Investing Daily Article of the Week
by Robert Rapier, Investing Daily
Investors in oil and gas companies have one more unpleasant surprise awaiting them at the end of the year.
Each year in their annual reports, companies report on their future cash flows, net of costs, based on their proved reserves. This is referred to as the Standardized Measure (SM), which must be calculated according to specific guidelines set by the U.S. Securities and Exchange Commission (SEC).
The SM is the present value of the future cash flows from proved oil, natural gas liquids (NGLs), and natural gas reserves, minus development costs, income taxes and existing exploration costs, discounted by 10%. All oil and gas firms that trade on a U.S. exchange must provide the Standardized Measure in their filings with the SEC.
This is an important metric for valuing oil and gas companies. In theory, a company should be worth at least its SM. So if a company is trading at less than the value of its SM-in other words, if its enterprise value to SM ratio is less than 1-the company is in theory trading at less than its worth.
I say “in theory,” because there are some very important caveats that apply.
It is important to understand that the SM is based on year-end proved reserves. So let's review the difference between a proved reserve and a resource.
An oil resource describes the total amount of oil in place, most of which typically can't be technically or economically recovered.
The portion of the resource that is technically AND economically recoverable at prevailing prices is the proved reserve. Because of the requirement that the oil be economically recoverable, proved reserves are a function of commodity prices and available technology.
Oil and gas resources that became proved reserves as prices rose will no longer be considered as such should lower prices make them uneconomic to produce.
This is often the reason that companies have to write down proved reserves, though there are also times when it happens because a company believed there was oil or gas and found out later that there wasn't.
