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David Melton

David Melton

Since 1980, Mr. Melton has been involved in the oil and gas industry and since 1985 has had executive oil and gas management positions.  Mr.…

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5 Points To Consider Before Buying Oil Stocks In 2020

If you are among those who are somewhat contrarian in nature and are ready to rush in and buy oil and gas stocks when they are down, downturns like this can be a great time to do so. But you really need to know what you are buying and what questions to ask your broker in order to give yourself a realistic chance of financial success. Not all public oil and gas company stocks are created equal. In other words, there is a difference between not following the crowd and “true value investing”. Another very important issue to consider is the publicly traded oil company’s booked reserves which may never be produced and how secure are they. These are called Proved Undeveloped Reserves. This article is designed to point out some very key and crucial points that you should know which could cause the stock’s value to be suppressed for quite some time. There are those investors who are aware of the issues discussed herein and know how to take calculated risks, but many do not, so this discussion is for those who don’t, especially when it comes to understanding the dynamics surrounding Proved Undeveloped Reserves and how they can affect stock value.

Since the history-making plunge in oil prices on April 20, 2020, the Internet has been full of opportunities to “buy now” when oil prices and stock prices are down. Whether you are just planning to sell the stock at some point in time in the near future to realize a quick profit or if you are looking to hold on to it in hopes of realizing future cash dividend payments, it is important you know the answers to the following. For example:

1. Do you fully understand what determines the true value in the stock you are buying?

2. What are Proved Undeveloped Reserves and how do they affect stock values?

3. Do you know how the new 2008 SEC ruling regarding Proved Undeveloped Reserves can affect your investment?

4. How does the “breakeven price point” of booked reserves affect the company’s cash dividends?

5. At what oil and gas commodity price should you buy in at and at what price are the company’s reserves valued?

Do you fully understand what determines “true value” in the stock you are buying?

Publicly traded companies can book reserves that look good on paper, but they may never be produced. It is important for you, the investor, to know exactly which reserves actually put true value into the company, not just in their annual report that increases the stock price.

For example, companies generally try to place each of several categories of “Proved Reserves” on their balance sheet. But, does each category represent a realistic value? For example, there are three different “Proved Reserve categories” in which the SEC allows a company to place on its bottom-line value.

These are:

Proved Developed Producing (PDP) - current oil and gas production and reservoir analysis of ultimate recovery from existing wells (i.e. current cash flow).

Proved Developed Non-Producing (PDNP) - oil and gas that has been verified in existing wells, but not yet producing. Commonly called “newly drilled and completed and not online” or proven "behind pipe reserves" which can fit the description of PUD reserves in that these types of reserves (behind the pipe) may never be produced any time soon, if ever due to many unforeseen circumstances, such as oil and gas prices and future available cash for the CAPEX attributable to recovering these “behind the pipe” reserves.

Proved Undeveloped (PUD) - oil and gas that may be recovered from new development wells on undrilled acreage completed in the same geological formation as the existing direct offset wells (requires substantial Capital Expenditures for drilling new wells).

According to the Oil and Gas Financial Journal, “the primary determinants in assessing the true value of an oil and gas company are, at the time of valuation: 1) reserves, 2) level of production, and 3) commodity price at the time of valuation.” While the level of production, and commodity price at the time of valuation variables are relatively straightforward to determine, the question of how best to measure a company’s reserve stocks remains somewhat questionable at best due to the vast number of extenuating factors.

But all of these Proved Reserve categories have risks. For example, if you only look at the PDP reserves (the company’s cash flow) for its true value, then the rise and fall of daily oil and gas prices can affect the company’s ability to “breakeven” in price downturns, such as is 2Q 2020, thus lowering the company’s overall bottom-line value.

Calculating a total “breakeven” amount includes many costs such things as, lease operating expenses, production tax, return on capital expenditures (CAPEX), servicing bank debt, making payroll, accommodating associated admin/overhead costs, and other contractual obligations.

One especially problematic issue for investors is the acquisition of properties that are under contracts negotiated when oil and gas prices were higher but have not closed and that are due to close soon after a significant oil and gas price drop. In this all too common scenario, the value of the property to be acquired is to be out of balance with current pride conditions and closing will take away from the company’s most precious commodity – cash. Most of the time, investors are not aware of any such “land mine” contractual acquisition obligations.

