In last week’s Energy Letter — The Lessons of Chapter 11 —  I discussed the importance of investing in companies with management you can trust. The value of a company is based in large part on guidance provided by management. If management provides consistently reliable and realistic guidance, you can have more confidence in the value of your investment.

These thoughts were very much on my mind as I read a recent Bloomberg News article We’re Sitting on 10 Billion Barrels of Oil! OK, Two. The gist was that the reserves numbers that oil and gas companies present to investors are often many times higher than those that are reported to the US Securities and Exchange Commission (SEC). For example:

Lee Tillman, CEO of Marathon Oil Corp., told investors last month that the company was potentially sitting on the equivalent of 4.3 billion barrels in its US shale acreage. That number was 5.5 times higher than the proved reserves Marathon reported to federal regulators.

Such discrepancies are rife in the US shale industry. Drillers use bigger forecasts to sell the hydraulic fracturing boom to investors and to persuade lawmakers to lift the 39-year-old ban on crude exports. Sixty-two of 73 US shale drillers reported one estimate in mandatory filings with the Securities and Exchange Commission while citing higher potential figures to the public, according to data compiled by Bloomberg.

The article went on to say that some drillers are giving potential reserves numbers to investors that are more than 20 times those that are filed with the SEC.


Source: Bloomberg News

The disparity stems from the fact that, in making presentations to investors, companies aren’t bound by the SEC accounting rules and are protected by the Private Securities Litigation Reform Act of 1995, which provides a “safe harbor” for some forward-looking statements. As a result, what is presented to investors is usually more speculative (e.g., “potential reserves”) than what is reported to the SEC in the annual report on Form 10-K, which provides a comprehensive overview of a company’s business and financial condition with audited financial statements.

Are some of these companies exaggerating? Probably. The Bloomberg story noted that 62 of 73 US shale drillers reported higher estimates to investors than to the SEC, with the average number reported to investors 6.6 times higher for potential resources than that reported to the SEC for proved reserves. Notable companies that reported the same number in both cases include Aggressive Portfolio holding Jones Energy (NYSE: JONE), as well as Cimarex Energy (NYSE: XEC), EXCO Resources (NYSE: XCO), Triangle Petroleum (NYSE: TPLM), and Southwestern Energy (NYSE: SWN) — which is the only company with a market cap over $1 billion that reported the same number to investors and the SEC.

 Even proved reserves can be further subdivided into proved developed (PD) and proved undeveloped (PUD). PD means the resource can be produced with existing or minimal investment, while PUD may be booked as “proved reserves” if the development plan for those reserves provides for drilling within five years of being booked. If circumstances change and a company becomes unable to justify the five-year development then it may be required to reduce its reserves estimate.

Development can be a function of oil and gas prices. With $100/bbl oil some resources may be economic to develop that are uneconomic at $60/bbl oil. So, you sometimes see reserves go on and back off the books as prices rise and fall, even in cases where the company still owns the rights to the resources and may develop them after prices rise.

So what’s an investor to do? Again, it’s important to be able to trust company management. The company telling investors it has 20 times more potential resources than proved reserves isn’t necessarily exaggerating, especially if the company has a track record of delivering on its projections.

Even if the higher potential estimates can be trusted, do they necessarily represent a value to investors? It depends on the value of the proved reserves and the confidence we have in their claims of potential resources relative to the company’s enterprise value (EV). We can attempt to compare different companies by assigning a value to their proved reserves — taking into account the percentage that is natural gas, natural gas liquids, and crude oil — and then comparing that to each company’s EV. I will do this for a number of oil and gas companies in the next issue of The Energy Strategist.  

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