Reserve report to corporate budget
Engineers provide the foundation if you know how to use it
By Allison Firestone
Reserve engineers and financial analysts do not always speak the same language. However, engineers for exploration and production (E&P) companies provide a great foundation for drafting a corporate budget, but you have to know how to use it.
Reserve engineers are often tasked with conducting an engineering study of hydrocarbon reserves to determine the future cash flows and value of oil and gas assets. This study produces a reserve report, which contains a discussion section and tabular data. The discussion section lists all relevant information used to determine the annual cash flows and discounted values, which are displayed in the tabular data section. Reserve reports are primarily used for SEC reporting purposes and to determine the value and borrowing capacity of an E&P company, but can also be used as the basis for a corporate budget. Depending on lending and reporting requirements, most companies are required to produce an annual reserve report, which can be either created or audited by an outside reserve engineering firm.
To create a reserve report, reserve engineers weigh the revenues and costs of extracting reserves in order to determine the company’s ability to maintain positive cash flows throughout the operation of each well. But how do the operating cash flows in a reserve report compare to the monthly revenues and expenses in a corporate budget or financial forecast? How can a financial analyst use this report to develop a corporate budget?
Here are four steps for creating a corporate budget based on a reserve report:
Step 1: Analyze and interpret the report
You do not need an engineering degree to read a reserve report. You do, however, need to understand where to look for key assumptions and information within the report to translate it into a corporate budget.
The objective of the reserve report is to determine the value of hydrocarbons, not the company. The monthly cash flows generated by a reserve database typically do not include certain key elements of a corporate budget such as overhead costs, insurance, hedging and other services. The reserve report does not account for these elements because they are not required to produce the reserves. A financial analyst must consider more than just the revenues and costs associated with production when developing a company’s budget.
A reserve report is created for a specific purpose, so the underlying assumptions will differ based on the standards used to develop the report. The reviewer should establish an understanding of the guidelines that were followed when the reserve report was created or audited under either SEC or SPEE (Society of Petroleum Evaluation Engineers) standards. Regardless of which standards are followed, the discussion section will note every assumption used to create the reserve report. The discussion section is just as critical as the values generated. SPEE suggests reserve engineers include the economic assumptions listed in Table 1 in the discussion section of the report. The financial analyst can use this section of the report to identify which costs need to be added to the cash flows from the reserve report and the level of independent verification performed of costs and pricing.
Step 2: Confirm assumptions are up to date
When creating a budget from the reserve report, the financial analyst must ensure the assumptions have not changed since the reserve report was created. Many assumptions are weighed to calculate cash flows such as future prices, the cost to operate and maintain current production, and the cost and timing of future drilling or abandonment. All of these assumptions are laid out in the discussion section of the report. While reserve engineers must consider the timing and cost of extraction when determining the economic value of production, these assumptions may not align with current prices or management strategy.
Pricing is a key assumption in every reserve report and E&P budget. The easiest way to determine monthly revenue and update pricing for the budget is to apply current prices to the monthly production listed in the reserve report. While E&P companies use index pricing, there is often a differential built in to the reserve database representing geographic location and quality adjustments. The financial analyst can determine the differential by comparing the prices displayed in the report to the price curve that was used. Applying the same differential to current index prices will determine budget revenue.
To ensure assumptions of revenue align, the financial analyst reviews production estimates in addition to pricing. Reserves are broken into multiple categories: Proved, Probable, Possible and Contingent. There are multiple categories of Proved reserves. This includes Proved Developed Producing, which are currently being produced and Proved Undeveloped, which still need to be drilled. The probability of successfully extracting the reserves diminishes with each category, so a percentage factor is often applied to each category to “risk” the production. The amount of risking can be determined based on historical performance or the expectation of management.
Another important assumption that can change frequently is management’s drilling plan. If the timing in the report does not align with the current plan, the drilling capex and operating cash flow streams must be updated to reflect the current and best assumption of timing. Depending on the magnitude of the change, it may be beneficial to draft a new reserve report from the database. Changes related to production and the economic viability of drilling are most accurately identified by reserve engineering software.
Step 3: Identify omitted costs
After ensuring the data in the reserve report aligns with current assumptions, it is important to identify revenue and costs outside the scope of the reserve report to confirm the corporate budget is accurate. As previously mentioned, there are costs included in the corporate budget that do not always appear in the reserve report. These costs include general and administrative expenses (G&A), land costs, interest and insurance.
It is crucial to review a company’s historical financials to determine G&A and other non-operating costs or non-producing service lines that need to be included in the budget. A review of the reserve report’s discussion is often conducted to determine the inclusion of non-recurring or maintenance costs that the company may incur. It is also necessary to identify if upcoming plugging and abandonment costs are included and the assumptions of netting salvage value to that cost.
Step 4: Compile supporting facts
A preliminary budget is developed after assumptions are confirmed and all costs and sources of revenue not listed in the reserve report are identified. The company’s historical lease operating statements (production month basis), financials and other available information are used to independently verify the accuracy of the budget.
According to SPEE guidelines, engineers must identify the sources of information and degree of independent verification. The financial analyst can assume the engineers utilized their expertise to accurately forecast the production curves, but the analyst must still apply professional skepticism when analyzing the pricing and costs included.
Important questions to consider when comparing the budget to historical and other projected data include:
- How do future projections relate to past performance?
- Has the company historically produced reserves that meet their reserve report estimates?
- Has the company historically achieved the pricing in the report compared to the index used?
- What is the probability of success for future drilling prospects?
- To what degree does management expect future performance to differ from historical performance?
The reserve report is an important tool when documenting a company’s reserves for acquisition, an SEC report, asset sale, and many other valuation purposes. An analyst can use the reserve report in a number of ways if he or she knows how to use the discussion section in connection with the cash flows. The reserve engineers offer their expertise to calculate the future production streams of the company’s reserves. Knowledge of how to read the report, isolate and change certain costs or revenues, incorporate other business expenses, and independently test the results enables a financial analyst to use a standard report as the basis for creating a corporate budget.
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Allison Firestone, Director
Dacarba LLC, Houston