Oil & Gas Reserves Estimates: Science, Art & Magic
Category: Oil & Gas...
Posted Friday, January 09, 2004 at 06:20 PM [GMT-6]

In response to my earlier post about Royal Dutch/Shell's decision to write down its proved reserves by 20%, my pal Daniel over at Behind the Wall of Sleep left this comment:

Daniel is referring to something that occurred about five or six years ago, when a Canadian company called Bre-X announced that it had discovered one of the largest deposits of gold in the world, in the jungles of Borneo. The alleged discovery eventually turned political, with the government of Indonesia getting involved, and finally the American company Freeport-McMoRan Copper & Gold was brought in to be a third-party objective project manager. (Daniel no doubt remembers this because FM is a Louisiana company, right there in Daniel's swamping grounds.) Anyway, it turned out that there was little or no gold and Bre-X collapsed under the weight of public opinion (investors are so fickle, you know?). Here's an interesting summary of the scandal, if you care to learn more.

Having refreshed my memory about the Bre-X scandal, I have to respectfully disagree with Daniel in that this was conscious fraud, compounded by corporate greed, from the get-go. In the case of Shell's writedown, however, I don't see the same smoking gun. Now, I do agree that corporate greed is probably a factor, but not in the obvious way that we see in many business scandals.

No, Shell's situation is hardly scandalous, as it simply reflects the reality of the difficulties in projecting the value of oil and gas reserves. The engineering challenges coupled with internal corporate politics make reserves estimates a game that's hard to win.

Let me say right off that I'm not a petroleum engineer, but I spent the better part of 15 years working alongside of engineers as they evaluated oil and gas reserves, and with management as it secondguessed and/or blessed those evaluations. So I feel pretty confident that a reservoir engineer for a major oil company wouldn't have much problem with this statement: you never really know how much oil (or gas) is in a given reservoir until you've plugged the last well and tallied up the production. (And even that's not true, as there will always be hydrocarbons left in an abandoned field...sometimes significant amounts. The abandonment decision is rarely based solely on how much oil or gas is left. But that's another post.)

If you're not from an oil-producing region, you may not realize that oil and gas is not found in a big underground lake, where you can drill down and just suck it up through a bunch of steel straws. Hydrocarbons are trapped in the pores of solid rock and those pores are often microscopic in size. We don't have time or space to delve into the intricacies of how oil and gas is produced from this rock; suffice it to say that it's a fascinating feat of engineering, physics and geology.

The real trick is, of course, to guess the size of that section of rock containing the oil. Then you have to guess how much oil is trapped in the rock's pores, and how much you can expect to recover, given some very strong natural tendencies of the rock to hang onto the oil. And, finally, you have to figure out how quickly you can pump out the petroleum...and "as quickly as possible" is not the right answer. Contrary to logic, those rock reservoirs can be quite fragile, and many a good oilfield has been ruined by failure to treat it with the equivalent of kid gloves during the producing stage.

But that's just the beginning of the reserves estimation process. It's not enough to produce oil and gas; you have to produce it profitably (darn those stockholders!). That means being able to estimate such "simple" things as: the price you'll receive for future production; the future costs involved in developing the field (capital investment); the future costs of producing and transporting the oil and gas; future tax rates imposed by all the various governmental entities that want a piece of the action; the amount of overhead burden the corporation is going to saddle your group with (remember, we're talking about a major oil company here). Oh, did I mention that by "future," I mean up to 40 years or longer?

As you might imagine, an error in one of these estimates can affect the outcome, but taken in aggregate, the potential for compounding of errors is significant.

Then there are the "soft" factors that play into the equation. At some point in the past, it's a certainty that your executive management has made a commitment to the stock analysts about reserves additions and the percentage of current production that your company will replace via new reserves. You, as a lowly reservoir engineer, have no idea where the numbers behind this commitment came from; all you know is that it's a huge number and it's your job to achieve the goal.

It's important to make that reserves goal, because the stock market expects it. But it's even more important because incentive bonuses and stock options are depending on it. And not just for the executives, although they surely get the lion's share. But every major oil company has an incentive bonus program that extends throughout the ranks, and reserves replacement is part of the computation (in some form or fashion) that determines your bonus and that of your co-workers.

In addition, your estimates are subject to a long line of second-guessers and tweakers, as the numbers move up the line and are aggregated with those from other producing fields and projects and operating divisions and subsidiaries. At each step of the way, because of the aforementioned "soft factors," any adjustments in numbers will almost surely be made in a mindset of "imposed optimism." At one level, 9.45 is legitimately rounded up to 9.5; at the next level, 9.5 is deemed to be meaninglessly precise...let's make it a nice round 10. And so on. Apply this optimism to all the components of the estimate, and then to the estimate itself, and you'll clearly see how easily the numbers get inflated, with absolutely no single person along the way taking an intentionally fraudulent or misleading step.

Sure, every publicly traded company has a series of checks and balances and audits and reviews that should mitigate these tendencies. That's apparently how Shell discovered the current situation. But these are times of endless cost-cutting and "productivity-enhancements" (fewer people doing more work), and quality control isn't exactly optimized.

So, every now and then the estimating errors and unintentional biases and irrational exuberance catches up to you, and if you're someone like Shell, you own up to it, take your licks and move on. A few people will get demoted or assigned to Uzbekistan; there may even be a firing or two. But in the end, it still comes down to how much oil and gas you can coax out of that rock, and you'll never know for sure until it's over.