Oil and gas reserves and production sustainability
Every upstream energy company extracts oil and gas from an estimated volume of conventional or unconventional reserves lying underground. But as reservoirs deplete, production levels also fall. So there is naturally a need to know how long a given upstream company can sustain its current production levels at a given number of production facilities.
The reserves-to-production ratio addresses this quantitative need for production sustainability measurement. We calculate this ratio by dividing the upstream company’s total proved reserves by its current rate of production.
Impact on cash flow
The above chart indicates the reserves-to-production ratio for a select group of S&P 500 independent oil and gas upstream companies as of 2014. The higher the reserves-to-production ratio, the longer the company’s possibility of maintaining its current production levels. Higher reserves-to-production ratios also indicate upstream companies’ ability to maintain cash flow over a long timeframe.
As seen in above chart, within the S&P 500, upstream companies including ConocoPhillips (COP), Cimarex Energy Company (XEC), and Occidental Petroleum Corporation (OXY) have relatively higher reserves-to-production ratios than big hitters like Noble Energy (NBL) and Murphy Oil Corporation (MUR).
Apart from investing directly in these companies, investors can also gain exposure to upstream energy companies like these by investing in the SPDR S&P Oil and Gas Exploration & Production ETF (XOP). The First Trust ISE-Reverse Natural Gas ETF (FCG) invests specifically in natural gas producers.
Assumptions of the reserves-to-production ratio
We should note that the reserves-to-production ratio makes certain assumptions, such as the constancy of current production levels in the future. At the same time, the ratio also ignores any exploration or developmental work that could bring new reserves or production online in the future. So, essentially, it’s a ratio based and focused on current circumstances.
From an economic and business perspective, upstream companies’ underlying reserves and production levels are constantly changing, depending on the changes in the price of crude oil or natural gas as well as on technological advances.
In the next part of this series, we’ll discuss the reserve replacement cost metric.