WARNING: LONG POST. LOOK AWAY NOW.At the AGM, DC-10 made the...

WARNING: LONG POST. LOOK AWAY NOW.

At the AGM, DC-10 made the comment that the Arrow acquisition was at a higher metric than many think...

So, some of us have been doing some research and thinking and consulting with others about the important issue of reserves and metrics paid for reserves. And, as always, the devil is in the detail.

RESERVES - THE BASIC CONCEPT

A reserve is a subset of a resource. Essentially, you can book a reserve when you can demonstrate that a certain portion of your resource, (1) has a market to sell to, and (2) that you can economically produce the gas to get it to that market.

So the combination of production pilots and coreholes, and commercial agreements, allow a company to upgrade a contingent resource to a reserve. A reserve is a resource that has a market, and one that you can economically produce and sell into.

But underneath that basic idea lies an awful lot of complexity about exactly what the certifers require to book a reserve. The certifiers that ESG use, NSAI, are particuarly conservative with their certifications. Not all certifers are.

IT IS ALL IN THE ASSUMPTIONS AND 'CUT-OFFS'

For instance, when deciding how much of a contingent resource can be upgraded to a reserve, certain assumptions have to be made about the price the gas will be sold for. So, if your cost of production is, say, $4 per GJ, and you can only receive $3.50/GJ when you sell it, that gas is not economic and so cannot be upgraded to a reserve. Yes, the gas is 'there', but it is not a reserve that anyone is going to value.

So in any project, whether it be gas or oil or minerals, there will be a portion of the contingent resource that can be produced economically (the reserve), and a portion that will forever remain as a contingent resource because the cost of production is above the amount you can realise for the gas. Fair enough?

ESG'S RESERVE IS TIGHTLY MEASURED

Okay, so now we get to the really interesting bit - ESG's 2P reserves, and the assumptions that underlie them. NSAI use an assumed gas price of $3.50/GJ for ESG's gas. That is, only the portion of ESG's gas that has (so far) been proven it can be produced economically (below $3.50/GJ) can be put into the reserve category (and there also needs to be a market for that gas too).

ARROW'S RESERVE - GILDING THE LILY

Have a guess at what price Arrow's based their 2P reserves on? $9.00/GJ. Yep, the assumption that underpinned their reserves assumed an export price of $9.00/GJ. So, any gas that can be produced at $8.90/GJ they called a 'reserve'. You can see how that takes in a much bigger portion of the contingent resource than does a more conservative assumption.

Now, along comes Shell. They decide that using a $9.00/GJ cut off for measuring reserves isn't reasonable. The independent expert decided that:

"On the basis of our analysis, we have adopted a real 2010 gas price of between $3.0 and $4.0 per GJ to apply to uncontracted gas sales to the Domgas market."

and

"Given the potential range of gas prices for LNG export gas sales and the potential demand for CSG from an LNG plant, we have adopted a real (in 2010 terms) long term ex-field gas price in the range of $7.0 and $9.0 per GJ to apply to the potential gas sales to an LNG plant."

source 3 June, IE Report, pp.42-43.

So, in other words, if you look at what Shell paid to take over Arrow, based on Arrow's reserves, the metric looks quite low (becausew the 2P reserve is artificially high). But once you realise that Arrow's reserves were artificially high, due to their high gas price assumptions, the real metric per 2P reserve (using more stringent assumptions) was a lot higher.

Gas that Arrow could produce at $8.90/GJ was in the reserves category!

So the Arrow sale metric (at lower assumptions) was high; the sale metric at Arrow's inflated metric was a lot lower.

IMPLICATIONS FOR ESG - COMPARING APPLES WITH APPLES

Now back to ESG. ESG's 988PJ of 2P reserves is based on gas price assumptions of $3.50/GJ. So any portion of the gas that is produced above $3.50/GJ is at the moment stuck in the CR, not in the reserves.

THE AH-HA MOMENT

But what if ESG signs a large GSA to supply gas into QLD, at export prices..? consider now what the 'break-even point' is for that portion of gas, which can be sold at export prices. All of a sudden, with the stroke of a pen, a large portion of ESG's contingent resource suddenly becomes economic. Not through extra production testing, but simply because more of their known gas can already be classified in the reserve category.

Now, all this may seem like pedantics - how much you can call a reserve and how much is just a contingent resource.

But bear this in mind. The signing of a GSA into QLD not only increases the market for ESG's gas, but it raises the bar in terms of price, and how much of ESG's CR can be classified a reserve.

An instant and very large reserve upgrade.

So, when people try to tell you that Arrow got a low metric, and so in an acquisition scenario, you shouldn't expect very much from ESG, bear in mind the fact that Arrow had artificially high reserves. And when you look at what Shell paid, based on stricter criteria (like that which ESG use), you find that the Arrow price was just as higher as any acquisitions pre-GFC.

And lastly, when you look at ESG's current 2P of 988PJ, and think they do not yet have enough gas to supply LNG, think again! Apply export prices to ESG's contingent resource, and lo!, a much bigger reserve than they have yet certifed.

Happy researching.

Yaq