The Evolution of Economic Forecasts and Risk Adjustments in Property Evaluation in the U.S.
Authors: Hickman T. Scott 
Published: December 2007

The evaluation engineer generates not only reserve projections, but alsocash flows and often fair-market-value (FMV) estimates. These tasks requireecopolitical assumptions in addition to the technology involved. This paperdiscusses the evolution of economic and risk considerations into current"industry-accepted" practices and the engineer's role in the evaluationprocess.

Introduction

Given that a company's reserve base is its collateral and source ofoperating funds, it is not surprising that a need has long existed for reserveevaluations to facilitate financial reporting requirements. These uses requireprojections of cash flow, net profit, payout, and expenditure. The generalpayout, and expenditure. The general acceptance of the "time value ofmoney" concept added the need for discounting and rate-of-returnindicators. Increasingly, political considerationse.g., conservation, politicalconsiderationse.g., conservation, prorationing, and pricing regulationshaveprorationing, and pricing regulationshave affected U.S. domestic reserveevaluations. Converting a reserve estimate to a cash-flow projection oftenrequires reservoir engineers projection often requires reservoir engineers toexercise judgments on subjects beyond their areas of technical expertise. Although reserve evaluations traditionally exclude quantitative riskconsideration, the engineer is frequently requested to estimate FMV, whichinvolves producing property risk in all its many guises. In response toindustry's increasingly complex evaluation needs, evaluation engineering hasevolved into a distinct subdiscipline. The typical evaluator is an experiencedreservoir engineer with sufficient exposure to evaluation requirements torecognize both the physical and the ecopolitical uncertainties involved. Thehighest degree of professionalism is required because the reserve evaluator hasa fiduciary responsibility to the investor or management. These "endusers" depend on the evaluator to use "accepted" or"standard" industry practices when such standards are seldom defined. Estimating FMV and the evaluation engineer's role in this process is not fullyunderstood within industry and remains a mystery to outsiders.

Reserve Evaluation

The first reserve evaluation apparently has been lost in history, but thefirst bank oil loan was reported in 1928. Petroleum engineering was in itsinfancy. Because of the lack of accurate technical data and the chaos thatexisted in marketing, early evaluations could hardly have been more than roughestimates. The introduction of conservation, prorationing, and tax laws duringthe 1930's prorationing, and tax laws during the 1930's and 1940's gave a morereliable data base from which to estimate reserves. After the East Texas fieldwas prorated and the U.S. economy strengthened in the late 1930's, domesticdemand began to exceed supply. Oil prices improved enough to allow expansion tobe financed by cash flow. After World War II, supply overtook demand owing tolarge U.S. discoveries and some displacement of U.S. crude by gas and non-U.S.oil. As a result, producing rates, particularly in Texas, were further limitedby particularly in Texas, were further limited by prorationing, making itharder to finance prorationing, making it harder to finance operations out of areduced cash flow. Bank borrowing became necessary, which increased the demandfor reserve evaluations. Postwar technical advances greatly improved theaccuracy of reserve projections. Industry-accepted reserve evaluation methodsbegan to emerge and reserve definitions were established. Evaluating reservesbecame a fairly routine engineering procedure where the only ecopoliticalprocedure where the only ecopolitical considerations were the allowable and thenumber of producing days in Texas. Pricing was constant and reserve projectionswere based on top allowable or exponential declines. More than 90% of theevaluation effort dealt with the technical aspects. Reservoir engineering andpetroleum geology continued to mature as disciplines. Data-gathering tools forlogging, coring, and testing became more accurate and comprehensive. Theevaluator needed increased expertise as secondary recovery became widespreadand offshore drilling introduced new concepts in the 1960's. The threatened orshort-lived oil embargoes in the late 1960's were an unheeded presage. When oilprices increased in 1973, presage. When oil prices increased in 1973, engineerswere faced with the need to forecast economic parameters. Close on the heels ofescalating energy prices was political reality in the form of oil pricepolitical reality in the form of oil price controls, the 1978 Natural Gas Policy Act, and the U.S. government's ultimate solution to the energy crisisthe Windfall Profit Tax. These political constraints combined with increasingoptimism about oil and gas prices began to relegate engineering to a secondary role.

JPT

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