The Aramco IPO and the Black Art of Estimating Oil Reserves

Saudi Arabia has announced that 5% of state owned Aramco is to be put up for sale perhaps as early as 2018. As part of the process, the country’s oil reserves will be subject to audit by western consultants, presumably to OECD standards. Given that Saudi Arabia has not adjusted oil reserves for production since 1980 there is a widely held view that the official figure of 267 billion barrels is a gross overstatement of reality. The audit will be interesting to say the least, especially since  Iraq, Iran, Kuwait and UAE are all guilty of the same malpractice. Deducting the 156 billion barrels produced since 1936 leaves 110 billion bbls remaining. Only time will tell where reality lies.

There is a lot going on in the Kingdom of Saudi Arabia (KSA) right now. Regional competitor Iran has come in from the cold and boosted oil production by 760,000 bpd at a time when higher prices would have suited all OPEC. Wars rage in Iraq and Syria to the North, and Saudi Arabia is waging war in Yemen to the South. The Kingdom has had to venture onto capital markets to borrow money in order to fund welfare spending at home. Donald Trump has been elected US president and has restated goals of US energy independence whilst signalling an end to oil dependency on KSA. OPEC has announced that demand for oil may peak in 15 years if countries aggressively try to cut emissions. And Saudi Arabia has announced that 5% of Aramco is for sale, valuing the corporation at $2 trillion.

This post begins with a look into the black art of estimating reserves and concludes that none of the methods currently in use are satisfactory. They are in fact woefully inadequate. The Middle East OPEC countries are operating to a set of unwritten reserve reporting rules all of their own that have no semblance of similarity to the OECD standard that is also critically flawed. How then are potential OECD investors in Aramco going to value the investment?

Reserves Reporting Standards

There are two main reserves reporting institutions 1) The US Securities Exchange Commission  (SEC) and 2) The Society of Petroleum Engineers (SPE) backed by The American Association of Petroleum Geologists and others. There has been a large degree of convergence in the methodologies in the past decade but one still needs to be cautious in the interpretation, especially between 1P (proven) and 2p (proven + probable) reserves and the broader term of resources.

Accounting methodology

The first stage in understanding petroleum (oil and gas) reserves is to understand the accounting methodology:

  • Reserves at beginning of year
  • Minus production
  • ± Revisions
  • + Additions (new discoveries)
  • = Reserves at end of year

The SPE Methodology

The SPE methodology is based upon the Petroleum Resource Management System (PRMS) (Figure 1):

Figure 1 The petroleum resource management system of the SPE.

The SPE scheme arranges reserves and resources into a 9 box matrix where the x-axis is the range in physical estimates based on data, e.g. seismic, well logs, well tests and cores. The y-axis is a measure of commercial viability where the reserves are actually in production, in the process of being developed or where development is planned. The contingent resource category comprises reserves that have actually been discovered but for which no development plan exists. To be discovered means that at least one well has been drilled and discovered oil or gas. The prospective resource category is based on prospects identified on seismic where the possibility of a discovery is identified but has not yet been drilled.

The definitions of 1P, 2P and 3P are more woolly. Proved (1P):

Proved Reserves are those quantities of petroleum, which, by analysis of geoscience and engineering data, can be estimated with reasonable certainty to be commercially recoverable, from a given date forward, from known reservoirs and under defined economic conditions, operating methods, and government regulations.

2P is less certain than 1 P and 3P less certain than 2P. Commercially recoverable is in bold because unlike volumes in place, which should give or take revisions be constant, commercial viability varies with the oil price and with technological advances. The fall in the oil price has created severe problems for western oil companies since the fall in price has made swathes of production, current and planned, unprofitable, wiping out large portions of reserves and share price valuations.

The SEC Methodology

The SEC rules have changed significantly over the last decade and are now by and large aligned with the SPE methodology. The SEC was formerly ultra-conservative, allowing only 1P reserves to be reported. New rules are more relaxed where:

The new rules define proved developed oil and gas reserves as those that can be recovered through existing wells with existing equipment and operating methods or that can be recovered in other ways through extraction technology installed and operational at the time of the reserves estimate.

and

For undeveloped oil and gas reserves, the new rules will permit companies to claim proved reserves beyond spacing areas immediate adjacent to developed areas if the company establishes with reasonable certainty that these reserves are producible economically.

Formerly the SEC only permitted proved developed reserves to be reported but the definition has now been broadened so that the SEC definition of reserves is now broadly equivalent to the SPE definition.

