Investors that are reviewing year-end reserve reports from companies in the energy sector should examine these reports carefully, as exploration and production companies have some flexibility on the amount of proved undeveloped reserves that it can record on its books.

IN PICTURES: 4 Biggest Investor Errors

Modernization of Oil and Gas Reporting
Several years ago, the Securities and Exchange Commission (SEC) changed the regulations regarding the reporting requirements of oil and gas reserves. One change involved the booking of proved undeveloped reserves (PUDs) for the industry. This refers to reserves that are in the proved category, but haven't been allocated capital to drill.

PUD Locations
The old rules allowed exploration and production companies to record future drilling locations that were not adjacent to a producing well as PUDs only if these locations could be economically produced with certainty. The new rules loosened these criteria, allowing companies to record PUDs if reliable technology makes the production of these reserves "reasonably certain."

This change benefited companies with holdings in unconventional resource plays where a "manufacturing" business model of development has been adopted, involving little exploration risk for the operator.

Investors should determine the number of PUD locations that an exploration and production company records for every producing well in a resource play, as a more aggressive company might book more locations and appear to have faster growth than others.

Two companies that seem conservative in determining PUDs include Range Resources (NYSE:RRC) and Comstock Resources (NYSE:CRK). Range Resources reported 4.4 Tcfe of proved reserves at the end of 2010, a 42% increase over 2009. Range Resources disclosed that on its Marcellus Shale properties, the company booked 1.9 PUD locations for every producing well.

Range Resources also disclosed that it did not record any PUDs from drilling into the Utica and Devonian Shale formations on its acreage. The company has drilled one test well into each of these formations, and will wait until it completes further development.

Comstock Resources also reported reserves at the end of 2010, and disclosed that it recorded a maximum of two offset drilling locations as PUDs for every producing well.

Five-Year Period Rule
The new rules also mandated that exploration and production companies must remove undeveloped reserves from the proved category if the company can't develop them within a five year period. The SEC allowed an exception to this rule if "specific circumstances" exist that prevented the development within that time frame. Some companies may be reluctant to removed PUDs as this will affect the value the market assigns to the company.

Several companies have written off PUDs at the end of 2010 due to the five-year rule. GMX Resources (Nasdaq:GMXR) removed 219.6 Bcfe of reserves from this category related to the Cotton Valley Sand formation. The company decided that it could not develop these resources within the five year time frame as it is shifting capital to the Bakken and Niobrara plays.

Rex Energy (Nasdaq:REXX) also took similar action regarding its PUDs in the Appalachian and Illinois Basins, and removed 17.2 Bcfe of reserves from this category.

Bottom Line
Reserve reporting in the exploration and production industry can be dense and confusing, and an aggressive operator may present an unrealistic picture of a company's oil and gas properties. (For related reading, also take a look at What Determines Oil Prices?)

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

Related Articles
  1. Investing

    Time to Bring Active Back into a Portfolio?

    While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
  2. Investing

    What a Family Tradition Taught Me About Investing

    We share some lessons from friends and family on saving money and planning for retirement.
  3. Economics

    Investing Opportunities as Central Banks Diverge

    After the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
  4. Stock Analysis

    The Biggest Risks of Investing in Pfizer Stock

    Learn the biggest potential risks that may affect the price of Pfizer's stock, complete with a fundamental analysis and review of other external factors.
  5. Professionals

    4 Must Watch Films and Documentaries for Accountants

    Learn how these must-watch movies for accountants teach about the importance of ethics in a world driven by greed and financial power.
  6. Stock Analysis

    Allstate: How Being Boring Earns it Billions (ALL)

    A summary of what Allstate Insurance sells and whom it sells it to including recent mergers and acquisitions that have helped boost its bottom line.
  7. Chart Advisor

    Copper Continues Its Descent

    Copper prices have been under pressure lately and based on these charts it doesn't seem that it will reverse any time soon.
  8. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  9. Active Trading

    An Introduction To Depreciation

    Companies make choices and assumptions in calculating depreciation, and you need to know how these affect the bottom line.
  10. Markets

    PEG Ratio Nails Down Value Stocks

    Learn how this simple calculation can help you determine a stock's earnings potential.
  1. Which mutual funds made money in 2008?

    Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
  2. Can working capital be depreciated?

    Working capital as current assets cannot be depreciated the way long-term, fixed assets are. In accounting, depreciation ... Read Full Answer >>
  3. Do working capital funds expire?

    While working capital funds do not expire, the working capital figure does change over time. This is because it is calculated ... Read Full Answer >>
  4. Do hedge funds invest in commodities?

    There are several hedge funds that invest in commodities. Many hedge funds have broad macroeconomic strategies and invest ... Read Full Answer >>
  5. How much working capital does a small business need?

    The amount of working capital a small business needs to run smoothly depends largely on the type of business, its operating ... Read Full Answer >>
  6. What does high working capital say about a company's financial prospects?

    If a company has high working capital, it has more than enough liquid funds to meet its short-term obligations. Working capital, ... Read Full Answer >>

You May Also Like

Trading Center