Investing in Oil and Gas Companies – The Formula for Estimating Oil and Gas Resources

Investing in oil and gas companies can be very lucrative, especially when you have invested in an energy stock before they announce to have found a new resource.

When oil and gas companies decide to explore a new potential structure for oil or gas, it is of course very interesting to know how you can estimate the potential recoverable resources. Although estimating oil and gas resources is probably the most difficult part in analyzing energy stocks, it is the only way you can valuate a potential new reservoir.

After the oil and gas companies acquired and interpreted the seismic data, a visualization of the underground structure can be created in terms of areal extent and thickness. Subsequently, the theoretical quantity of oil or gas in place can be estimated for the first time.

The Formula for Estimating Oil and Gas Resources

Recoverable Cubic Meters of Hydrocarbons in place (RCMHIP) = A x NP x P x RF x HS x SF

To find out how I determine the values of the individual components of this formula I refer you to the note at the bottom of this page.

A = the Area of the structure (in square meters)
This is the maximum area that is expected to contain oil or gas, estimated from the visualization, created with the seismic data, or when available, the additional data from one of the phases of the oil and gas drilling process.

NP = the Net Pay (in metres)
The net pay is an interpretation of the average thickness (vertical height) that would hold the hydrocarbons. Sometimes the net pay is quoted as a net-to-gross ratio; then you have to calculate the net pay yourself (i.e. when the net-to-gross ratio is 1-to-15 and the depth is 3,000 metres then the net pay is 200 metres).

P = the Porosity (as a fraction)
Typical porosity of the oil or gas bearing sandstone ranges between 1% and 40%, with most common levels at around 15% to 30%.

RF = the Recovery Factor (as a fraction)
The recovery factor is the proportion of oil or gas that is recoverable from the reservoir. For oil fields typical recovery factors are between 10% and 40%, and up to 70%, while for gas it commonly ranges between 50% and 80%. Permeability, which is the ability of the hydrocarbon to flow through the voids, is incorporated in the recovery factor.

HS = Hydrocarbon Saturation (as a fraction)
Hydrocarbon saturation represents the proportion of oil present with water (found in all reservoirs in varying levels of saturation). The hydrocarbon saturation is estimated by well logs (detailed records of the borehole) with typical levels of 50% to 90%.

SF = the Shrinkage Factor (as a fraction)
The shrinkage factor shows the reduction in oil volume recovered on the surface. The shrinkage factor for oil commonly ranges from 0.50 to 0.95.

For gas the Formation Volume Factor (FVF) is used, which is the inverse of the SF. Due to reduction in pressure at the Earth’s surface, gas expands from 50 to 350 times its original volume, depending on depth and composition of the gas. Hence a gas expansion factor is used, changing the equation for estimating the possible recoverable cubic meters of hydrocarbons (gas) to: A x NP x P x RF x HS x FVF.

In order to calculate the Recoverable Oil in Place (ROIP) you have to multiply the RCMHIP with factor 6.29. The 6.29 factor represents the number of barrels of oil in a cubic metre.

By multiplying the RCMHIP by 35.3 the equation equals the number of cubic feet of gas (as used in gas reservoirs). Keep in mind that for calculating the Recoverable Gas in Place (RGIP) you have to use the Formation Volume Factor (FVF) instead of the Shrinkage Factor (SF) in the formula.

Of course, the veracity of the assumptions in estimating oil and gas resources can only be established once an exploration well has been drilled. When the hydrocarbons are found, the reservoir will be tested to confirm the quality of the reservoir (porosity and permeability) and to confirm the net pay zone. To confirm the areal extent of the reservoir the oil and gas company has to drill one or more appraisal wells.

Every time new information is revealed from one of the phases of the drilling process, a new visualization of the underground structure can be created and the theoretical quantity of oil or gas in place can be estimated again.

Note: In stead of estimating all the individual components of the formula myself, I often contact the oil and gas company directly, to kindly ask them what their best estimates for these components are. In order to be extra conservative in my calculation I always apply a discount rate of 20% on the numbers received.

Cautionary note: Always keep in mind that estimating oil and gas resources is an inexact science, depending on the amount of information available, the quality and the correct interpretation of that information. Remember that although the reported numbers must be as accurate as possible, mistakes are easily made.

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