OECD Reserves Reporting Standard

At this point it is worth pointing out that the BP Statistical Review reports 1P reserves which is a very conservative measure being the top left box of the matrix (Figure 1). Figures 2 and 3 show the reserves evolution for European countries – Norway, the UK and Denmark. What we see are year on year adjustments that simply reflect the accounting methodology. The reason for showing this is to compare and contrast with the picture from the Middle East OPEC countries, including Saudi Arabia.

Figure 2 The evolution of North Sea reserves as reported by BP.

Figure 3 Line chart showing the evolution of North Sea reserves.

Since 1980 Norway has produced 28 billion barrels of oil and the UK has produced 27 billion barrels of oil. And yet UK reserves were never above 9 billion and Norwegian reserves never above 12 billion. The main point I want to make, therefore, is the fact that the conservative definition of reserves used in the OECD is a useless measure of how much oil or gas may actually be produced. A better measure may be 2P reserves + contingent + prospective resources if one wants a measure of how much exploitable oil and gas is actually there.

Middle East OPEC Reserves Reporting Standard

Oil Drum readers from days of old will be familiar with the oddities of ME OPEC reserves reporting that are shown in Figures 4 and 5. There are two rather suspicious elements to this. The first is that all countries bar Qatar revised their reserves upwards by substantial amounts in the 1980s. Saudi Arabia, Kuwait and the UAE did this only once, but Iran and Iraq have both had two upwards revisions since (Figure 5). These upwards revisions have nothing to do with new discoveries being made but rather reflect a revised view of the oil that may be recovered from existing fields, mainly revising upwards the recovery factors. While in the good old days of The Oil Drum a decade ago this caused consternation among peak oilers, I conclude today that these upwards revisions are probably valid, though need to be subject to audit.

Figure 4 ME OPEC countries oil reserves according to BP.

Figure 5 ME OPEC countries oil reserves according to BP.

What is less easy to defend is the flat line reporting. For example, the UAE has reported a value of exactly 97.8 billion barrels since 1996. No effort has been made by any of these countries bar maybe Qatar, to carry out the basic accounting practice of deducting production from reserves. So what do these numbers mean if anything at all?

Saudi Arabia Reserves

A good starting point for the discussion of Saudi reserves is the table dating from 1975 published by the Rand Corporation (Figure 6). A little history is useful to know. Prior to 1974, Aramco was known as the Arabian American Oil Company and was owned by companies we now know as Exxon, Mobil, Chevron and Texaco. Following US assistance to Israel during the Yom Kippur war in 1973 the government took a 25% stake, increasing that to 60% in 1974. In 1980 the whole company was nationalised and the name changed to Aramco. The point is that the Rand table was compiled at a time western companies were active in Saudi Arabia and had access to the data. It lists all fields by order of size and shows 176 billion bbls of reserves, 24 billion barrels produced to date for an ultimate recovery of 200 billion barrels.

The reserves figure of 176 billion bbls for 1975 compares with the BP number of 168 billion bbls reported in 1980. If we adjust 176 billion for the 13 billion bbls produced in the four years 1975-1979 we arrive at 163 billion barrels, close to the BP figure. I am satisfied that the Rand Corporation and BP figures are closely aligned.

I am going to allow Saudi Arabia the large hike in reserves during the late 1980s since recovery factors may well have been understated. This could be why the Rand Corporation has low? set against most fields. But I am not going to allow them to not deduct production.

Figure 6 Table of Saudi oil fields from the Rand Corporation dated 1975.

Figure 7 Saudi Arabia oil production using the API Facts and Figures Centennial edition (1959) for 1936 to 1959 and BP from 1965. The large dip in production post-1980 was Saudi Arabia + OPEC cutting production in order to support price. Their current strategy to maintain market share is designed to avoid a repetition of such drastic restraint. The dark green line is a bottom up forecast I made for Saudi Arabia following several weeks of epic blogging on the Oil Drum (Figure 8). The forecast was looking good until three years ago. The decline shown in my forecast was based on the anticipated watering out of wells on Ghawar that appears NOT YET to have happened. I wonder if anticipated decline of Ghawar lies behind the plans for the IPO.

Figure 8 A bottom up forecast of Saudi oil production that I produced in 2006 as published on The Oil Drum. The post-peak decline was based on a model for wells watering out in core production areas of Ghawar that must happen one day.

Figure 9 Saudi Arabian production began in 1936. If we assume that the official reserves figure of 267 billion barrels is in fact an expression of URR, then the dark green line shows reserves depletion for production.

