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.
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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.
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.
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?)
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