ANALYSIS OF OIL AND GAS COMPANIES’ FINANCIAL STATEMENTS

The financial statements of oil and gas producing companies contain a great deal of information
that is not contained in the financial statements of companies in other industries. The reporting
requirements resulted primarily from the conclusion that neither the successful efforts method
nor the full cost method effectively communicates information that is useful in projecting the
future cash flows of oil and gas producing companies. Instead, the extensive disclosures
mandated specifically designed to provide additional information that is presumed to be useful to
an investor or potential investor.

In this topic, various ratios and techniques employed by investment analysts, company
personnel, and others in evaluating the financial performance of oil and gas producing companies
are discussed. The topic focuses on the ratios that are unique to oil and gas producing companies.

Source of data
The financial statements and disclosures are the primary source of the data necessary to compute
most of the ratios unique to oil and gas companies. As discussed previously, disclosures must be
presented in the annual reports of both successful efforts and full cost companies. Specifically,
the following disclosures are required:

Historical cost–based:
1. Proved reserve quantity information
2. Capitalized costs relating to oil and gas producing activities
3. Costs incurred for property acquisition, exploration, and development activities
4. Results of operations for oil and gas producing activities

Future value–based:
5. A standardized measure of discounted future net cash flows relating to proved oil and gas
reserve quantities
6. Changes in the standardized measure of discounted future net cash flows relating to proved
oil and gas reserve quantities

Comparing Financial Reports

Financial statements and other reports are evaluated for several different purposes. Oil and gas
companies compete in capital markets for new investment amount. Investors must determine
which companies to invest in, and lenders must determine to which companies to lend money.
To make these determinations, investors and lenders use various criteria, including the analysis
of certain key ratios or performance measures. Investors and lenders then compare the ratios to
identify the firms that have the greatest potential for successful performance in the future.

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In addition, companies are continuously seeking to improve their own performance. One
technique a company can use to evaluate its performance is to compare itself to other similar
companies. This comparison is commonly referred to as benchmarking. The process involves
identifying a pool of companies who are “peer” companies, i.e., companies that are similar to the
company in size, operations, and various other factors. Performance measures or key ratios are
computed for all of those companies and analyzed to determine how the company compares to
its peer companies. In this way, comparative strengths and weaknesses can be identified. A plan
can then be established and implemented to build on the strengths and correct the weaknesses.
Benchmarking is a critical step in improving the quality of business processes.

Whether the financial statement analysis is performed by outside investors or for internal
benchmarking, it is important to keep in mind that an analysis that involves trends over several
years is typically much more informative than the calculation of ratios for a single year. Recall
that, one of the unique characteristics of the oil and gas industry is the often long time span
between when exploration expenditures are made and when the results are known, i.e., whether
oil or gas has been found. The use of ratios computed over several years will not resolve the
timing problem of expenditures made in one year and results known in another. However, it will
somewhat mitigate the effects and is superior to single year analysis.

The ratios commonly used in the oil and gas industry for financial statement analysis and
benchmarking are discussed in this topic. The ratios discussed are reserve ratios, reserve cost
ratios, reserve value ratios, and financial ratios.

A. RESERVE RATIOS

1. Reserve Replacement Ratio

One key performance measure is the reserve replacement ratio. This ratio measures a company’s
success in replacing production and accordingly measures a company’s ability to continue to
operate in the future. The primary means by which reserves can be replaced are by discoveries,
extensions, in place purchases, and revisions. Replacement of reserves through revisions is
troublesome and is viewed by some as being an artificial source of growth.

A firm that is not replacing the reserves it produces will ultimately deplete its pool of available
reserves and be forced to either purchase reserves in place or simply cease to do business. Since
purchasing reserves in place is typically more expensive than acquisition of reserves through
discoveries and extensions, it is desirable for a company to consistently add to its reserves at a
rate equal to or higher than its rate of production. Accordingly, a company replacing the reserves
it produces should have a reserve replacement ratio of at least 1.

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The reserve replacement ratio is somewhat problematic, since it does not reflect the value of the
reserve replacements. Another problem is determining which categories of reserves to include in
the calculation. Specifically, reserve additions resulting from revisions in previous estimates and
purchases of reserves in place are often treated in different ways. Consequently, there are
multiple ways to calculate the reserve replacement ratio, three of which are described below. The
most basic formula is as follows:

Computed in this manner, the reserve replacement ratio considers only reserve additions
resulting from current discoveries, extensions, and improved recovery. Some analysts argue that
economic conditions may result in revisions in previously discovered reserves, and that those
revisions should not be overlooked in examining a company’s ability to replace its reserves.