During discussions on The Oil Drum, the idea emerged that reported ME OPEC reserves were more a view of ultimate recovery (URR) rather than an expression of what may remain to be produced. We know with virtual 100% certainty that the flat line reserves reports are false. And so, in absence of any other information I am going to assume that the figure of 267 billion bbls reported by BP for 2015 is a measure of URR. If we deduct the 156 billion barrels produced since 1936 we get 110 billion barrels of remaining reserves as illustrated in Figure 9. This is just 41% of the figure claimed by Saudi Arabia. I am not claiming these numbers are correct but simply pointing out that the official figures cannot be correct either. Auditing the real data is going to be exciting to say the least.

Discussion

Saudi Arabia is placing a value of £2 trillion on Aramco that is both a production and a refining company. 5% of that will cost $100 billion. Investors with deep pockets are sought. The Saudi annual budget is of the order $224 billion [note that I originally wrongly stated this number to be $98 billion], and so this sale, dressed up as building a sovereign wealth fund, will do no more than pay for 5 months of the Kingdom’s bills. Of course it’s not as simple and straightforward as that, but as writing this post has progressed, I’ve found it increasingly difficult to understand the underlying motive.

But where will investors be looking to value Aramco? Reserves are one metric very difficult to tie down. Production statistics are easier but I have found it strangely difficult to find summary production stats for peers like ExxonMobil and Shell. Here’s a very rough guide gleaned form various sources.

  • ExxonMobil 4.3 Mbpd
  • Shell 3.7 Mboe/day
  • Chevron 2.7 Mbpd
  • Total 2.1 Mbpd
  • Total = 12.8 Mbpd

And market capitalisations:

  • ExxonMobil $349 billion
  • Shell $219 billion
  • Chevron $207 billion
  • Total $140 billion
  • Total = $915 billion

And then if we look at Aramco we find:

  • Production 12 Mbpd
  • Anticipated capitalisation $2000 billion

Houston we have a problem!

Added to that markets tend to value minority stakes in State owned companies lower than OECD peers. According to Bloomberg:

Despite the prince’s bullishness, foreign investors rarely value state-owned oil companies as dispassionately as their crude-reserve numbers suggest — or as government officials might hope. State-controlled OAO Rosneft, for example, is the largest oil producer in Russia and one of the world’s largest. It pumps 5 million barrels a day — far more than Chevron — yet its market capitalization is just $50 billion, a fraction of Chevron’s $180 billion.

Much will depend on the structure of the deal. With lifting costs <$10 / bbl in Saudi Arabia, if investors are exposed to the full glare of profits then perhaps a $2 trillion price tag can be justified. It is not normal for States like Saudi Arabia or Russia to allow third  parties full exposure to profits. Let’s get the back of the envelope out:

  • Oil price = $50 / bbl
  • Lifting cost = $10 / bbl
  • Profit = $40 / bbl
  • Production of 12 Mbpd * 365 = 4.4 billion bbls / year
  • 4.4 billion * $40 = $176 billion in profit / annum
  • On a PE ratio = 10 gives a market cap of $1.8 trillion
  • And then there is the refining business on top

It looks like the Saudi princes are using the same envelope as me. In this calculation, reserves become important in determining how long Saudi Arabia can maintain 12 Mbpd production.

[Footnote: observing that the Saudi budget is $98 billion and Aramco profits would be $176 billion @ $50 / bbl, where to Hell does the rest of the money go?]

 

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26 Responses to The Aramco IPO and the Black Art of Estimating Oil Reserves

  1. Gaznotprom says:

    Maybe Saudi are just wanting a dollop of funny money, there’s plenty of it buying bonds with negative yields…

  2. Javier says:

    Thanks for a most interesting article, Euan.

    I’ve found it increasingly difficult to understand the underlying motive.

    It is clear that Saudi Arabia no longer believes they can get all the money they need just from oil. This problem probably arises as much from the growing population of KSA, as from the perceived future oil market, that can decline from depletion and energy transition, or suffer from a complicated global economy situation.

    One would predict that the best time to sell is when you reach peak production.

    • Euan Mearns says:

      Saudi production looks incredibly strong at present and so it is undoubtedly a good time to sell. If they are at peak it will mean they can no longer afford the investment to keep things going.

  3. Euan: From what you’ve written it’s apparent that due diligence reviews could lead to a major downward revision in Saudi reserves. But the risk is so obvious that I find it hard to see how the Saudis would be issuing an IPO without having checked to make sure their reserves were in good shape first. Are there any rumors floating about?