As we are seeing in 2Q 2020, many companies are scrambling to readjust their admin/overhead costs so they can at least pay the monthly lease operating costs and service their bank debt in order to keep these PDP reserves alive.

But, with PDP reserves, they are only as good as profit margins. That is why the SEC allows the other ‘proved reserves’ to be booked as value such as PUD reserves.

What are Proved Undeveloped Reserves (PUD)?

As previously stated, Proved Undeveloped Reserves (PUD) quantify oil and gas that will be recovered on undrilled acreage from new development wells completed in the same geological formation as the existing, direct offset wells (requires substantial Capital Expenditures for drilling new wells). A good question to ask is what price point has been placed on these reserves.

You’ll notice a key point in the definition: Oil and gas reserves that “will be recovered from new development wells on undrilled acreage”. The question is, when will they be recovered, if ever? Another important consideration is what was the price point used at the time that the PUD reserves were booked. In other words, were the economics a snapshot in time rather than future planning if prices dropped. In such cases, it may not be economic in the future to develop the PUD reserves and it may never be, which could also cause the loss of their associated oil and gas leases. In the 1980’s many companies lost their PUD locations due to the non-drilling of the term leases in which those PUD reserves were associated with. Further, these PUD reserves require substantial Capital Expenditures to be fully realized. The question here is: What if there is no capital to expand? Another concern is whether or not this “undrilled acreage” is held by current production from the existing PDP wells (HBP) or are they term leases that could expire because they are not HBP.

In addition, another real issue regarding this HBP leasehold where the PUD evaluations are listed is if those leases are subject to being lost due to a ‘depth clause’ and/or ‘Pugh clause’. In other words, after a certain period of time, a ‘depth clause’ in the lease allows ownership of formations not being produced (according to their spacing unit size) to revert from the company as Lessee back to the Lessor, which devalues those PUD reserves.

There are two types of ‘depth clauses which should concern the investor, either “deepest depth drilled” or “deepest producing formation”:

Related: The State Of Texas Collected Huge Royalty Check Before Price Crash

deepest depth drilled - “It is hereby understood and agreed that at the end of the primary term hereof, or any renewal or extension hereof, unless this lease is being otherwise maintained as provided for herein, this lease shall expire as to all depths lying below the stratigraphic equivalent of 100’ below the base of the deepest depth drilled of any well drilled on the leased premises or on lands pooled therewith.”

and deepest producing formation - “It is hereby understood and agreed that at the end of the primary term hereof, or any renewal or extension hereof, unless this lease is being otherwise maintained as provided for herein, this lease shall expire as to all depths lying below the stratigraphic equivalent of 100’ below the base of the deepest producing formation of any well drilled on the leased premises or on lands pooled therewith.” The same goes for the Pugh clause, which allows for all undrilled spacing units to revert back to the Lessor. For example, the company has a PDP well on a lease covering 640 acres which is spaced on 160 acres for that well (one well per 160 acres).

The Pugh clause in the lease states something like:

Beyond the Primary Term of the Oil and Gas Lease, absent any provision that would otherwise maintain the entire Lease in full force and effect, the lease will expire as to all acreage not included in a producing unit.”

The main critical issue regarding PUD values is the company’s ability or inability to maintain the associated leasehold while waiting for new wells to be drilled and then “hold” (or extend) the leased acreage by production, thus still holding this future value in place.

For these and other reasons which are not always known to investors in a company’s stock, PUD values are the riskiest of the three Proved Reserve categories.

Do you know how the new 2008 SEC ruling regarding Proved Undeveloped Reserves can affect your investment?

The author is not an expert on SEC matters, but through research found that according to the SEC’s definition of Proved Undeveloped Reserves prior to 2008, PUD’s were described was:

“Those quantities of crude oil, natural gas, NGLs and condensate, which, by analysis of geoscience and engineering data, can be estimated with certainty to be economically producible—from a given date forward, from known reservoirs, and under existing conditions, operating methods, and government regulations—prior to the time at which contracts providing the right to operate expire, unless evidence indicates that renewal is reasonably certain, regardless of whether deterministic or probabilistic methods are used for the estimation.”

