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Reserve Audit Processusing SPE Petroleum Resources Management System (PRMS) : 

Prepared for GCA Clients, July 2007 Reserve Audit Processusing SPE Petroleum Resources Management System (PRMS)

Topics for Discussion : 

Topics for Discussion Brief comments on the revised “Standards” document and “auditing” Review of key features of the new SPE PRMS definitions

Standards Pertaining to the Estimating and Auditing of Oil and Gas Reserve Information : 

Standards Pertaining to the Estimating and Auditing of Oil and Gas Reserve Information Although the standards have no legal or other force, they represent a generally-accepted set of guidelines for the conduct of Reserves Estimation and Auditing The original version was published in 1977 and last updated in 2001 The current 2007 edition: Includes modifications required to incorporate the latest PRMS Although it remains concerned with Reserves only at present Clarifies the terms “auditors” and “auditing”, as well as “process review” Acknowledges the integration of geoscience with engineering in the preparation of reliable reserves information Companies may require their internal or external Reserves Estimators and Auditors to comply with these standards

Part I: Reserve Audit Fundamentals : 

Part I: Reserve Audit Fundamentals Prepared for GCA’s clients, July 2007

Reserves Audit - 1 : 

Reserves Audit - 1 “A Reserves Audit is the process of reviewing certain of the pertinent facts interpreted and assumptions made that have resulted in an estimate of reserves and/or Reserves Information prepared by others and the rendering of an opinion about: the appropriateness of the methodologies employed the adequacy and quality of the data relied upon the depth and thoroughness of the reserves estimation process the classification of reserves appropriate to the relevant definitions used the reasonableness of the estimated reserves quantities and/or the Reserves Information The term “reasonableness” cannot be defined with precision but should reflect a quantity and/or value difference of not more than plus or minus 10%, or the subject Reserves Information does not meet minimum recommended audit standards This tolerance can be applied to any level of reserves or Reserves Information aggregation, depending upon the nature of the assignment, but is most often limited to Proved Reserves Information A separate predetermined and disclosed tolerance may be appropriate for other reserves classifications”

Reserves Audit - 2 : 

Reserves Audit - 2 “Often a reserves audit includes a detailed review of certain critical assumptions and independent assessments with acceptance of other information less critical to the reserves estimation” “A reserves audit should be of sufficient rigor to determine the appropriate reserves classification for all reserves in the property set evaluated and to clearly state the reserves classification system being utilized” “In some cases, the auditing procedure may require independent estimates of Reserves Information for some or all properties”

Process Review : 

Process Review “A Process Review is the result of an investigation by a person who is qualified by experience and training equivalent to that of a Reserves Auditor to address the adequacy and effectiveness of an entity’s internal processes and controls relative to reserves estimation These internal processes and controls most often include some form of an independent internal or external reserves audit system The Process Review should not include an opinion relative to the reasonableness of the reserves quantities or Reserves Information and should be limited to the process and control system reviewed The term process review includes reports that have also been termed “procedural audits” or “procedural reviews” in the industry Although such reviews may provide value to the entity, an external or internal Process Review is not of sufficient rigor to establish appropriate classifications and quantities of reserves and should not be represented to the public as being equivalent to an audit of reserves”

Audit Methodology : 

Audit Methodology The following list is intended to establish broad requirements for the conduct of a reserves or resources audit A more comprehensive data list is available separately The fundamental methodology for an audit is that the company prepares the estimates and that audit checks them Therefore every number presented by the company must be traceable and supported by documented analysis All work to be carried out consistent with the specific definitions and guidelines Whether they are regulatory (e.g. SEC) or industry (e.g. SPE PRMS) Use the appropriate evaluation methodologies And compare with more than one approach Be consistent across assets Maintain a thorough audit trail And always exercise informed professional judgment

Audit / Documentation Check List – 1 : 

Audit / Documentation Check List – 1 Development plan* in place and approved – internal, partner(s), government Funding commitment Market and/or production constraints Methodology used - deterministic, probabilistic or scenario Assessment method - volumetric or performance based / primary & secondary Proved area/volume tests applied Vertical (LKH) – illustrate with logs, pressure plots and cross sections Lateral – illustrate with maps  Reservoir drive - document assumptions and role of analogs Producibility - evidence from well tests or other data * Documentation should relate to specific project and decision to invest

Audit / Documentation Check List – 2 : 

