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Proven and Probable Reserves – A Primer
The Securities and Exchange Commission Industry Standard Guide 7 defines reserves as that part of a mineral deposit that could be economically and legally extracted and produced at the time of the reserve determination. “Economically” here means that the recent price of the mineral covers not only all costs of production but also would ensure a reasonable return on capital employed. The reserves must be producible with current technologies and methods. “Legally” means that the company has a legal right to work on the resource or has good reason to believe that permits to do so will be forthcoming at reasonable cost. Companies in most extractive industries publish annual estimates of their proven and probable reserves in their form 10-Ks filed with the SEC. The information is either in the notes to the financial statements or in a section in the business description.
While companies in most extractive industries give reserve information, the statistics are more important for companies that have few operations besides mineral extraction. These include “independent” oil and natural gas producers, such as Anadarko (APC), Apache (APA), and Pioneer (PXD); precious and base metal miners, such as Newmont (NEM) and Freeport-McMoran (FCX); and coal producers, such as Peabody (BTU) and CONSOL (CNX). Since the integrated oil companies, including Exxon Mobil (XOM - Free Exxon Stock Report), do much more than just produce oil and gas, reserve information is not as important to their valuations.
Oil and gas companies may publish three kinds of reserve estimates: proven, probable, and possible, though the latter category is rare, as it implies only about a 10% chance that the minerals are actually present. Reserves are “proven” by a combination of enough test wells and seismic surveys to indicate around a 90% probability that they exist; “probable” reserves are established by wider-spaced test wells and should have at least a 50% chance of being present. Oil and gas reserves are further divided into “proved developed” and “proved undeveloped”. The former are currently being extracted or can be produced with minimal capital outlays, while the latter would need extra investment and time to be accessed. The reserves information permits investors to calculate useful figures, such as reserve life (proven reserves divided by the most recent year’s output) and proven reserves per share of common stock.
Oil and gas producers also have to publish an annual estimate of future cash flows deriving from their proven reserves. This is called the Standardized Measure of Future Net Cash Flows; nicknamed the “PV10”. It is a forecast of the present value of future cash profits (before depreciation and depletion costs) from exploiting proven reserves, discounted at a rate of 10%. Beside acquisitions, discoveries, and production, the yearend figure includes an item called “Revisions of previous quantity estimates”, which reflects changing prices. For Anadarko, this number jumped from a positive $2.3 billion in 2009 to plus $5.4 billion in 2010 and constituted over half of the 2010 increase in APC’s PV10 figure.
In sum, proven and probable reserves, reserve life, and the PV10 estimate can suggest that an extractive industry stock is a bit over- or undervalued, mitigating irrational exuberance or pessimism that may be based on recent news.
At the time of this article’s writing, the author had a position in Exxon Mobil.