Not All Oil and Gas Reserves Are Created Equal

Now that oil and gas companies are mostly done reporting their year-end results, the annual 10-K filings are starting to hit the SEC's website. For many of you, reading regulatory filings is about as exciting as watching the Canadian men's curling team in action. I'm excited to start digging in, though.

Today I'll be looking at increases in company PUDs. Let's take a moment to talk about why you should care about this funny-sounding acronym.

Proved reserves are a very big deal in the world of oil and gas production. Reserves are the source of future growth in production and cash flow for E&P companies. Companies also frequently use reserve-based lending facilities to finance their expansion. Investors therefore want to see reserves growing at a steady clip.

In addition to proved developed reserves, which are "behind pipe," as they say in the oil patch, companies can also claim proved undeveloped (PUD) reserves. These quantities have not been drilled or completed as producing wells, so there is a future cost associated with moving these PUDs into the developed category. This shows up in the standardized measure of discounted future net cash flows as a line item called "Future development costs." Chesapeake Energy (NYSE: CHK), for example, reports a future cost of $8.9 billion to develop its PUDs.

I don't mean to characterize proved undeveloped reserves as an illusory source of future earning power. The SEC has taken steps to ensure that PUDs don't just sit on the books, inflating reserve values indefinitely. The issue is that significant PUD bookings can make companies look more efficient than they actually are.

Newfield Exploration's (NYSE: NFX) overall finding and development costs of $1.50/mcfe in 2009 look great, but the company also spent about $3/mcfe to move PUDs into the developed category. My concern is that companies piling up a lot of PUDs are recognizing benefits today (i.e., flashy reserve replacement ratios and reserve-based valuation premiums) while pushing significant costs into future periods.

Here are some of the biggest jumps in proved undeveloped reserves that I've spotted so far:

Data from SEC Filings.

So, are these big increases anything to be worried about? We'll look at the implications for these and other firms' future development budgets next time.