Table 3 (14564 bytes) summarizes the standard measure disclosure for Maxus Energy's 1993 Indonesian reserves.

For the purpose of illustrating this method, it is assumed that all reserves are oil. Gas does make a difference but the contribution of gas and natural gas liquids is only 7%.

With an oil price of $17-00/bbl, the booked reserves equal 192.3 million bbl ($3,269 million/$17.00/bbl). Subtracting the development and production costs from future cash flows yields $1,011 million - the contractor's share of profit oil in dollars ($3,269 million - $2,258 million).

The contractor's pretax share of profit oil under some older contracts is 34.0909% and under newer ones is 28.8462%. Assuming that Maxus Energy's profit oil share is about 30%, the total profit oil is then about $3,373 million ($1,012 million/0.30).

The government's profit share then is equal to $2,361 million ($3,373 million - $1,012 million). Adding the government's total profit share to the equals $5,630 million, the total gross revenues from the working interest reserves.

Dividing this by $17.00/bbl yields total working interest reserves of 331 million bbl of oil equivalent. The entitlement reserves unsurprisingly amount to 58% of the working interest share of reserves.

The reported standard measure of $335 million yields a value of about $1.00/bbl for a working interest barrel (discounted at 10%). This is consistent with the nature of the fiscal system, and the unescalated oil price basis that the SEC requires.

The approach adds a layer of analytical insight to the exercise of evaluating a company's reserves. But, it requires a basic understanding of the fiscal system for the country in which the reserves are reported.

RESERVES DISCLOSURE

Reserve replacement analysis today is at best a proxy for value replacement. The SEC standardized measure is helpful information in some respects, but because reserves from production sharing systems are based upon entitlement, shareholders have little to refer to other than the SEC standardized measure.

With net-revenue barrels for U.S. properties and other similar countries, analysts and shareholders can at least audit and judge the veracity of the information. In many instances this is not the case with production sharing contracts and service agreements.

Furthermore, the question arises with service agreement reserves. What reserves are being booked? Will companies book the equivalent of working interest, net-revenue interest, or entitlement reserves?

Perhaps additional disclosure could be based on working-interest barrels plus basic information about the fiscal system associated with those reserves.

The virtue of working interest barrels is that they are subject primarily to engineering principles and will not change drastically with oil price changes. Working-interest reserves provide a common ground for nearly all parties concerned.

Knowing roughly what reserves are worth in different countries adds another dimension to the reserve replacement concept.

One company may discover 25 million bbl of Australian reserves and another 100 million bbl of Malaysian reserves. The company with the Australian reserves will very likely add more to their bottom line.

With the globalization of the industry we will ultimately see improvements and standardization in reserve reporting. The sooner the better.