Audit / Documentation Check List – 2 License expiry Typically, no reserve recognition outside current license term, unless specific legal rights to extend (or precedence) exist Improved Recovery increment issues Describe method to be used Successful pilot, actual implementation, commercial use in the area  Royalty treatment Volumes taken in kind not included in Reserves   Royalty paid in cash: Excluded; or If included as Reserves, royalty treated as cost in economic limit test

Audit / Documentation Check List – 3 : 

Audit / Documentation Check List – 3 Net Interest - economic interest or working interest? Flare & Fuel Economic limit test Annual production forecast Defined costs and prices "as of assessment date“ for SEC License expiry/quota issues incorporated Abandonment cost accruals incorporated Developed/Undeveloped split Developed includes behind pipe or other volumes requiring capital investment, at a minority fraction (say 10% - 20%) of a new well cost

Part II: Reserve and Resources definitions PRMS 2007 : 

Part II: Reserve and Resources definitions PRMS 2007 Prepared for GCA’s clients, July 2007

Resources Classification : 

Resources Classification Reserves Discovered, recoverable, commercial, remaining Proved, Probable, Possible 1P, 2P, 3P (now formalized) Contingent Resources Discovered, potentially recoverable, not yet commercial, remaining 1C, 2C, 3C (new terms) Equivalent to Low, Best and High Estimates Prospective Resources Undiscovered, potentially recoverable, potentially commercial, remaining Low, Best and High Estimates Unrecoverable Discovered or undiscovered, not recoverable Classification Categorization

Discovery Status : 

Discovery Status “A discovery is one petroleum accumulation, or several petroleum accumulations collectively, for which one or several exploratory wells have established through testing, sampling, and/or logging the existence of a significant quantity of potentially moveable hydrocarbons” The PRMS intentionally does not require a flow test in order to establish a discovery In some instances it may nevertheless be considered that logging alone would not be considered sufficient to identify a discovery since some indication of fluid type and producibility will normally be required to comply with the following requirement: “In this context, “significant” implies that there is evidence of a sufficient quantity of petroleum to justify estimating the in-place volume demonstrated by the well(s) and for evaluating the potential for economic recovery”

Determination of Commerciality : 

Determination of Commerciality “Discovered recoverable volumes (Contingent Resources) may be considered commercially producible, and thus Reserves, if the entity claiming commerciality has demonstrated firm intention to proceed with development and such intention is based upon all of the following criteria: Evidence to support a reasonable timetable for development A reasonable assessment of the future economics of such development projects meeting defined investment and operating criteria A reasonable expectation that there will be a market for all or at least the expected sales quantities of production required to justify development Evidence that the necessary production and transportation facilities are available or can be made available Evidence that legal, contractual, environmental and other social and economic concerns will allow for the actual implementation of the recovery project being evaluated” With some minor differences, these criteria were typically applied to Proved reserves under prior guidelines Distinction between “economic” and “commercial”

Economics and “ELT” : 

Economics and “ELT” “While each organization may define specific investment criteria, a project is generally considered to be “economic” if its “best estimate” case has a positive net present value under the organization’s standard discount rate, or if at least has a positive undiscounted cash flow” “Economic limit is defined as the production rate beyond which the net operating cash flows from a project, which may be an individual well, lease, or entire field, are negative, a point in time that defines the project’s economic life Operating costs should ... exclude depreciation, abandonment and reclamation costs, and income tax, as well as any overhead above that required to operate the subject property itself Operating costs may be reduced, and thus project life extended, by various cost-reduction and revenue-enhancement approaches, such as sharing of production facilities, pooling maintenance contracts, or marketing of associated non-hydrocarbons”

Project-Based Classification : 

Project-Based Classification The Reservoir assessment determines the petroleum initially in place, and fluid and rock properties that affect petroleum recovery The Project is applied to a specific reservoir volume to generate production and cash flow schedule One project may develop many reservoirs or many projects may develop one reservoir The Property incorporates contractual rights and obligations, and fiscal terms, defining the entitlement share of investments, production and revenue One property may encompass many reservoirs or one reservoir may span many properties

Project Maturity - Reserves : 

Project Maturity - Reserves On Production The development project is currently producing and selling petroleum to market Approved for Development All necessary approvals have been obtained, capital funds have been committed, and implementation of the development project is under way Justified for Development Implementation of the development project is justified on the basis of reasonable forecast commercial conditions at the time of reporting, and there are reasonable expectations that all necessary approvals/contracts will be obtained

Project Maturity – Contingent Resources : 

Project Maturity – Contingent Resources Development Pending A discovered accumulation where project activities are ongoing to justify commercial development in the foreseeable future Development Unclarified or on Hold A discovered accumulation where project activities are on hold and/or where justification as a commercial development may be subject to significant delay Development Not Viable A discovered accumulation for which there are no current plans to develop or to acquire additional data at the time due to limited production potential

