Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

If you ever find yourself at a cocktail party with a bunch of oil executives, one phrase is a guaranteed mood-killer: "reserve replacement."

Not merely awkward to say, it is the industry's bogeyman. Because in a business chiefly concerned with getting stuff out of the ground, you need to replace that stuff pretty consistently unless you want to, well, eventually run out of stuff.

Last year, the stuff-gathering did not go so well. Not replacing your reserves can be due to several things, such as striking out on a big exploration prospect or simply dialing back investment in finding new fields.

It can also just be about those fickle little things called prices.

One of the things that makes proved reserves proved is a reasonable certainty they can be produced economically. A barrel of oil that costs more to get out of the ground than anyone is likely to pay for it isn't, from any rational viewpoint, going to be produced. So, depending on the vagaries of the commodity markets, it can disappear from the books, even if it physically still lurks there beneath the ground.

A good example of how this works is what happened last year with Exxon Mobil, which suffered a serious reversal in its reserve replacement ratio:

Crouching Tiger
Exxon's reserve replacement ratio crashed below 100 percent in 2015
Source: Bloomberg
Note: Reserve replacement ratio including acquisitions and disposals.

The big hit came at home, as the collapse in U.S. natural gas prices forced Exxon to take some of those proved reserves off its books. It's important to note this isn't the same as a financial impairment, as a change in circumstances can see those reserves re-categorized as proved again.

Exxon certainly wasn't alone in this regard. Surveying 11 U.S.-focused E&P companies' filings for 2015, they collectively cut their proved reserves by a net 2.12 billion barrels of oil equivalent (before factoring in disposals). Gas accounted for almost 60 percent of the write-down.

Physically, of course, the gas still exists. So might the recent rally in gas prices help restore that existence to the accounting plane?

For now, it doesn't seem like it. Under SEC rules, the average of the year's month-end prices is used when assessing reserves. Looking at the market so far this year and using futures prices as a proxy for what will happen between now and New Year's Eve, it's looking like average U.S. gas prices will be within a few cents of 2015's figure:

Rinse And Repeat
It looks like 2016 will be another year where U.S. natural gas averages just over $2.50
Source: Bloomberg
Note: Annual averages based on month-end spot prices. Figure for 2016 blends average year-to-date prices and current futures prices.

One comfort is that the low prices on their own shouldn't lead to another savage round of cuts to proved gas reserves. That's partly because companies took a kitchen-sink approach to this in 2015 in order not to suffer the indignity of doing it two years in a row. As Derek Ryder, a retired petroleum reservoir engineer, puts it: "If you're going to take hits, take all the hits you're going to take at once."

Falling production costs in U.S. shale could also help by improving the economics of marginal reserves even at low prices. And even if average prices haven't moved much, the outlook has improved: Futures prices for 2017 are now about 11 percent higher than at the start of this year, according to Bloomberg data.

OPEC's sudden (and tentative) intervention in the market this week may also help on the oil side by encouraging a more bullish view of where prices are going, even if actual supply cuts are slow to materialize.

Big Oil will need the help. While their large portfolio of assets allows them to sanction new projects to help smooth out reserve replacement, they have been slashing investment to protect dividend payments to shareholders. According to a recent analysis by consultancy Wood Mackenzie, exploration spending by the major oil companies fell by more than 50 percent in 2015.

Some of that fall, similar to what has been seen in U.S. shale, represents beneficial things like cutting contractor fees and focusing on easier prospects rather than big, complex projects like Arctic drilling.

Even so, new megaprojects are out of favor. Looking ahead, Wood Mackenzie thinks only half of the majors' production will be replaced by conventional exploration, necessitating a push into other options, such as unconventional resources like shale and, of course, acquisitions.

M&A has been conspicuous by its absence in this downturn. Potential targets haven't wanted to sell out at the bottom, while the majors have held out for low oil prices to drag those targets to the negotiating table. On this front, OPEC's shot of adrenaline to sentiment is less helpful.

Altogether, 2016 seems unlikely to be as bad as last year when it comes to reserve replacement but, equally, hardly deserving of a toast, either. In one sense, investors should applaud this: Favoring value over volume is a strategy the industry has often spoken of but failed to live by. Pursuing other avenues for profit that don't prioritize booking reserves could be a useful exercise.

So much for aspirations. In the here and now, investors, like oil executives, tend to look at depleting reserves with mounting dread. OPEC or not, it will be surprising indeed if 2017 turns out to be another year where Big Oil holds off on cutting big deals. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

  1. Chesapeake Energy, Cimarex Energy, Concho Resources, Continental Resources, Devon Energy, Energen, EOG Resources, EQT, Pioneer Natural Resources, Range Resources and Southwestern Energy.

To contact the author of this story:
Liam Denning in New York at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net