American Oil and Gas Reporter - May 2016 - 43

SpecialReport: Acquisitions & Divestitures

Getting The Engineering Right

Approach Improves Reserves Analysis
By W. John Lee
COLLEGE STATION, TX.-There are
numerous considerations that go into
finding the right acquisition opportunities,
but the bottom-line measurement of any
asset's present or potential value can be
summed by a single question: How much
recoverable oil and gas is in the ground?
In commercial real estate, the art of
the deal is all about negotiating savvy,
and success is celebrated at closing. In
oil and gas property transactions, deal
making is more engineering than art, and
success is difficult to quantify until long
after the handshakes are done. Did the
asset meet the buyer's expectations over
time? Did the property have more reserves
upside than the seller anticipated?
Properly doing the scientific due diligence to get accurate answers to reserves
questions before signing on the dotted line
is what ultimately distinguishes good deals
from bad ones for both buyers and sellers.
Timing can be everything in property
transactions, so speed is important, as is
adhering to applicable industry standards
and regulatory guidelines. But accuracy
is job one in A&D reserve evaluations.
The only way to ensure fair market value
is to model the production trends of
wells, and forecast the modeled results
to determine the volumes of oil and gas
that can be expected to be recovered in
10, 20 or 30 or more years. Having confidence in reserve assessments requires
understanding the reservoir, and how the
production and decline profiles of current
wells can impact recovery in the future.
For buyers, overestimating reserves
can increase business and financial risk
significantly by creating unrealistic projections of the value a property can generate over its productive life. With that
in mind, there are certain appraisal methods that are particularly subject to error
in resource plays, especially with respect
to overly optimistic assessments.
An example is reserve evaluations
based on traditional type curves. There
are numerous technical considerations
involved in constructing type curves, and
simply averaging production at a given
point and stepping it through time will
not achieve realistic outcomes if individual

well profiles are changing, which they
tend to do as reservoirs deplete. The resulting type-curve estimates can be quite
inaccurate.
The U.S. Securities and Exchange
Commission is well aware of the shortcomings of traditional type curve-based
calculations, and oil and gas companies
also should be suspicious that reserves
estimated using type curves will be too
high. An investment advisory firm conducted a study a few years ago that investigated reserves claims made from
type wells and concluded that the outcomes
showed a consistent optimistic bias.
Best Available Model
Reserve analysts must use the best
available model, but the best available
model sometimes is not a high-confidence
model when applied to individual wells
in resource plays. The key is to group a
large number of wells-100 or more, if
possible-to ascertain an average value
across a broad population. The more
wells in a grouping, the more confidence
there will be in the model, as long as the
analysis consistently uses similar wells
in similar locations.
The SEC has determined that it will
accept evaluations based on "reliable
technology" that takes into account the
effects from larger well groups. This approach was detailed in the Society of Petroleum Evaluation Engineers' Monograph
3 (first published in 2010 and revised in
2013). Monograph 3 provides specific
guidelines for the "reasonable and practical" evaluation of undeveloped reserves
in resource plays. It presents a workflow
that includes:
* Determining whether the reservoir
is a resource play;
* Identifying analogous wells (completion and production characteristics)
and determining estimated ultimate recoveries;
* Creating a log normal distribution
of analogous well EURs;
* Determining the proved areas using
the distribution model; and
* Adjusting deterministic EURs to
statistical EURs.
Using reliable technology, it is legitimate
to take into account the so-called portfolio

effect. The portfolio effect arises from the
fact that SEC rules require 90 percent confidence that a certain volume can be produced from a well before the reserves can
be booked. On an individual well basis,
that is good and conservative practice.
However, there will be a lot of variance
in a group of 100 wells. Some wells will
be above-average producers, some will
be average, and some will be below average. The reliable technology approach
looks at the 90 percent confidence number
for the entire mix, rather than each individual well, recognizing that some future
wells will be better than others.
By lumping in a group the 90 percent
confidence production forecasts of 100+
wells in a given area, the portfolio effect
results in larger reserve volumes per well
than ever could be claimed by looking at
each well's reserves at a 90 percent confidence factor and then multiplying by
100. In fact, reliable technology likely
will increase reserves potential in resource
plays by 150-200 percent, compared with
simply adding the conservative estimates
from individual wells.
I have talked with operators who are
understandably concerned that the SEC
will not accept evaluations performed
using reliable technology. However, the
SEC has looked at the technology, and
while its staff certainly will look closely
at the numbers and demand proof, the
results will be accepted when the approach
is applied correctly.
Modeling Decline Trends
Of course, the output of any analysis
is only as good as the data input. The reliable technology method needs a certain
number of producing wells, and the only
information available frequently is public
domain data. However, as long as there
are enough wells, predictions can be
made with confidence, assuming the same
recovery distribution among all producing
wells in the group describes what will
happen in wells not yet drilled.
One of the key requirements is having
accurate data on decline trends. If EUR
estimates used in the recovery distribution
of producing wells is too optimistic, then
the reserves projections for undeveloped
areas also will be overly optimistic. The
MAY 2016 43

American Oil and Gas Reporter - May 2016

Table of Contents for the Digital Edition of American Oil and Gas Reporter - May 2016