In 2008, the SEC published a proposed rule called “Modernization of Oil and Gas Reporting”. After receiving comments during an extensive rulemaking process, the final rule became effective on January 1, 2010 (161 pages, compete with historical background and industry guidance). You may see the final rule here.

These revised rules for oil and gas reserve disclosures further defined the requirements for “proved reserves” in the hopes of giving investors and shareholders a more accurate understanding of a company’s current assets. According to the SEC, proved reserves are defined as the estimated quantities of oil and gas anticipated to be economically producible, as of a given date, under existing economic and operating conditions. Proved reserves can be defined as both developed or undeveloped in oil and gas that has been verified in current wells, but not yet producing which includes PUD’s, which is oil & gas that will be recovered from new development wells on undrilled acreage in the same geological formation as the direct offset wells (requires Capital Expenditures for new wells categories). While oil and gas companies historically included PUD quantities within their annual financial disclosures, the 2008 rule goes a step further by broadening the terms under which a company could list undeveloped reserves as “proved” for both shareholders and potential investors.

While the new SEC regulations do not change this risk structure, they do give companies greater leeway in booking PUD reserves than they had prior to 2010. The finalized definition of PUD reserves removed

the previous “certainty” test that was required for reserves to be considered PUD reserves and replaced it with a “reasonable certainty” test.

What does this slight shift in language mean to PUD reserve values? Simply put, companies that would previously be required to invest capital in exploration drilling to meet PUD standards now can rely on both deterministic—involving actual drilling—and probabilistic methods to estimate PUD reserves.

Importantly, this new description change also allows the use of evidence—economic data, drilling statistics, and geoscience—gathered from reliable technology to meet the reasonable certainty test of economic producibility for lease parcels further removed from currently productive units, rather than just those units immediately adjacent to productive wells. Essentially, the area from which companies can estimate and book proved reserves was drastically increased as a result of the new rules, which in turn makes them riskier in nature and less likely to show real value.

As a result, the revised 2008 SEC guidelines have provided the oil and gas industry with what could be considered a regulatory windfall. Thanks to the loosened requirements on PUD estimates, companies now have both an opportunity to report on these risky reserves while also increasing the levels booked on their annual reports to shareholders and investors.

But if the revised SEC regulations now provide companies with added flexibility to report on these distinct reserve classes, the degree to which these assets affect the company’s current and future value remains unclear unless other factors are considered. For example, what is the company’s Breakeven Price Points in the area of these PDP and PUD reserves. To explore this, the author considers the three scenarios listed above and examines to what degree reserve levels—both developed and, more importantly, undeveloped—affect a company’s total valuation and its leasing practices.

The bottom line is that, following the enactment of the revised 2008 SEC guidelines, some analysts predicted there would likely be an increase in booked PUD reserves across the industry. Because the new regulation loosened the requirements around establishing reserves as proved to include probabilistic methods, companies no longer needed to sink large amounts of upfront capital into exploration and drilling in order to book new PUD reserves.

How does the “breakeven price point” of booked reserves affect the company’s cash dividends?

In the post – 2010 SEC reporting scenario, investors looking for “true value” must address the effect “breakeven” price point of booked reserves will have on the company’s cash dividends. A simple answer is that ‘profits’ generate cash dividends. In other words, a cash dividend is funds or money paid to stockholders generally as part of the corporation's current earnings or accumulated profits. The board of directors must declare the issuing of all dividends and decide if the dividend payment can reinvest their dividends. Most brokers offer a choice to reinvest or accept cash dividends.

In a previous article I wrote for Oilprice.com dated January 4, 2018, I mention the importance of establishing safe ‘breakeven price points.” The term “safe” refers to the ability to operate and maintain leases during down pricing scenarios because the revenue from a given property at the low pride point still exceeds the total costs for Acquisition, CAPEX, Lease Operating Expense, and Production Tax. are present, while at the same time generate a profit.

Related: Oil Holds Gains As Demand Continues To Rise

For example, in 2Q 2020, if a company is able to operate and still make a good profit from any given property, then they had to initially set their price points for Acquisition, CAPEX, Lease Operating and Production Tax of that property at a lower level below the current actual price point. And, for the company to be profitable, their total revenue from all producing properties had to exceed the breakeven price points of all their producing properties.

