What Is Organic Reserve Replacement?
Organic reserve replacement is the supply of oil reserves acquired through exploration and production, as opposed to purchasing proven reserves. Recoverable reserves are those oil and gas reserves that are economically and technically feasible to extract given current oil prices, economic conditions, operational methods, and government regulations.
Key Highlights:
- Essential Indicator: Organic reserve replacement is a vital metric for evaluating an oil company’s health.
- Investor Focus: Investors should consider organic replacement when assessing a company’s reserve-replacement ratio.
- Long-term Viability: Ensuring consistent reserve replacement is crucial for the long-term viability of oil companies.
The Importance of Organic Reserve Replacement
Organic reserve replacement is pivotal for assessing an oil or gas company’s financial health. One crucial evaluation tool is the reserve-replacement ratio, which compares the amount of proved reserves added to a company’s base during the year to the amount of oil and gas produced. For sustainable profitability and longevity, a company’s reserve-replacement ratio should at least be 100%. A ratio below this threshold suggests the company is depleting its reserves and could eventually run out of supply if the trend continues.
Exploring Organic Reserves
Both smaller and intermediate-sized oil and gas companies often rely on specialists in exploration and production (E&P) to discover organic reserves. In contrast, large integrated corporations like Exxon and BP have dedicated departments for these tasks. The term ‘finding and development’ (F&D) encompasses the process and costs related to researching, developing, or acquiring property to establish commodity reserves. Within the industry, E&P and F&D activities are known as ‘upstream functions.’
Exploration generally starts in areas with high potential, indicated by local geology and nearby petroleum deposits. A range of techniques, such as induced polarization (IP) surveys, drilling, assaying, seismological sounding, and the use of electrical currents, aid this process. Once a promising area is identified, an exploratory well is drilled to gather detailed geological data. Offshore exploration is notably costly, with a single exploratory well potentially costing $150 million, and a success rate of approximately one in five. Bringing an exploratory well into production can take several years.
Assessing Financial Health Through Organic Reserves
During the exploration stage, some companies employ the full cost accounting (FC) method, capitalizing all operating expenses irrespective of success in finding commercially viable reserves. This approach can inflate the balance sheet, as costs are treated as assets. Conversely, the successful efforts (SE) method is more conservative and only capitalizes expenses associated with successful location of new reserves.
Oil quantities are measured in barrels, while gas is quantified in cubic feet. The costs incurred in discovering new reserves are totaled and divided by the estimated new quantity found. Investors should weigh a company’s organic replacement when evaluating the reserve-replacement ratio, as it provides insights into the company’s upstream efforts and financial health. This ratio is a key indicator of future profitability and the results generated from drilling and exploration investments.
Related Terms: proven reserves, reserve-replacement ratio, exploration and production, upstream functions, full cost accounting, successful efforts.
