Reserve report to corporate budget
ENGINEERS PROVIDE THE FOUNDATION IF YOU KNOW HOW TO USE IT
ALLISON FIRESTONE, OPPORTUNE LLP, HOUSTON
RESERVE ENGINEERS and financial analysts do not always speak
the same language. However, engineers for exploration and production
(E&P) companies provide a great foundation for drafting a corporate
budget, but you have to know how to use it.
Reserve engineers are often tasked with conducting an engineering
study of hydrocarbon reserves to determine the future cash flows
and value of oil and gas assets. This study produces a reserve report,
which contains a discussion section and tabular data. The discussion
section lists all relevant information used to determine the annual
cash flows and discounted values, which are displayed in the tabular
data section. Reserve reports are primarily used for SEC reporting
purposes and to determine the value and borrowing capacity of an
E&P company, but can also be used as the basis for a corporate budget.
Depending on lending and reporting requirements, most companies
are required to produce an annual reserve report, which can be either
created or audited by an outside reserve engineering firm.
To create a reserve report, reserve engineers weigh the revenues
and costs of extracting reserves in order to determine the company’s
ability to maintain positive cash flows throughout the operation of
each well. But how do the operating cash flows in a reserve report
compare to the monthly revenues and expenses in a corporate budget
or financial forecast? How can a financial analyst use this report to
develop a corporate budget?
Here are four steps for creating a corporate budget based on a
Step 1: Analyze and interpret the report
You do not need an engineering degree to read a reserve report. You
do, however, need to understand where to look for key assumptions
and information within the report to translate it into a corporate
The objective of the reserve report is to determine the value of
hydrocarbons, not the company. The monthly cash flows generated
by a reserve database typically do not include certain key elements
of a corporate budget such as overhead costs, insurance, hedging and
other services. The reserve report does not account for these elements
because they are not required to produce the reserves. A financial
analyst must consider more than just the revenues and costs associated with production when developing a company’s budget.
A reserve report is created for a specific purpose, so the underlying
Step 2: Confirm assumptions are up to date
assumptions will differ based on the standards used to develop the
report. The reviewer should establish an understanding of the guide-
lines that were followed when the reserve report was created or audited
under either SEC or SPEE (Society of Petroleum Evaluation Engineers)
standards. Regardless of which standards are followed, the discussion
section will note every assumption used to create the reserve report.
The discussion section is just as critical as the values generated. SPEE
suggests reserve engineers include the economic assumptions listed
in Table 1 in the discussion section of the report. The financial analyst
can use this section of the report to identify which costs need to be
added to the cash flows from the reserve report and the level of in-
dependent verification performed of costs and pricing.
When creating a budget from the reserve report, the financial analyst
must ensure the assumptions have not changed since the reserve
report was created. Many assumptions are weighed to calculate cash
flows such as future prices, the cost to operate and maintain current
production, and the cost and timing of future drilling or abandonment.
All of these assumptions are laid out in the discussion section of the
report. While reserve engineers must consider the timing and cost
of extraction when determining the economic value of production,
these assumptions may not align with current prices or management
Pricing is a key assumption in every reserve report and E&P budget.
The easiest way to determine monthly revenue and update pricing
for the budget is to apply current prices to the monthly production
listed in the reserve report. While E&P companies use index pricing,
there is often a differential built in to the reserve database representing
geographic location and quality adjustments. The financial analyst
can determine the differential by comparing the prices displayed in
the report to the price curve that was used. Applying the same differential to current index prices will determine budget revenue.
To ensure assumptions of revenue align, the financial analyst reviews production estimates in addition to pricing. Reserves are broken
into multiple categories: Proved, Probable, Possible and Contingent.
There are multiple categories of Proved reserves. This includes Proved
Developed Producing, which are currently being produced and Proved
Undeveloped, which still need to be drilled. The probability of successfully extracting the reserves diminishes with each category, so a
percentage factor is often applied to each category to “risk” the production. The amount of risking can be determined based on historical
performance or the expectation of management.
Another important assumption that can change frequently is
management’s drilling plan. If the timing in the report does not align
with the current plan, the drilling capex and operating cash flow
streams must be updated to reflect the current and best assumption
of timing. Depending on the magnitude of the change, it may be
beneficial to draft a new reserve report from the database. Changes
related to production and the economic viability of drilling are most
accurately identified by reserve engineering software.
Step 3: Identify omitted costs
After ensuring the data in the reserve report aligns with current assumptions, it is important to identify revenue and costs outside the
scope of the reserve report to confirm the corporate budget is accurate.