RESERVE COST RATIOS

The reserve cost ratios are based on costs and on reserves. When a company has both oil and gas
reserves, the reserve cost ratios are computed by converting the reserves to a common unit of
measure based on energy content (BOE).

Finding costs ratios

Finding costs per BOE is one of the most common, but difficult to define, performance measures
used in evaluating oil and gas operations. Finding costs per BOE is the most frequently cited ratio
utilized in evaluating the efficiency of a company in adding new reserves. The basic ratio consists
of the finding costs of adding new reserves divided by the new reserves added. The difficulty with
calculating and using the finding costs per BOE ratio results from several factors.

First, there is no consensus regarding which costs should be included as finding costs. Second,
companies use different methods of accounting for oil and gas exploration and development
operations, i.e., full cost and successful efforts. Consequently, even if there were a specific
definition of finding costs, the amounts would likely still differ, since the various accounting
methods treat the costs differently in terms of expense and capitalization. Third, there is typically
a timing difference between the period(s) when the finding costs were actually expended and when
the new reserves are actually reported in the financial statements. This timing difference poses a
difficulty in interpreting the finding costs per BOE ratio. Finally, there is some debate as to which
reserve estimates should actually be used in the calculation.

These issues are discussed below.

Two methods of accounting for exploration and development costs are currently accepted in
practice: the successful efforts method and the full cost method. In general, under the successful
efforts method, geological and geophysical (G&G) exploration costs are written off as incurred.
The costs of dry exploratory wells are written off when the determination is made that the well is
dry. The costs of successful exploratory wells and successful and dry development wells are
capitalized and amortized over production. Under the full cost method, all costs incurred in
exploration, drilling, and development are capitalized and amortized. Clearly, any attempt to
calculate finding costs for a sample of both full cost and successful efforts companies would
require a detailed evaluation of all of the reported costs to ensure that equivalent costs, whether
expensed or capitalized, are used.

In computing finding costs per BOE, there should be correspondence or matching between the
costs in the numerator and the reserves in the denominator. The difficulty is determining which
reserves should be used to correspond to the costs in the numerator. Reserves categories include
reserves added through discoveries and extensions, purchases of reserves in place, revisions in
reserve estimates, and enhanced recovery. If reserves added through extensions and discoveries
are to be used, then finding costs per BOE should be calculated as follows:

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Some analysts include current reserve revisions, while others exclude them. There is no single,
consistently used method. One possible solution that is frequently used is recomputing the previous
year’s finding costs per BOE by adjusting the reserves for that year by revisions reported in the
current year. The logic is that since the revisions relate to prior years rather than the current year,
the revisions should be reflected in the ratio for the prior years. Obviously this solution assumes
that finding costs per BOE would be analyzed in the context of several years’ data rather than for
a single year.

The next issue is whether to include reserves purchased in place. If these reserves are to be included
in the calculation, proved properties must be included in the numerator so that costs and reserves
correspond. The formula would be as follows:

Finally, sometimes finding costs per BOE is computed by attempting to include all costs
necessary to replace reserves. This ratio includes all of the costs in the above ratio plus the cost
of unproved properties and development drilling expenditures, as follows:

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The purpose of a development well is not to find reserves but to produce previously discovered
proved reserves. Consequently, when development drilling costs are included in the ratio, this
ratio is sometimes referred to as a finding and development cost ratio or a reserve replacement
cost ratio.

These different formulae can result in significantly different finding costs per BOE. Gaddis,
Brock, and Boynton used the financial statements of several oil and gas producers to demonstrate
the vastly different results in finding costs per BOE.

• Method A: G&G costs and exploratory drilling costs only are divided by reserve additions,
excluding revisions.
• Method B: G&G costs and exploratory drilling costs only are divided by reserve additions,
including revisions.
• Method C: G&G costs, exploratory drilling costs, and development drilling costs are divided
by all reserve additions, including revisions.

