E&Ps With Something to Prove

Proved reserves are one of the murkiest areas of oil & gas company accounting. If you start poking around the various E&Ps' annual reports, you'll quickly see that not all reserves are created equal.

In most basic terms, proved reserves are hydrocarbons that an E&P can reasonably expect to produce at some point in the future, based on current prices and oilfield costs. With geologic, technological, and economic factors all playing a part, there is some art to reserve estimation, in addition to all the science. This is why firms bring in specialists like Netherland, Sewell & Associates to audit their internal calculations.

The proved reserves category is further divided into proved developed and proved undeveloped reserves. The difference between the two is that proved developed reserves have wells and equipment in place. Proved developed producing reserves (PDPs) are obviously the most objective, whereas proved undeveloped reserves (PUDs) have the most to, er, prove.

Who's got a PUD problem?
When scanning E&P annual reports recently, I noticed enormous variance in PUD bookings as a percentage of total proved reserves. Here is a sampling:

On the low end of the spectrum, we see Cimarex and Devon, two independents that were forced to record huge non-cash asset writedowns, based on year-end 2008 prices.

When Devon reported its impairment, I definitely overreacted. Though I gave a more balanced assessment of the firm's accounting treatment the following day, I'd like to formally renounce my comments on the quality of Devon's reserve booking practices. The small percentage of PUDs booked by these firms is a strong point in their favor, and highlights the distortion caused by year-end pricing (a reporting convention wisely being phased out by the SEC).

In the middle of the pack, we have Chesapeake and Southwestern. There are many other E&Ps with PUDs in this general range, which I would consider to be typical of firms pursuing a fairly balanced blend of acquisition and drillbit growth.

Next, there's Carrizo, whose PUDs, I should point out, have fallen from 60% in 2006 and 53% in 2007. Still, the company identifies its PUD bookings as "significant."

So what does that say about the last two?
Without looking any deeper, it would seem that both GMX and ATP belong in the PUD penalty box. A closer analysis reveals significant differences between the firms, however.

In the case of ATP, the Rodney Dangerfield of the deepwater, I wondered aloud about the short case back in September. Skepticism about the firm's reserve bookings could be a factor there, though it must surely take a distant second place to the above-average debt load that the firm's been dutifully working off.

To write off ATP for its unusually high amount of proved undeveloped reserves would be to ignore the firm's unique business strategy, in my view. Acquiring other people's PUDs and bringing them into production is literally all that ATP does. These relatively large offshore developments take a fair bit of time to bring online. As a consequence, ATP has a lot of undeveloped reserves waiting on deck. Given the firm's 98% development success rate since inception in 1991, I'm inclined to believe that ATP isn't getting in over its head with these offshore reserve bookings.

As for GMX, I have some concerns. Back before the Haynesville shale hoopla of 2008, GMX was almost exclusively focused on the Cotton Valley sand play, a shallower target stacked above the Haynesville in East Texas. In 2008, 92% of the firm's wells targeted the Cotton Valley, and the play accounts for over 98% of GMX's proved undeveloped drilling locations.

Booking a relatively large amount of PUDs, as GMX has done over the past few years, effectively understates finding and development (F&D) costs (exploration and development costs divided by total reserve additions). GMX boasts of "best in class" F&D costs, but this ignores the roughly $560 million in costs that the firm estimates it would have to incur to develop these reserves. To put that cost in perspective, GMX recently projected discretionary cash flow of roughly $50 million in 2009.

Another issue with this pile of Cotton Valley PUDs is that the economics of this tight gas play have deteriorated significantly, as noted by other operators like EXCO Resources. GMX has, as a result, totally refocused on Haynesville/Bossier development, directing 98% of its 2009 budget to this new play. To claim so many proved reserves in the Cotton Valley, while current economics seem to dictate nearly complete avoidance of the play, appears aggressive.