One of the stories making the rounds last week was the downward revision of U.S. oil and natural gas reserves. Today I want to review what this means.

The Energy Information Administration (EIA) reported that U.S. crude oil proved reserves declined by 11.8% or 4.7 billion barrels (bbl) from their year-end 2014 levels to 35.2 billion bbl at year-end 2015. U.S. natural gas proved reserves decreased by 64.5 trillion cubic feet (Tcf), or 16.6%, to 324.3 Tcf at year-end 2015. Those figures were published in the EIA’s U.S. Crude Oil and Natural Gas Proved Reserves report.

First, note that this references year-end 2015 levels. The EIA won’t release year-end 2016 proved reserves until about this time next year (although BP will estimate them before that in the annual BP Statistical Review that will be released next summer). However, based on another year of depressed energy prices in 2016 it is likely that there will be another decline in reserves when those numbers are reported. Why? Because proved reserves are a function of oil and gas prices.

To review, “resource” refers to the total volume of oil or gas in place in the ground. The proved reserve is that fraction of the resource that is technically and economically recoverable with a high probability (more than 90%) at prevailing prices. Thus, even though the estimate of the resource may not change, the estimate of proved reserves will fluctuate with oil and gas prices (and as those reserves is depleted).

To understand how this works in practice, let’s look at a simplified example. Consider an oil deposit that would require a well that costs $5 million to drill and complete. Now, assume that this deposit is projected to ultimately produce 100,000 barrels of oil over the course of its lifetime. Ignoring the time factor for simplicity, that means that just the cost of the oil well breaks down to $50 per barrel of oil produced. Add in the operating costs and taxes, and this well might have a breakeven price of $70/bbl. Thus, this is oil that could be classified as a proved reserve if the prevailing price of oil is $80/bbl, but not if it’s $50/bbl.      

To put those U.S. proved oil reserves numbers in context, the year-end 2015 proved crude oil reserve of 35.2 billion barrels is equivalent to about 11 years of production at the current rate. Of course that doesn’t mean we will run out of oil in 11 years, because there will be new oil discoveries. In fact, today’s proved reserves are at about the same level as in 1980, despite the fact that the U.S. has since produced some 80 billion barrels of oil.

These downgrades in reserves estimates do impact the books of oil and gas companies. At the end of each year the Securities and Exchange Commission (SEC) requires all listed U.S. energy companies to report something called the standardized measure (SM). The SM is the present value of future cash flows from proved oil, natural gas liquids (NGLs), and natural gas reserves, minus development costs, income taxes and exploration costs, discounted at 10% annually. The SM must be calculated according to specific guidelines set by the SEC.

The SM is calculated according to the average prices received over the past 12 months for oil, NGLs, and natural gas. The SM is also one of the metrics we use to evaluate oil and gas companies for possible recommendation in The Energy Strategist. As companies release annual reports for 2016, we will look at the SM for all publicly traded oil and gas companies in the U.S. to see which look undervalued and overvalued according to this metric. Consider subscribing for profitable advice on energy investments.     

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