On the other hand, many of the conditions that result in revisions in estimates are beyond the
control of a company’s management. Thus, inclusion of those reserves does not accurately
reflect management’s role in reserve replacement. An alternative reserve replacement ratio that
includes any current year revisions in reserve estimates in the numerator of the formula is as
follows:

Another calculation includes reserves that are purchased in place (rather than acquired through
discovery). Some analysts argue that, in certain situations, purchasing reserves is an alternative
that may be in the best interest of the company. If reserves acquired by purchase are included in
the numerator of the reserve replacement ratio, then any reserves sold in place (as opposed to
through production) should be added to the denominator as follows:

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Example
Assume that the following information appears in a disclosure on Tyler Company’s 2012 annual
report. This basic data is used throughout the chapter to calculate various ratios.

Estimated Quantities of Net Proved Crude Oil and Natural Gas Liquids
(Worldwide Totals) in Thousands of Barrels
Year ended Dec. 31 2010 2011 2012
Beginning of year proved reserves 2,553 2,654 2,729
Revisions of previous estimates 60 130 221
Improved recovery 210 132 115
Purchases of reserves in place 50 15 10
Sales of reserves in place (23) (32) (37)
Extensions and discoveries 53 73 65
Production (249) (243) (275)
End of year proved reserves 2,654 2,729 2,828

The reserve replacement ratios calculated using the three alternative methods for 2010,
2011, and 2012 are as follows:

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If a company has both oil and gas reserves, the reserve replacement ratio and the reserve life
ratio (discussed below) typically are calculated separately for each mineral. The ratios may be
calculated using equivalent units if called for by the particular analysis being done.

2. Reserve life ratio

The reserve life ratio is used to approximate or measure the number of years that production
could continue at the current rate if no new reserves were added. The higher the reserve life ratio,
the longer a firm could continue to generate enough cash flow to cover its financial obligations
even if it curtailed exploration and discovery activities—assuming current production generates
enough cash flow to cover financial obligations. The reserve life ratio is calculated as follows:

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Example
Using the basic data from the previous example for Tyler Company, the reserve life ratio for
each year is as follows:

3. Net wells to gross wells ratio

Companies must disclose their total gross wells and net wells in their financial reports. Gross
wells is the number of wells in which the company has any working interest, regardless of how
large or small the interest may be. Net wells is the net interest in the wells, i.e., the total of all
working interests in all wells. It is computed by multiplying each well in which a company has a
working interest by the relevant working interest percentage and summing the result. For
example, a company might have a 100% WI in 5 wells, a 75% working interest in 3 wells, and a
50% WI in 2 wells. It would then have 10 gross wells (i.e., 5 + 3 + 2) and 8.25 net wells (i.e., 5 ×
1.0 + 3 × 0.75 + 2 × 0.50).

The net wells to gross wells ratio is calculated as follows:

The ratio of net wells to gross wells is used as a gauge of future profitability. The rationale is if a
company owns a large interest in each well, the company is likely to be the operator, benefit
from being the operator, and as the operator, have a greater say in operations. In addition, the
company is likely to be more profitable as a result of consolidated interests (i.e., having
relatively larger interests in fewer properties rather than having to spread its resources over more
properties with smaller interests). A high ratio indicates that a company owns relatively large
working interests in wells, while a low ratio indicates that a company owns many small working
interests.

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Example
The table below shows Tyler’s interests in various wells and the calculation of gross wells and
net wells:
Gross Wells Working Net Wells
Interest
15 100% 15.0
10 75% 7.5
15 60% 9.0
20 50% 10.0
5 40% 2.0
2 20% 0.4
6 15% 0.9
2 10% 0.2
75 45.0

Tyler Company has an interest in 75 wells, so its gross wells is 75. Tyler’s net wells is 45, and its
ratio of net wells to gross wells is as follows:

4. Average reserves per well ratio

The average reserves per well ratio is another measure used to evaluate a company’s future
profitability. The measure calculates the average reserves per well. A high average reserves per
well ratio indicates that a given quantity of reserves can be produced with fewer wells and thus
be produced more efficiently and more profitably. Consequently, the higher the average reserves
per well ratio, the greater the company’s future profit potential. The formula is given below:

Example
Using the proved reserves presented earlier for Tyler Company and the net well calculation
presented earlier, the average reserves per well for each of the three years are (assuming the net
wells do not change over the years):

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When a company has both oil and gas reserves, the average reserves per well ratio and the
average daily production per well ratio (discussed below) are normally computed by converting
the reserves to a common unit of measure based on energy content, specifically, barrels of
energy (BOE). Most frequently, the British thermal unit conversion (Btu) (approximately 6 to 1)
is used to compute BOE. For example, if Tyler Company also had proved gas reserves at the
beginning of 2010 of 3,000,000 Mcf (cubic feets of natural gas), the average reserves per well
ratio for 2010, assuming the same net wells, would be as follows:

Average daily production per well

The average daily production rate per well is yet another measure of a company’s future
profitability. The higher the average daily production per well, the more efficiently and
profitably the reserves can be produced. The average daily production per well is computed as
follows:

Example
Using the reserve and production information presented thus far for Tyler Company, the average
daily production per well for each of the three years is as follows:

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