One of the metrics that is used by investors to judge the operating performance of the exploration and production industry is the reserve-replacement ratio. The reserve replacement ratio measures the amount of proved reserves added to a company's reserve base during the year relative to the amount of oil and gas produced.
The higher the reserve-replacement ratio the better because an exploration and production company is a wasting asset that will eventually disappear if its reserve-replacement ratio stays perpetually under 100%.

The reserve-replacement ratio is an important metric, but it shouldn't be the only one used to judge a company's expertise at drilling for oil and gas. This ratio should only be looked at in the context of other operating metrics. The cost to add those reserves is just as important.

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Organic Calculation
Carrizo Oil and Gas
(Nasdaq:CRZO) had one of the highest reserve-replacement ratios in the industry, at 705% in 2008. Something to watch for in interpreting this metric is whether it is calculated organically or including acquisitions. Organic replacement refers to reserves added through the drill bit by new discoveries or extensions of previous discoveries. A high reserve-replacement ratio is only seen as valid if it is organic, because it is easy to buy proved reserves, as there is an active market for these assets. Ultra Petroleum (NYSE:UPL) reported a reserve replacement ratio of 470% in 2008, achieved organically.

Back-Proved Reserves
Many exploration and production companies present the reserve replacement ratio by adding back-proved reserves that were removed from this category through price changes. Current rules require that exploration and production companies use commodity prices as of the last day of the year to determine the level of proved reserves. If prices are low enough then the company usually has to remove the amount of proved reserves that aren't economical to produce at that price.

Since exploration and production companies are perpetually optimistic about commodity prices always recovering, these reserves removed due only to price changes are sometimes added back to calculate the reserve replacement ratio for use in presentations to the investment community.

Average Reserve Replacement
Due to the geological difficulty in discovering new reserves, it can take years and tens of millions of dollars of expenditures before reserves enter the proved category. It might be better, then, to examine the reserve-replacement ratio on a three- or five-year average basis to smooth out this statistic.

An example of this is Goodrich Petroleum (NYSE:GDP), which has 402 Bcfe of proved reserves as of 12/31/2008. None of these proved reserves are from the Haynesville shale, where it has 63,500 net acres under lease. The company is planning on spending 65% of its 2009 capital budget of $230 million in the Haynesville shale.

The large integrated oil companies can have difficulty achieving a reserve replacement ratio above 100% due to the size of the reserve base. Exxon Mobil (NYSE:XOM), however, did manage to replace 110% of its reserves in 2008.

Bottom Line
The reserve-replacement ratio is a tricky measure that shouldn't be taken at face value as it provides a simplistic view of an exploration and production company's operating performance. Other measures of operating performance should also be examined to get a more comprehensive picture of the company. (For more, see 5 Must-Have Metrics For Value Investors.)

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