Production forecasting in the financial markets

Onshore, tight resource development continues to attract an increasing share of investment capital. The page shows how investors use production forecasting to mitigate downside risks and create investible opportunities in this market.

Investors

Investing is competitive. Because capital flows freely, markets quickly incorporate all publically available information about a company’s profitability and growth potential. How can E&P investors earn outsized returns in the face of a market that responds so completely and efficiently?

The trivial answer is that investors earn above-average returns by predicting a company’s cash flow both better than and before the market consensus. In order to predict cash flow, an investor with sufficient analytical expertise will start with the bedrock of an E&P company: production performance. In this context, high-quality, independent production forecasts generate a realistic expectation of performance, which may provide investors a competitive informational advantage, which might yield above-average returns. However, investors will generally only have access to publically available data.

Public domain information is sparse compared to that available to operators internally. In increasing order of objectivity, investors can generally examine:

Corporate Disclosures

This includes marketing presentations, press releases, and conference calls. This information is current and updated as new information evolves. However, it biased: even with the best intentions, management teams tend to be optimistic about asset performance.

Reserve Reports

Reserve reports and competent person’s reports provide a technically sound, but high-level summary of a company’s reserves and value at a point in time. They are usually incomplete evaluations for investors because they often don’t include asset by asset detail or sensitivities to commodity prices, whereas equities continuously price in new information. Reserve booking rules may also prevent a reserve report from including economically important resources based on arbitrary cutoffs such as drill spacing units from existing production or commodity pricing rules. If the reserves reports are produced by independent 3rd party consultants, as they often are, they will be less biased than corporate disclosures.

Geological Models

SPE papers, publically available core and log data, rock property data can be used to characterize resources in early days of development, before public production data is available. These data sources are the most difficult to collect, characterize, and evaluate. Relying on geological models exclusively will result in significant economic uncertainty, while tying a geologic model to properly evaluated production data will increase confidence in a model and forecast.

Public Production Data

Collected for royalty, severance tax and regulatory purposes, data in this category is unbiased and relatively current, but of varying quality and quantity depending on the jurisdiction.

Public production data is the backbone of independent analysis but requires resources to aggregate and expertise to analyze. Institutional investors - pension funds, hedge funds, etc, have the resources to dedicate to more detailed analysis, and these are the investors that drive the market. Sophisticated investors look for areas where analysis of public production data conflicts with corporate disclosures or reserve reports: these may be clues to market misperceptions, leading to mispriced investments and opportunities for above-average returns.

In many cases production forecasts created by analysts and engineers working on behalf of institutional money managers are at odds with an E&P company’s publically disclosed expectations. Discrepancies arise because:

1. Methodologies differ. The financial community primarily uses Arps or modified-Arps decline analysis to forecast production. Differences in reserve estimates compared to company disclosures can arise because of differing methodologies. Specifically, E&P companies have access to data and software that outside analysts do not. In addition, reserve estimates disclosed by companies are not always aligned with production forecasts.

1. The first five years have paramount importance. Investors project near-term production to the extent that it drives cash flow and NPV. Though analysts always compare their EUR estimates to company disclosures (when available), it’s near-term well performance drives the lion’s share of per-well NPV. It is less important to calculate the EUR than it is to nail down the first five years.

The chart below highlights cumulative recoveries and present values by month for the same type well, with 10% vs. 0% terminal decline rate. EURs differ significantly, with a 575 Mboe modeled EUR in the 0% tlim case and 525 Mboe for the 10% tlim case. Figure 1 below highlights that while recoveries differ in these two scenarios, NPV of cash flows do not. The pink solid line represents cumulative cash flow recovery in the 10% tlim case and dotted line is the 0% tlim case, both recovering ~80% of cash flow within the first 5 years. In the 0% terminal decline case, the same type well recovers only 55% of its EUR over the same time period (orange dotted line).

References

NEED REFERENCES TO CONNECT TO CONTENT ABOVE

Noteworthy papers in OnePetro

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Noteworthy books

Society of Petroleum Engineers (U.S.). 2011. Production forecasting. Richardson, Tex: Society of Petroleum Engineers. WorldCat or SPE Bookstore

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External links

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See also

Production forecasting glossary