Valuation of Oil and Gas Reserves Part 1 ($CFW)
Inflation fears and surprising China activity has injected new dynamism on energy E&P stocks. Exploration and production (E&P) is all about finding and exploiting oil and gas reserves. Exploration is a risky hit or miss activity, like internet or biotech startups, and most big oil exploration efforts have been value destroying for their shareholders. At the same time, there are some good track records like Contango Oil and Gas and ATP Oil and Gas, that I hope to discuss in the future, and shale natural gas exploration had its share of successes too.
I will focus instead my attention in the production part of the equation and its main asset: reserves. Oil and gas reserves are a measure of the probability of future production using current technology and oil and gas prices. I will use Cano Petroleum a 79% oil E&P as an example. I own CFW but this is not a buy recommendation I am using it to illustrate the valuation process.
The first step is to collect the total reserves from the last 10K (yearly results), 10Q (quarterly results), corporate presentation, or in this case a recent 8K (material event). The booking of reserves is done according to a set of rules developed by the Society of Petroleum Engineers –SPE. The three categories of reserves generally used are proven, probable, and possible reserves:
- 1P proven reserves : reasonably certain to be producible using current technology at current prices in a reasonable time frame (5 years). That reasonably certain definition is tricky, from what I could find the estimate should be close to 90% of being produced.
- 2P probable reserves : reasonably probable of being produced. In oil and gas lingo, close to 50% probability.
- 3P possible reserves : having a chance of being developed under favorable circumstances having a 10% certainty of being produced.
In the case of CFW, the study was done by a third party Miller & Lents, a known reserve engineering firm, and I could only find details on the proved reserves. Proved reserves are also qualified as developed producing -PDP, proved developed non-producing -PDNP, and proved undeveloped -PUD.
You are probably asking where is the disclosure of CFW’s probable and possible reserves. Any public company listed in the USA has to state its reserves with the SEC; the SEC in turn prohibits mentioning probable or possible reserves in their fillings. The oil and gas industry is not immune to disclosure abuses and we can not discount them in the future. However, several companies mention them in company presentations. The following is an example of Harvard Natural Resources –HNR- on its probable and possible:
CFW uses waterflooding, a secondary recovery technique, and a large part of its reserves are proved but undeveloped. During primary production the average oil field produces only 30 percent of the oil in the reservoir, a waterflood is often tried later. Some of the characteristics of this technique:
- Capricious results and time consuming.
- Investment upfront
- Costs decrease over time
Reserve engineers assigned proved undeveloped PUD reserves based on recoverables of 8-9% for the Panhandle and the Cato fields. That is low if you look at some of the analogue field results like the East Schaeffer waterflood that recovered 15% and initiated back in 1966 with obsolete technology and tactics. We can see the Cato reserves are responding, moving reserves from PUD to PDP and increasing production
Crude oil production was up 6% as compared to the third quarter and 21% compared to the prior year fourth quarter due to increased production from the Cato Field.
The Panhandle, the firm’s largest operating area, is not. When CFW began flooding the Panhandle field it picked Cockrell Ranch that is surrounded by successfully flooded acreages. Management was too bold last year about how the Cockrell Ranch flood would perform and, besides the stock tanking, they have been sued.
But the third party engineering firm confirmed the reserves one month ago did it not? Is this a variant perception opportunity? It could be if the valuation provides some margin of safety and the risks are under control. In part 2 we will run some multiples and provide valuation sensibilities based on Cockrell Ranch potential results .
Disclosure: Long CFW