Reserves reporting and disclosure

By the second week of February the forecasts, cash flows and classifications are complete, and Graham's firm has finished its audit. What remains is to explain the year in numbers: how the reserves changed from last year, why, at what cost, and what they are worth. Then the audit committee of the board will meet Graham, the board will approve the 10-K, and the company will file it with the reserves disclosures and the supplementary oil and gas information in its financial statements. Diane tells Ethan that the reconciliation is the part of the report that investors read most closely. “Anyone can publish a big number. The reconciliation shows whether last year's number was honest.” This lesson covers the reconciliation, the performance measures that come from it, and the disclosure required under the SEC rules.

The reserves reconciliation

A reconciliation, or roll-forward, explains the change in each reserves category between the start and end of the year. Each change is assigned to one cause. Production reduces reserves by the volume produced. Extensions and improved recovery add reserves from new drilling locations, from the extension of a pool's boundaries, and from improved recovery projects such as waterfloods. Discoveries add reserves in new pools. Technical revisions reflect new information about existing reserves, such as better or worse well performance. Economic factors reflect changes in price and cost forecasts. Acquisitions and dispositions record reserves bought and sold.

The categories matter because they say different things about the company. Additions from drilling show that capital is replacing production; revisions of previous estimates show whether earlier estimates were sound and how sensitive they are to price. The SEC rules and the accounting standard ASC 932 require a roll-forward of proved reserves, with categories including revisions of previous estimates, extensions and discoveries, improved recovery, purchases and sales of minerals in place, and production, and an explanation of significant changes.

# Year-end reserves reconciliation, reserve life, finding and development cost and the recycle ratio.
SI = False     # True: COGEH / NI 51-101 style, thousand m3 OE and Canadian dollars; False: SEC style, Mboe and US dollars
f = 1.0 if SI else 6.2898
u = "e3m3 OE" if SI else "Mboe"
# changes to proved (1P) and proved plus probable (2P), thousand m3 OE
items = [("opening (1 January)",         630,  960),
         ("extensions and improved recovery", 230, 420),
         ("technical revisions",          -45,   12),
         ("discoveries",                    0,    0),
         ("acquisitions",                  42,   58),
         ("dispositions",                   0,    0),
         ("economic factors",             -29,  -52),
         ("production",                  -168, -168)]
p1 = p2 = 0.0
print(f"{'':34s} {'1P':>8s} {'2P':>8s}  ({u})")
for name, a, b in items:
    p1 += a; p2 += b
    print(f"{name:34s} {a * f:8,.0f} {b * f:8,.0f}")
print(f"{'closing (31 December)':34s} {p1 * f:8,.0f} {p2 * f:8,.0f}")
prod = 168
print(f"reserve life index: 1P {p1 / prod:.1f} years, 2P {p2 / prod:.1f} years")
capital = 60.0 if SI else 67.0                  # exploration and development capital, millions
fdc_change = 12.0 if SI else 10.0               # change in future development capital, millions
adds_2p = 420 + 12 + 0 - 52                    # 2P additions excluding acquisitions, thousand m3 OE
unit_vol = 1e3 * (1 if SI else 6.2898)
fd = (capital + fdc_change) * 1e6 / (adds_2p * unit_vol)
netback = 255.0 if SI else 36.0                 # operating netback, dollars per m3 OE or per boe
print(f"2P F&D cost {fd:.1f} dollars per {'m3 OE' if SI else 'boe'}; netback {netback:.1f}; recycle ratio {netback / fd:.2f}")
print(f"production replacement (2P additions incl. acquisitions / production) {100 * (adds_2p + 58) / prod:.0f} percent")
if not SI:
    fdom = [63.1, 64.8, 66.2, 61.9, 60.4, 63.7, 65.0, 66.8, 64.1, 61.2, 59.8, 62.5]   # first-day-of-month WTI, illustrative
    print(f"SEC price: average of 12 first-day-of-month prices = {sum(fdom) / 12:.2f} US dollars per bbl (WTI, before differentials)")
    puds = [("location A", 2024), ("location B", 2025), ("location C", 2021), ("location D", 2026)]
    for n, yr in puds:
        ok = 2026 - yr < 5
        print(f"PUD {n} first booked {yr}: {'within' if ok else 'beyond'} the five-year development window at year-end 2026")

                                         1P       2P  (Mboe)
opening (1 January)                   3,963    6,038
extensions and improved recovery      1,447    2,642
technical revisions                    -283       75
discoveries                               0        0
acquisitions                            264      365
dispositions                              0        0
economic factors                       -182     -327
production                           -1,057   -1,057
closing (31 December)                 4,151    7,736
reserve life index: 1P 3.9 years, 2P 7.3 years
2P F&D cost 32.2 dollars per boe; netback 36.0; recycle ratio 1.12
production replacement (2P additions incl. acquisitions / production) 261 percent
SEC price: average of 12 first-day-of-month prices = 63.29 US dollars per bbl (WTI, before differentials)
PUD location A first booked 2024: within the five-year development window at year-end 2026
PUD location B first booked 2025: within the five-year development window at year-end 2026
PUD location C first booked 2021: beyond the five-year development window at year-end 2026
PUD location D first booked 2026: within the five-year development window at year-end 2026

Prairie Crest's proved reserves rose from about 3.96 to 4.15 million boe, and proved plus probable from 6.04 to 7.74 million. Production of 1.06 million boe was more than replaced: extensions and improved recovery, mainly the Phase 2 wells, the polymer conformance project and the north flank locations, added 1.45 million boe of proved and 2.64 of proved plus probable. Technical revisions were −0.28 million boe in proved, because two older horizontals declined faster than forecast, but slightly positive in proved plus probable. A small purchase of a partner's interest added 0.26 and 0.37 million boe, and the lower SEC price removed 0.18 and 0.33. Proved plus probable additions, including the purchase, replaced production 2.6 times.