Project Maturity – Prospective Resources : 

Project Maturity – Prospective Resources Prospect A project associated with a potential accumulation that is sufficiently well defined to represent a viable drilling target Lead A project associated with a potential accumulation that is currently poorly defined and requires more data acquisition and/or evaluation in order to be classified as a prospect Play A project associated with a prospective trend of potential prospects, but which requires more data acquisition and/or evaluation in order to define specific leads or prospects

Project Maturity Linked to Decision Gates(can be quantified if desired) : 

Project Maturity Linked to Decision Gates(can be quantified if desired) Chance of discovery Chance of commerciality

Volume Categorization : 

Volume Categorization The PRMS recognizes three distinct approaches to volume categorization Deterministic incremental (“risk-based”) Proved, Probable, Possible There are no “incremental” categories for CR or PR, so by inference this is expected to be applied to Reserves only Deterministic scenario (“cumulative”) 1P, 2P, 3P 1C, 2C, 3C Low, Best, High Estimates Probabilistic P90, P50, P10 The PRMS notes these approaches in the order given above Although the probabilistic method may be applied to any volume, it is also indicated that this is most often applied to volumetric calculations in the early phases of an exploitation and development project And although not mentioned, it is also typically applicable for Prospective Resources

Proved Reserves Comparison : 

Proved Reserves Comparison

Probable Reserves Comparison : 

Probable Reserves Comparison

Possible Reserves Comparison : 

Possible Reserves Comparison

Contingent Resources Comparison : 

Contingent Resources Comparison

Prospective Resources Comparison : 

Prospective Resources Comparison

Some Important Observations : 

Some Important Observations Brief observations on the following topics will be made Economics Project Financing Aggregation Best Estimate Transition from CR to Reserves Lease Fuel Risk Service Agreements Contract Extension Developed and Undeveloped

Economics : 

Economics “The economic evaluation underlying the investment decision is based on the entity’s reasonable forecast of future conditions, including costs and prices, which will exist during the life of the project (forecast case) Such forecasts are based on projected changes to current conditions SPE defines current conditions as the average of those existing during the previous 12 months Alternative economic scenarios are considered in the decision process and, in some cases, to supplement reporting requirements Evaluators may examine a case in which current conditions are held constant (no inflation or deflation) throughout the project life (constant case)” Companies (and consultants) need to define a consistent set of “forecast case” parameters such as oil and gas prices (and differentials), cost inflation, perhaps exchange rates, and discount rates to be used for reserve evaluation purposes Companies reporting to the SEC will of course continue to use constant prices and cost cases as of the reporting date

Project Financing : 

Project Financing “While SPE guidelines do not require that project financing be confirmed prior to classifying projects as Reserves, this may be another external requirement In many cases, loans are conditional upon the same criteria as above; that is, the project must be economic based on Proved Reserves only In general, if there is not a reasonable expectation that loans or other forms of financing (e.g., farm-outs) can be arranged such that the development will be initiated within a reasonable timeframe, then the project should be classified as Contingent Resources If financing is reasonably expected but not yet confirmed, the project may be classified as Reserves, but no Proved Reserves may be reported as above”

Aggregation : 

Aggregation “Petroleum quantities classified as Reserves, Contingent Resources, or Prospective Resources should not be aggregated with each other without due consideration of the significant differences in the criteria associated with their classification [emphasis added] In particular, there may be a significant risk that accumulations containing Contingent Resources and/or Prospective Resources will not achieve commercial production” GCA does not believe that it is appropriate to report the aggregation of different resource classes (such as Prospective or Contingent Resources with Reserves) under any circumstances Such classes should always be reported separately, with no totaling between classes Also, unless undertaken as part of an integrated portfolio analysis incorporating “chance of success”, Prospective Resources for individual prospects should not be aggregated

Best Estimate : 

Best Estimate “The best estimate ... is generally considered to represent the sum of Proved and Probable estimates (2P) when using the deterministic scenario or the probabilistic assessment methods It should be noted that under the deterministic incremental (risk-based) approach, discrete estimates are made for each category, and they should not be aggregated without due consideration of their associated risk.” GCA concurs that “generally” the best estimate is represented by the most likely case (termed 2P or P50 by definition), if such as been evaluated However, there are other circumstances to consider: Using the deterministic incremental approach, it is not necessarily the case that the sum of Proved plus Probable will necessarily represent the best estimate It is therefore recommended that reports include the individual reserves categories and not their aggregation The “best estimate’ of a well-established decline curve may actually be representative of Proved reserves, rather than 2P

