Thanks for your fabulous analysis of the latest reserve update...

Thanks for your fabulous analysis of the latest reserve update on JPR. Your work is much appreciated. I like Mohicans they were noble warriors, but I prefer Comanche Indians a far more aggressive and a fearsome warrior. Almost stopped the US's westward march in the 1840's, but I digress.

A few of us are heavily invested in JPR, for all the right reasons. A very good friend of mine has put together the following analysis of the reserves report which was not very user friendly. This breaks it down to a much more intelligible user friendly document which lets us know what it means to us. Bottom line, money in our pocket.

JPR Reserves Report 11 Sep 2013

I have had a good look at the JPR reserves report of 11 Sep 2013, and offer these observations. I do so in the hope that I might be able to attract some comment from others (particularly if anyone thinks that I am in error to any degree) as I do not pretend to be the font of all wisdom.

The assessor RES gave a figure of 102.5 million barrels combined for reserves classified as both C1 and C2.

McDaniel, the second assessor, gives a figure of 19.2 mmbo 2P (meaning combined for reserves classified as both 1P and 2P).

RES has gone up from the figure of 37 mmbo given in 2012. McDaniel's figure has downgraded our 2P figure of 24.2 mmbo set in 2012 down to 19.2 mmbo 2P.

What is the significance of these discrepancies and is there an explanation?

Different Functions, Roles and Standards.

The role and function of RES, the first assessor, was to make a quantitative assessment for the information of the Kazakhstan government as a pre-condition of that government granting certain approvals (production license etc.). The terms of reference under which RES was required to work, by the Kazakh government, are Russian based principles which are not the same as those used in the west.

McDaniel, the second assessor, was engaged to provide a Competent Person’s Report (a “CPR”) within the meaning of the standards used by the Society of Petroleum Engineers. That body sets the principles that we work by in the western world. McDaniel’s role was to provide JPR with a report on which a bank could base a lending valuation.

Different Measurement Principles.

The Russian principles require the assessor to follow a method of looking at the physical and geological facts. The assessor must then make a calculation, based on those facts, to determine the quantity of oil which the assessor considers to be correct. The western world principles include an exercise of that nature but under constraints that force the assessor to restrict the analysis to existing commercial realities. It is not enough for the western CPR analyst to accept that a well looks OK. There must also be commercial factors present and observed (such as proven flow capacity).

The explanation of the discrepancies lies in the difference between the respective missions and assessment principles in play as between the two assessors.

Wells J-53 and J-55

I will start to illustrate the explanation with a discussion of these 2 wells.

Wells J-53 and J-55 are troublesome wells. They are not regarded as complete and ready to be certified because of issues regarding (1) crumbling of the geological material in the oil reservoirs; and (2) water intrusion. They require further drilling and well modifications (cementing off the problem structures and similar intervention). As J-53 and J-55 need further work some analysts consider that they cannot clearly demonstrate their production capacity. For that reason, they are not included in the McDaniel certified statement of reserves.

J-53 and J-55 Not Counted

The necessary work must be done on wells J-53 and J-55 followed by tests conducted to enable data to be assembled (long-term flow-rate and decline curves and similar) before a Competent Person’s Report, of the type that McDaniel was commissioned to do, can cover them. JPR has not done the work or the tests to date. JPR's concentration is on exploration of its tenement not on preparation for production. For this reason, there is nothing in the McDaniel report failed to credit JPR with any reserves for these wells.

RES Did Include J-53 and J-55

By contrast the assessor RES did include J-53 and J-55 in its certification of reserves. That is because RES’s terms of reference were to work under Russian based principles which allow the assessor to apply wire line logs (instrument readings) as proof of production capacity. However the Competent Person’s Report must work on the principles of the western standard used by the Society of Petroleum Engineers which require the certification to be based on a physical demonstration rather than on instrument readings. For that reason, the Competent Person assessor could not include anything in the CPR report for these 2 wells J53 and J55 but the Kazakh assessor could do so and did.

Lender’s Prudential Factor

So we have a situation where J53 and J55 are included in the RES assessment, prepared for the information of the Kazakhstan government, but not in the McDaniel CPR certification. The explanation is partly the matters above but there is also another factor in play. That is, the assessor McDaniel was commissioned, not to say the quantity of oil present, but to provide a CPR certification which is to be based only on factors that are acceptable to a lending institution as a prudent basis for valuation. As many of us would be aware, the standard which applies to that form of reporting and valuing is quite restrictive and conservative.

Also Consider the Well J59

J-59 is a great well with two pay zones totalling around gross 144 metres and a net pay zone of around 83 metres. In Australia there can be much jubilation over 6 metres net pay onshore. J-59 flowed at around 1,300 barrels per day. That is very respectable. However J-59 has not been under observation for very long. Flow began on 28 Feb 2013 but no official test commenced until April with results scheduled for some time in June. In the July Quarterly Activities Report JPR made clear that the flow test progress was only sufficient for RES's methodology.

That has impacted on McDaniel's certification. As the data available for J-59 does not fit the requirements of the Society of Petroleum Engineers' standards of reliability, it was not recognised or used by McDaniel as a basis for certifying the presence of a petroleum reserve. However RES did include J-59 in its assessment and it is quite a significant component.

Summary of Reasons for Differences:

McDaniel is working to the standards of banks while RES's mission is to tell the Kazakh government how much oil is there on the basis of evidence. RES takes into account evidence derived from instrument readings while McDaniel generally works off visibly authenticated volume of flow over a pre-determined time duration.

RES is following the Russian discipline of C1 + C2 while McDaniel's certification is on the basis of 2P which is a different more stringent standard.

The main reason is that McDaniel's certification is limited to the wells J-50, J-51, J-52 and J-58 (and then, in the case of J-58, only to the Triassic 2B structure). By contrast RES has assessed reserves based on 7 wells.

RES has given recognition to all wells but McDaniel has only taken account of 4 of the 7 wells.

My conclusion

A bank needs to take a very cautious approach to assessing value as it needs a "no risk" basis on which to make a loan to a borrower. Hence the restricted nature of McDaniel's 2P assessment. As I am not proposing to make a no risk secured loan to JPR, I am not excessively influenced by McDaniel's figure.

I have made a speculative investment in JPR. My issue is the question - how valid was my speculation? How are things looking? Am I a participant in a business that appears to have a significant upside?

The answer to these questions is clearly "yes".

Post Script

McDaniel's report is not all bad news. It approves the use of a figure of $11-60 (after tax) as the value of a barrel of oil in the ground. I have always worked on the conservative figure of $5-00. The higher figure is most exciting.

Even on McDaniel's figures of reserves at 19.2 mmbo 2P if the company were sold at a price based on $11-60 per barrel in the ground its enterprise value amounts to $220,000,000 to $400,000,000. That translates to $1-47 per share. So I am feeling comfortable.

Mind you I have also reflected on the role of RES and asked myself is that company likely to mislead the Kazakh government? When I answer that question (in the negative) I begin to feel pretty smug because 102.5 mmbo times $11-6 comes to a cash value of the company around $1,189,000,000 or $7-93 per share.

Comments welcome.