Example
Using the reserve disclosure data presented earlier for Tyler Company, finding costs per BOE are
computed below using the various formulae. Assume the following costs (in thousands):

2010 2011 2012

Unproved property acquisition $ 25 $ 45 $ 80
Proved property acquisition 50 50 50
G&G 300 350 325
Exploratory drilling (including dry hole) 321 400 450
Development drilling 150 90 200

Formula 1 without revisions:

$300 + $321 = $11.717/BOE

2010:
53

$350 + $400 = $10.274/BOE

2011:

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$325 + $450 = $11.923/BOE

2012:
65
Formula 1 with revisions:

$300 + $321 = $5.496/BOE

2010:
53 + 60

$350 + $400 = $3.695/BOE

2011:
73 + 130

$325 + $450 = $2.710/BOE

2012:
65 + 221

Formula 2 without revisions:

$300 + $321 + $50 = $6.515/BOE

2010:
53 + 50

$350 + $400 + $50 = $9.091/BOE

2011:
73 + 15

$325 + $450 + $50 = $11.000/BOE

2012:
65 + 10

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In summary, since there is no consensus regarding the most appropriate formula, it is important
to consistently use the formula or formulas selected. Also, in any analysis, it is important to look
at trends and averages over several years.

Lifting costs per BOE

Lifting costs per BOE is a very popular performance indicator. Lifting costs per BOE is a
measure that may be used to evaluate the extent to which a company is controlling its operating
costs or how efficiently the company is getting oil and gas out of the ground, or both. The basic
formula is as follows:

In order to use this ratio appropriately, it is important to understand the costs that may or may not
be included and how the results should be interpreted.

Example
Assume that the production costs that appear on Tyler Company’s annual report are (in
thousands):

Year Lifting (Production) Costs (excluding DD&A) DD&A

2010 $500 $800
2011 525 775
2012 510 750

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Using the reserve production information presented previously, lifting cost per BOE would be
computed as follows:

DD&A per BOE

DD&A reflects the historical cost of finding and developing reserves and, as such, relates to prior
periods, while lifting costs relate to the current period. Consequently, DD&A per BOE is not
helpful in assessing current period efficiencies. However, since DD&A appears on the income
statement, it does affect current profitability. One means of dealing with depreciation, depletion,
and amortization (DD&A) is to omit DD&A on all wells, equipment, and facilities from the lifting
cost per BOE calculation and separately compute a ratio of DD&A per BOE. The formula is as
follows:

Example
Using the information presented previously for Tyler Company, DD&A per BOE is given in the
following

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 RESERVE VALUE RATIOS

Value of proved reserve additions per BOE

One criticism often leveled at ratio analyses using reserve quantities is that the analyses do not
convey information about the “quality” of the reserves added. Some reserves are of high quality,
i.e., they require relatively less in production, transportation, or refining costs. In contrast, the
production of other reserves requires extensive expenditures for lifting, transportation, or refining.
One such ratio is the value of proved reserve additions per BOE. This ratio is computed using
certain elements of the changes in the standardized measure disclosure and the reserve quantity
information disclosure. For example:

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As is the case with finding costs per BOE, the calculation of value of proved reserve additions per
BOE requires consistency between the value figures included in the numerator and the reserve
categories included in the denominator. Again, for the best results, multiple year analyses should
be used.

Example
The following information is taken from Tyler Company’s annual report:

Changes in Standardized Measure of Discounted Future Net Cash Flows in Thousands

Year ended Dec. 31 2010 2011 2012

Beginning of year $20,355 $20,212 $19,792

Changes due to prices and costs 801 500 (902)

Changes due to purchases in place 530 220 139

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Changes due to extensions, discoveries, and
improved recovery 599 890 712

Changes due to revisions in estimates 699 1,100 989

Changes due to sales in place (225) (350) (400)

Changes due to production (2,700) (2,980) (3,000)

Accretion of discount 153 200 250

Balance end of year $20,212 $19,792 $17,580

Extensions and discoveries 53 73 65

Improved recovery 210 132 115

Purchases of reserves in place 50 15 10

Revisions of previous estimates 60 130 221

Production (249) (243) (275)

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Value added ratio
Another popular reserve value ratio is the value added ratio. First, the value of proved reserve
additions per BOE ratio as described above is computed. This ratio is then compared to finding
costs per BOE. Specifically, the value added ratio is computed by dividing the value of proved
reserve additions per BOE ratio by the finding costs per BOE ratio. The objective of this analysis
is to compare the cost of finding reserves with the value added by those reserves. Obviously such
a comparison requires consistent use of costs and reserve categories in each formula. For example,
assume the following:

The comparison of finding costs and value added would require that the value of proved reserve
additions ratio per BOE include similar categories of values and reserves. Accordingly:

Example
The value added ratios for 2010, 2011, and 2012 for Tyler Company are computed below. (The
finding costs per BOE and value of proved reserve additions per BOE ratios were computed
previously.)

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