An analysis of 2010 year-end reserve reports from exploration and production companies indicate that the industry is starting to remove undeveloped reserves of natural gas from the proved category. This is due to the industry shift towards oil and liquids development and new government rules on reserve accounting adopted last year that impose a five year development limit on the industry.

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New Rules
In late 2008, the Securities and Exchange Commission (SEC) adopted a new set of rules governing the reporting requirements for oil and gas companies. One of these changes impacted the treatment of undeveloped reserves in the proved category.

The SEC imposed a five-year limit on keeping undeveloped reserves in the proved category, unless "specific circumstances" prevented its development within that time frame. What this means is that, unless an exploration and production company can drill and complete a well or set of wells on its properties within five years, the proved undeveloped reserves have to be shifted to the probable category.

The specific circumstances loophole was included so that undeveloped reserves associated with projects that take more than five years to develop, such as oil sands, would not have to be removed from the proved category.

The Evidence
Newfield Exploration (NYSE:NFX) just released its 2010 reserve report and showed a 20% increase in proved reserves compared to a year earlier. The company might have reported even stronger growth in proved reserves for the year, but was obligated to move 315 Bcfe of proved undeveloped reserves into the probable category.

These reserves were mostly natural gas and located in the mid continent area of the United States. Newfield Exploration cited a "deferral of development activity" that would make it unlikely the company would develop these assets within the five year time limit.

Venoco (NYSE:VQ) also released its 2010 reserve report and disclosed that the company had reclassified 2.7 million barrels of oil equivalent (BOE) of proved undeveloped reserves into the probable category. This was due to a planned reduction in drilling in 2011 on its natural gas properties. In the Sacramento Basin, which Venoco has been developing for years, the company plans to drill 40 wells in 2011, down from 100 in 2010.

Chesapeake Energy (NYSE:CHK) announced a plan earlier in the year to divert capital away from natural gas development and towards oil and liquids instead. The company also announced a new financial strategy to reduce its debt by 25% over the next two years through the reduction of leasehold acquisition and asset sales. Chesapeake Energy released its preliminary 2010 reserve report, but didn't disclose the removal of any undeveloped natural gas reserves from the proved category as a result of its new strategy. The company may have additional information on its reserves when it releases its final report.

Other companies are staying with natural gas and didn't remove any proved undeveloped natural gas reserves at the end of 2010 due to the five year rule. CONSOL Energy (NYSE:CNX) is accelerating the development of its natural gas properties and didn't recategorize any proved undeveloped reserves at the end of the year.

The Bottom Line
The exploration and production industry shift towards oil and liquids development will mean less development of natural gas properties over the next few years. This has resulted in the removal of undeveloped reserves of natural gas from the proved category. (For related reading, also take a look at Understanding Oil Industry Terminology.)

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