THE INFLUENCE OF FINANCIAL RISK ON RESERVES REPORTING AND INVESTMENT DECISIONS

Abstract

The determination of petroleum resources is a technical function executed by geoscientists and reservoir engineers. The determination and valuation of petroleum reserves is a commercial function that requires input from development and cost engineers, economists and financial and risk analysts. While the technical aspects of both determinations are generally carried out with diligence, the financial considerations are frequently given scant regard. Of particular note are the infrequent acknowledgement of risk and the application of appropriately considered discount rates.

It can be demonstrated that inappropriate selection of the discount rate can create material distortions in the determination and valuation of reserves.

Our proposition is that the rate at which the cash flows are discounted should reflect the reserves uncertainty, specifically the relationship between the proved reserves, which can be financed out of debt, and probable reserves that are typically financed out of equity. Specifically, for the valuation of proved+probable reserves, rather than use a corporate WACC, i.e. one which reflects the average ratio of the costs of debt and equity, investors should instead use a WACC which is based on the ratio of proved: probable reserves weighted cost of debt: equity.