    It’s also customary to accompany an IPO with a prospectus detailing the assets of the issuer, which in this case would presumably include an estimate of reserves. Any sign the Saudis are going to do this?

  4. Brian O S says:

    In response to your footnote: they’re not earning money from 12 Mbpd. They are burning c. 4 Mbpd themselves, and so exporting much less. Let’s see if they allow a public Aramco sell oil to the state at full price… Some will go into storage which will be drawn down to give an illusion of flat production one natural decline comes in (already?). Where did 12 Mbpd come from anyway – are you assuming they’ll produce their ‘spare capacity’ too?!

    I won’t be investing 🙂

    • Euan Mearns says:

      Thanks for the reminder and good comment. BP had Saudi on 12 MMbpd in 2015 C+C+NGL. C+C is closer to 10.

    • gweberbv says:

      4 Mbpd consumption in Saudia Arabia? Oh my god! This amounts to the demand of Germany and France combined.
      What is the rational behind this wastefulness? Are they mainly burning low quality oil that could not be sold at a decent price?

      • Euan Mearns says:

        I’m not sure, but its possible that oil consumed by refineries gets counted as domestic consumption that is then exported as refined products. BP shows oil consumption doubling in a decade.

  5. Euan Mearns says:

    This from The Oil Drum 2006. The image pre-dates 2004. The first thing to understand about Ghawar is that it is immense. The second thing to understand is that it is mortal. Divided into 6 main sub-divisions, N and S Ain Dar, Shedgum and Uthmaniyah all had good quality Arab D carbonate reservoir. These provided most of KSA’s production for decades but pre-2004 were beginning to run on empty. Yellow = swept areas, blue = dry oil remaining.

    In 2006, Haradh had been recently developed using smart multilateral horizontal wells and will chug along for a couple of decades. Hawiyah is a kind of dark horse. A lot of oil in place, but not readily producible.

    Since 2006, these blue blobs of dry oil in N Ghawar will have shrunk considerably. And when they are gone Saudi oil production costs will escalate dealing with high water cut and water disposal.

    All good things come to an end one day.

  6. Henrik M. Poulsen says:

    Rystad Energy numbers on Aramco (or KSA if you want) for 2016:

    Economical viable resources (incl. undiscovered): C+C 163 Bbbl and NGL+ Dry gas 49 Bboe

    Production: C+C 10,7 mmbbld, NGL 1,2 mmbbld & Gas 1,6 mmboed

    Total Free Cash Flow: 150 BUSD (in 2015, 172 BUSD, which is very close to Euan’s envelope calculations), whereof government take is 128 BUSD and only 22 BUSD remain within Aramco.
    This implies an average tax rate at 85%. With this tax rate the NPV of Aramco’s free cash flow is calculated to 545 BUSD, while the equivalent for KSA’s government take is 3,1 TUSD. The NPVs assume an oil price increase to 100 USD/bbl by 2021 followed by a 2,5 % annual inflation. The annual discount rate is set to 10%. Thus the future fiscal regime (which need to changed and communicated before any IPO) is crucial in order to put a fair price on Aramco. However, 2 TUSD seems to be way too high, even though we take into account a significant price raise and lower government take than 85% – lets say 75%, which is not uncommon world wide.

    • Euan Mearns says:

      Hi Henrik, thanks for a most informed comment. I should have got you to write the post 😉 I’d be interested to know how you get to 163 Bbbl. Economical viable resources are of course reserves – perhaps 3P. The emphasis here must be on economical viable. In Ghawar, for example, there is a vast area of swept reservoir that could produce wet oil (oil+water) but only at high cost. Lets say $40 / bbl. Is that economically viable for the Saudi State?

      Its a pity I was too dumb to not think about the relationship between KSA and Aramco in terms of taxation 🙁 I was thinking more in terms of PSCs and tariffs. But I think you hit the nail on the head. $545 billion @ $100 / bbl suggests to me that the OECD investment community will be thinking $300 billion when they take all the risks and uncertainties into account leaving the IPO at $15 billion and at that level a flotation will not take place.

      As a rule, Arab OPEC is normally only interested in screwing investors – personal experience from Algeria and Kurdistan.

      My best guess is that Aramco needs a lot of capital for investment in new projects to maintain production at a time when the State is bust. I predict the IPO will not occur and that Saudi production falters in the years ahead which may at least make your $100 / bbl prospect come true.

      Finally, I’d be very interested to know the Rystad view for breakeven (all costs) in the Permian (and other US) shale oil plays.