Transition from CR to Reserves : 

Transition from CR to Reserves “Without new technical information, there should be no change in the distribution of technically recoverable volumes and their categorization boundaries when conditions are satisfied sufficiently to reclassify a project from Contingent Resources to Reserves ” This implies that 1C becomes 1P, 2C becomes 2P, and 3C becomes 3P While in principle this is reasonable, there are two implications, especially for the Low Estimate: If this were to apply in all cases, the 1C estimate would have to be made including all constraints (other than commercial ones) that apply for Proved reserves, such as complying with LKH Alternatively, if the 1C estimate did not comply with the Proved volume constraints, it would need to be revised before moving to Proved

Lease Fuel : 

Lease Fuel “For consistency, lease fuel should be treated as shrinkage and is not included in sales quantities or resource estimates However, some regulatory guidelines may allow lease fuel to be included in Reserves estimates where it replaces alternative sources of fuel and/or power that would be purchased in their absence Where claimed as Reserves, such fuel quantities should be reported separately from sales, and their value must be included as an operating expense Flared gas and oil and other losses are always treated as shrinkage and are not included in either product sales or Reserves” The recommendation is therefore to exclude fuel from Reserves However, it is not clear why the value should be included as an operating expense, as long as the value is not included in sales There is no “cost” associated with this volume

Risked-Service Agreements : 

Risked-Service Agreements “Risked-Service Contracts (RSCs) are similar to PSCs, but in this case, the producers are paid in cash rather than in production As with PSCs, the Reserves claimed are based on the parties’ net economic interest” The requirement is therefore to assess net volumes based on net economic interest (entitlement), rather than working interest, which some companies have used

Contract Extension : 

Contract Extension “Reserves should not be claimed for those volumes that will be produced beyond the ending date of the current agreement unless there is reasonable expectation that an extension, a renewal, or a new contract will be granted Such reasonable expectation may be based on the historical treatment of similar agreements by the license-issuing jurisdiction Otherwise, forecast production beyond the contract term should be classified as Contingent Resources with an associated reduced chance of commercialization Moreover, it may not be reasonable to assume that the fiscal terms in a negotiated extension will be similar to existing terms Similar logic should be applied where gas sales agreements are required to ensure adequate markets Reserves should not be claimed for those quantities that will be produced beyond those specified in the current agreement or reasonably forecast to be included in future agreements In either of the above cases, where the risk of cessation of rights to produce or inability to secure gas contracts is not considered significant, evaluators may choose to incorporate the uncertainty by categorizing quantities to be recovered beyond the current contract as Probable or Possible Reserves” It is important to keep in mind that the requirement for reporting of Proved reserves is still one of “reasonable certainty”, so if that condition is not met, then no Proved Reserves can be reported after the termination of the contract term If the “reasonable expectation” criterion can be met, then Probable and/or Possible Reserves can be assigned Consideration applies to terms as well as “will it happen?”

Developed and Undeveloped Reserves : 

Developed and Undeveloped Reserves “Reserves ... may be allocated to the following subdivisions based on the funding and operational status of wells and associated facilities within the reservoir development plan” “Developed Reserves are expected quantities to be recovered from existing wells and facilities” “Undeveloped Reserves are quantities expected to be recovered through future investments” Thus these subdivisions are applied to all Reserves categories, not just Proved Regarding the distinction between PDNP and PUD, the PRMS says: “Undeveloped Reserves [are] ... where a relatively large expenditure (e.g. when compared to the cost of drilling a new well) is required to (a) recomplete an existing well or (b) install production or transportation facilities for primary or improved recovery projects This is useful, but there is no quantitative guidance given

Unconventional Resources : 

Unconventional Resources

Conclusions : 

Conclusions The PRMS is a major contribution to international oil and gas resources management and one that many companies will adopt There is clear recognition of the different ways that reserves and resources can be estimated and these are all embraced within the system Certain changes in procedures will probably be required to ensure that the differences with the prior definitions are recognized and incorporated into resource reporting Nothing will change with respect to reporting Proved reserves to the SEC Contingent Resources should become better understood and more acceptable as a valid resource category and not just “not reserves” The revised “Standards” document should remain a valuable guidebook in the practical and ethical application of reserves estimation and auditing procedures

Reserve Audit Processusing SPE Petroleum Resources Management System (PRMS) : 

Prepared for GCA Clients, July 2007 Reserve Audit Processusing SPE Petroleum Resources Management System (PRMS)