Low natural gas price casts doubt on ‘proven’ reserves
Low natural gas price casts doubt on ‘proven’ reserves nathan vanderklippe
CALGARY— From Monday's Globe and Mail
Published Sunday, Apr. 01, 2012 7:00PM EDT
Last updated Monday, Apr. 02, 2012 6:55AM EDT
Most years, it’s an eye-glazing exercise. But calculating “reserves” – how much oil or gas an energy company has buried on its lands – has taken on a sudden new importance for an industry in the throes of a remarkable pricing spiral.
Every spring, energy companies update their reserves based on price forecasts done at the end of the prior year. Price is an important consideration in determining the most important class of reserves, called “proven,” because a company can only say it’s capable of producing a certain volume of energy if it’s profitable enough to do so.
Normally, the year-end price estimates are a pretty good indication of what’s to come, and make for a reasonable estimate of a company’s reserves. But this year, a sudden drop in natural gas prices has raised significant question marks over the accuracy of the reserve figures that have been issued in recent weeks.
“It’s a safe assumption that a large part of Canada’s natural gas (NG-FT2.170.020.98%) reserves are [overstated],” said Eric Nuttall, portfolio manager for Sprott Energy Fund.
That has significant ramifications, especially for those looking to evaluate the worth of companies with major gas holdings. Reserves are an important component of calculating the net asset value of a company. And this year, they could be wrong, by a lot. The difference in assumptions is stark, and anyone looking at corporate reports might be led to expect stronger pricing than companies are actually getting. Indeed, gas prices have gotten bad enough that observers expect cash flow for some companies to dip into negative territory.
Despite falling 50% over the past year, many natural gas stocks are about to enter another major decline.
And if you know what's going on here, you can use this coming decline to make huge capital gains over the next 12 months.
The key idea in this coming trade is something called "reserve write downs." It will cause billions of dollars of market valuation to vanish... overnight. Some very well-known energy firms (that you might own) will suffer huge share price declines.
Here's how it's going to work...
A resource estimate is a geologic "best guess" of how much of a commodity exists within a particular deposit, be it ounces of gold, barrels of oil, or cubic feet of natural gas. A geologist takes information about the deposit's size and grade from drilling results... and then creates a statistical model of the deposit. From that model, he or she can estimate the size of the resource.
However, the amount in the ground is not the amount that can be produced. That's where the reserve estimate comes in. Reserves are a whittled-down subset of total resources. That whittling-down process has two steps.
First, geologic and technologic factors determine a resource's recovery rate, reducing the resource to the parts that are "technically recoverable." For example, recovering oil in conventional fields like those in Saudi Arabia is much easier than recovering oil trapped in tight layers of rock.
Then, economic considerations further reduce the resource to only the bits that are "economically recoverable." In other words, the higher the price of a given commodity, the higher the "economically recoverable" reserves are. If oil is at $120 per barrel, a field has much more "economically recoverable" oil than it does when oil is at $60 per barrel. The higher prices allow firms to spend more money to recover more oil.
With natural gas, the advent of horizontal drilling and multi-stage fracturing altered the first parameter dramatically, ballooning North America's technically recoverable gas resources. And while natural gas prices held steady, reserves ballooned too.
The key bit there was "while gas prices held."
But that honeymoon is over. Natural gas prices in North America have declined roughly 35% this year and are down approximately 60% over the last 12 months. Compared to the unsustainable highs reached in 2008, gas prices have fallen more than 80%.
You have just made the case for price adjustment for supply and demand.Numbers are adjusted down--that's the economic consideration--short supply follows suit--and price adjustment to the upside take place.Hang in and things get better real quick. Still see big uptick before election.