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Market in need of a ‘most probable’ reserve estimate: By Eric Knight

Financial Times: Letters: Market in need of a ‘most probable’ reserve estimate: By Eric Knight:

Posted 24 Sept 04

From Mr Eric Knight.

Sir, The reclassification of 23 per cent of Shell’s proved reserves this year cast doubt on both Shell’s governance and the longevity of its reserves. The need to reform Shell’s structure now appears genuinely to have been accepted. Of equal importance, however, is the need to restore confidence in Shell’s reserves.

Oil and gas recoverable from both discovered and undiscovered deposits is known as a company’s resource base. Exploration, acquisitions and technological advancement increase this resource base and are a key indicator of long-term potential. Reserves, which account for part of the resource base, are sub-divided into “possible”, “probable” and “proved”, in order of increasing conservatism.

The “proved” category is the only estimate of reserves required to be disclosed in filings with the US Securities and Exchange Commission (SEC).

As a consequence, it is frequently the only estimate available and is widely used to calculate the reserve replacement ratio.

SEC rules require “reasonable certainty” that the resource can be produced under existing economic and operating conditions. In spite of this, oil companies still have considerable discretion in managing the pace at which proved reserves are booked. In the wake of Shell’s reclassification, companies have taken to stressing the conservatism of their proved reserves estimates.

But this misses the point. It is precisely because proved reserves are so conservatively defined and estimated that they provide an incomplete and somewhat misleading picture for shareholders.

Oil companies commonly use the sum of “proved” and “probable” (or 2P) reserves to value each other.

As an insider’s best estimate of what will be produced over the entire life cycle of an established deposit, it provides a more comprehensive estimate for the assessment of performance. The reclassification of Shell’s proved reserves resulted in a reduction in its proved reserve life from 13 years to just over 10 years. However, in terms of 2P reserves, Shell’s reserve life appears to be approximately 20 years (including oil sands) and is fully in line with its peers.

Oil companies operate in far more difficult environments than they did when the SEC rules were first established. That is not to say the rules should change.

What the market needs is a “most probable” reserve estimate, as well as some form of broader resource estimate, in order better to evaluate upstream performance and longer-term potential.

Shell and its peers can and should lead the industry forward by providing these estimates on a uniform basis, without waiting for the rules to change.

In the meantime, shareholders can take comfort in Shell’s AA+ rated balance sheet and strong operating cash flow, likely to exceed $25bn (£14bn) this year.

Eric Knight, Managing Director, Knight Vinke Asset Management, New York, NY 10017, US

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