What is Reserve-Replacement Ratio?

Reserve-replacement ratio (RRR) is the amount of oil added to a company's reserves divided by the amount extracted for production. This calculation is a metric used by investors to judge an oil company's operating performance.

Key Takeaways

  • Reserve-replacement ratio (RRR) is the amount of oil added to a company's reserves divided by the amount extracted for production and is a metric used by investors to judge an oil company's operating performance.
  • Reserve-replacement ratio of 100% indicates that the company can sustain current production levels.
  • A high reserve-replacement ratio achieved through organic replacement is considered better than a high reserve-replacement ratio achieved through purchasing proved reserves.

Understanding 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 that the company has produced. According to conventional market wisdom, when demand is stable, a company's reserve-replacement ratio must be at least 100% for the company to sustain current production levels. Any figure greater than 100% likely indicates that the company has room for growth. Conversely, any number less than 100% telegraphs a cause for concern that the company may soon run out of oil.

The reserve replacement ratio is often calculated on national or global terms, typically in the context of long-term broad industry forecasting and macroeconomic analysis. Due to the fact that national numbers for reserves are prone to being manipulated, these numbers should be taken with a grain of proverbial salt. In fact, simplistic interpretations of the reserve-replacement ratio have historically caused undue panic that the oil supply would run dry, dating as far back as the 1800s. This phenomenon has been particularly common in the U.S. Case in point: since 1920, the ratio of proved reserves-to-production has hovered between eight years and 17 years. But history has shown that these were false assumptions because this analytical data failed to consider future reserve growth.

Pairing Reserve-Replacement Ratio With Other Data

Although the reserve-replacement ratio can indeed be a valuable indicator that investors should rely on to gauge how well an oil company is performing, this metric alone does not offer a complete and accurate picture of a given oil company's fitness. For this reason, the reserve-replacement ratio should be contemplated in concert with several other operating metrics. These may include the reserve-life index, enterprise value to debt-adjusted cash flow ratio, enterprise value to daily production ratio, and total capital expenditure (CAPEX) spending.

CAPEX spending refers to funds an oil company expends to source and develop additional reserves. This figure may vary from period to period and can be affected by new technologies, changes to supply and demand dynamics, and fluctuating oil prices. A high reserve-replacement ratio achieved through organic replacement is considered better than a high reserve-replacement ratio achieved through purchasing proved reserves.

Since oil production estimates fluctuate from year to year, it is shrew to calculate the reserve-replacement ratio over multiple years, to glean more accurate long-term projections.