Performance measures

Several measures derived from the reconciliation are watched by investors. The reserve life index is reserves divided by annual production: about 3.9 years for proved and 7.3 years for proved plus probable here, short because the Bakken horizontals decline quickly and the company replaces reserves mainly by drilling. Production replacement is the ratio of reserves added to reserves produced. Finding and development (F&D) cost is the capital spent in the year, plus the change in estimated future development capital, divided by the reserves added, excluding acquisitions. Including acquisitions gives finding, development and acquisition (FD&A) cost.

The recycle ratio is the operating netback divided by the F&D cost. It measures how many dollars of netback each dollar of capital generates, and a value above about 2 is generally considered healthy. Prairie Crest's proved plus probable F&D cost is about 32 dollars per boe against a netback of 36 dollars per boe, a recycle ratio of 1.12. That is weak, and it reflects both the year's spending on the waterflood and conformance projects, whose reserves additions will grow as they respond, and the high royalty burden on fee leases, which reduces the netback.

Disclosure under the SEC rules

Subpart 1200 of Regulation S-K sets out the oil and gas disclosure in the 10-K. Item 1202 requires proved reserves by product and geographic area, divided into developed and undeveloped, with a description of the internal controls over the estimates and the qualifications of the technical person primarily responsible, and the third-party report as an exhibit where one was used. Item 1203 requires disclosure of proved undeveloped reserves, including changes during the year, progress in converting them to developed reserves, and an explanation for any that will remain undeveloped for five years or more. Other items cover production, prices and costs, drilling activity, delivery commitments and acreage.

The proved reserves must be estimated with the SEC price: the unweighted average of the first-day-of-the-month prices for the twelve months before the end of the year, adjusted for differentials, with current costs. The supplementary information required by ASC 932 includes the standardized measure of discounted future net cash flows, which applies the SEC price and year-end costs, deducts future income taxes, and discounts at 10 percent, and a summary of its changes during the year. The standardized measure is not a fair value; it is a consistent, mechanical measure that allows comparison between companies.

Ethan's last check before the report goes to the board is a set of consistency tests. Every reserves number must trace to a forecast in the evaluation database; the production in the reconciliation must equal the volume sold; the undeveloped locations must match the approved development plan; and the future development capital must be in the long-range plan that the board has seen. He also checks the location schedule against the time rules.

The SEC rules allow proved undeveloped reserves only for locations scheduled to be drilled within five years of initial booking, unless specific circumstances justify a longer time. The script checks the company's four remaining undeveloped locations against this rule. Location C was first booked in 2021 and has still not been drilled, so at year-end 2026 it is beyond the five-year window and must be removed from proved reserves unless the company can show specific circumstances, which it cannot. The location still appears in the probable category, where the five-year rule does not apply in the same way, but Graham advises that a location deferred this long should be reconsidered entirely.

Closing the cycle

At the audit committee meeting, Graham presents his firm's findings: the proved estimates are reasonable in aggregate, the process is sound, and the five-year rule has been applied correctly. The committee asks about the downward revision on the older horizontals, and Ethan explains how the type curves have been adjusted. The board approves the 10-K, which the company files before the deadline at the end of February for a large accelerated filer or in March for a smaller company.

The work does not end with the filing. The same models are now the basis of the 2027 budget approved in Lesson 9, the borrowing base review with the banks in April, and the long-range plan. The Spruce Ridge survey will be shot in the summer, the CO2 supply study continues, and the actual results of the Phase 2 wells will test the type curve. Next year's evaluation will start from this year's forecasts, and the reconciliation will show how well they held up. Diane's last comment to Ethan sums up the discipline. “Every number in that report is a forecast about the future. We will not get them all right. What we owe the people who rely on them is that they are honest, documented, and as likely to be too low as too high.”

Reviewing the year as a whole

Before the meeting, Diane asks Ethan to step back from the detail and write one page on what the year's numbers say about the company. He makes four points. First, the reserves base is growing, but it is short-lived: at 3.9 years of proved reserve life the company must keep drilling simply to hold production flat, which makes it sensitive to any interruption in capital. Second, the probable reserves are large relative to the proved, so a great deal of value depends on the waterflood expansion and the north flank performing as expected; the pilot results and the first north flank wells are the most important information the company can obtain next year. Third, the downward technical revision on the older horizontals is a warning that the type curves may be slightly optimistic in the long-term tail, and the terminal decline assumptions should be watched. Fourth, the recycle ratio shows that the company is creating value, but not by a wide margin, so cost control and the choice of projects in the capital budget matter.

Graham reads the page and tells Diane it is the most useful thing in the package. The board receives it with the reserves report. It is the kind of document that turns a compliance exercise into a management tool: the reserves evaluation is not only a number for the annual filing but the company's best statement of what it owns, what it is worth and what it must do next.