An example of this could be taken from what oil yearly average oil prices have done since 1974 (PetroDollar) through 2019 and dividing that by half ($36.39/2 = $18.19). This $18.19 figure is not far-fetched when you consider the second chart where the yearly average oil price during this same time period was below this 49-year average 65% of the time for a price of near $20 per barrel.

Unfortunately, according to a report from the Federal Reserve Bank in Dallas dated March 2020, the average breakeven price point for the country is a little less than $50 per barrel ($49.17), which equates to companies not being able to develop their PUD reserves during downturns like those seen today (April-May 2020) thus further risking the non-HPB leases to expire and a loss of booked PUD values.

So, more awareness on the investor’s part is to thoroughly research these breakeven price points and ask your stock advisor to assist you in order to better assess the ability of realizing true achievable value from these types of reserves.

What oil and gas price do you buy in at?

Have you heard people say, “I will wait to invest when prices go back up?” A couple of questions and a comment: What price would they consider safe? What did they base that answer on?

If they invest after prices go back up, then they are setting themselves up for failure. History has repeatedly shown us that sharp price declines are followed by declines in drilling and completions costs which allow for lower breakeven price points. Conversely, increasing oil and gas prices are closely followed by higher drilling and completion costs which can ultimately lead to higher breakeven price points.

The obvious answer to the question of when to buy in is to buy when oil and gas prices are their lowest. But, in order to make “safe” investments during low pride scenarios, you must have the ability to select a realistic breakeven price point which will work throughout the anticipated time frame of your investment (for example, half of the yearly average oil and gas prices from 1974-2019, as shown above).

These types of investments may be hard to find. But perseverance and patience will allow you to locate these opportunities. Generally, your small to mid-size companies have much lower overhead costs.

If you got interested in the oil and gas business after 2005, you may not know that in 1998, oil traded for the year at an average price of $11.91 per barrel. I was involved with a company during that time in Santa Barbara, California that had breakeven price points at $4 per barrel. This unusually low breakeven price point allowed the company to be very aggressive in adding additional properties to their portfolio at a time when other companies were selling because the revenue from the low prices did not cover their operating expenses (CAPEX, Lease Operating Expense, and Production Tax).

In addition, you may not know that the following yearly average oil prices are actually less than you might expect. These figures represent the number of times these yearly average prices have occurred in the history of the oil and gas business (1859 – 2019) and the percentage of time from 1974 - 2019.

$ 40 per barrel – 15 times = 34%

$ 50 per barrel – 12 times = 27%

$ 60 per barrel –  9 times = 20%

$ 70 per barrel –  6 times = 13%

$ 80 per barrel –  5 times = 11%

$ 90 per barrel –  2 times = 4%

$100 per barrel – 0 times = 0%

In summary, pick your ‘buy in price’ wisely. The associated breakeven price points of the company you are interested in along with their overvaluing of PUDs can cripple your ability to make money. Are there any companies that have this ‘magic bullet’ formula? Yes, you just have to know how to find them or ask your stockbroker the questions I have proposed in this article. And, if you rely on a stockbroker or other investment advisor, then you should insist they understand these principles and get you the information which answers the questions raised in this article.

Conclusion

This article explores the potential risks and financial rewards for investors in oil and gas companies who book PUD properties, while at the same time delay the development of these reserves from those same properties. By highlighting the different scenarios described above, this author suggests that E&P companies do, in fact, seek to gain financially from both the increase in Proved Developed Reserves (those that are produced and sold to market) as well as Proved Undeveloped Reserves (PUD) that may never make it out of the ground. However, sufficient evidence exists to show that the current regulatory model for oil and gas reserves reporting is inadequate; it allows the stock price of a publicly-traded company to benefit from the PUD reserves they have booked, but without fairly disclosing to investors the factors which make it uneconomic to ever develop and bring those PUD reserves to market and at the expense of the public through nondevelopment of these PUD reserves.

By David Melton for Oilprice.com

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  • Jfh Auditor on May 26 2020 said:
    great article on a topic that does not get covered enough. in my professional opinion, PUD is presented in a manner unfair to investors. as an auditor, we have no solid ground to stand on with PUD as long as client can say they will develop before lease terms come to date. often times this is done despite the company not having a good case for available funds to develop, but since it is in future, there is no strong argument unless the company has never raised capital before.

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