      • Doug T. says:

        Given the recent production highs, and 156 Bbbls produced to date, 163 Bbbl remaining seems like a reasonable rough Hubbert curve. Hard to imagine it’s only 110 as one would derive in the simple subtraction implied in the first chart.

        Aramco has also been quite busy with the drill bit, according to BHI running well over 120 rigs (oddly, almost half of those are reported as gas rigs). Capital burn must be heavy to maintain production.

    • confused mike says:

      Henrik, Euan,
      I like the approach taken here but would more extreme in terms of challenge to KSA:
      If the post tax free cash flow is 22BUSD the five per cent equity investor (100B on 2T) would only receive ~1B so a yield of 1% and that is before any investment in either more E&P or refining.
      For a 12 m BBL/day production if we were to say 5B USD per year capital investment (seems low compared to the majors?) the yield drops to 0.75% with risk that commodity price drops and/or production prices rise.
      Better to take a 10 year bond (10 year today yield: 2.3%).
      Also agree that if 100B is one years deficit the 5% IPO means next year back to the well for another 5%.

      • Henrik M. Poulsen says:

        Mike.
        Remember that 2016 is an abnormal low revenue year. More likely future average numbers would be an annual FCF at 50 BUSD + 20 BUSD in CAPEX for Aramco, and 300 BUSD in government take for the ministry. The government take for the last two years has fallen by respectively 150 BUSD in 2015 and 170 BUSD in 2016 = 320 BUSD.
        Another issue, there is no Chinese wall between Aramco and the Ministry, so the taxation (dividend?) is more a ‘mutual agreement between the parties’. Prior to a possible IPO, must a complete new, transparent and reliable fiscal regime be established. Today Aramco is taxed about 85%, I doubt this level is sustainable to attract (international) investors.

  7. Henrik M. Poulsen says:

    Aramco C+C reserves/resources:
    – 1P = 66 Bbbl
    – 2P = 114 Bbbl
    – Resource base, which in our terms is equivalent to something like 2,5P +2,5C = 163 Bbbl
    – Resource potential includes also undiscovered not awarded, thus we are talking about KSA instead of Aramco = 203 Bbbl. (economic viable resources means resources which will provide a positive NPV after full cycle costs, with a 10 % annual discount rate).

    98-99 % of KSA’s liquid production potential in 2020 has a full cycle break even cost < 40 USD/bbl, so hardly any of KSA's resources nor production are very vulnerable to oil prices. However, their national budget is!!

    BTW your 98 BUSD Saudi budget seems very low?

    I'll come back to you on the shale data.

    • Euan Mearns says:

      BTW your 98 BUSD Saudi budget seems very low?

      http://www.us-sabc.org/i4a/pages/index.cfm?pageid=4319

      I think I somehow managed to note the size of the deficit and not the budget.

      • Henrik M. Poulsen says:

        Thanks Euan. 98 BUSD in deficit makes sense.
        However, selling 5% of Aramco will, even with the prince’s very positive value estimation, cover for one year deficit only. KSA need the oil price to surge by at least $ 30-35/bbl to balance their current budget. This might happen 3 years down the line. In the mean time they would need a blend of budget cuts, borrowing and maybe selling Aramco shares, to remain floating. The problem is that KSA doesn’t produce anything else of value than hydrocarbons, so by selling Aramco shares they achieve only curtailing of their (future) revenue stream. This is a giant ‘Dutch disease’, much bigger than the original one.

    • Euan Mearns says:

      Henrik, I like your numbers a lot! Your 2P is basically bang on my 110 billion bbls. The stretch to 3P- may make Aramco money but at a cost that will bankrupt KSA – it ain’t going to happen.

      Undiscovered in Saudi is likely very small. They have a large inventory of discovered undeveloped – billion bbl fields to die for – that are basically too small to be relevant to the Saudi production system. The main Arab D anhydrite seal / carbonate reservoir play is such that oil got trapped in large anticlines. The seal is like polythene stretched over the whole play. Its a 2 dimensional system. You drill bumps at the base of Arab D anhydrite and you find oil. All the bumps have been drilled long ago. The last major discovery was Shaybah in 1968.

      The gas cap for the whole system is in Qatar / Iran.

      • SE says:

        “The gas cap for the whole system is in Qatar / Iran.”

        Is this true?

        Is this perhaps part of the reason KSA is funding ISIS in order to block the route of a Qatari gas pipeline into Europe?

  8. Stuart says:

    It’s all very interesting. One of the reasons to IPO Aramco is to convert Saudi wealth into something more fungible, so it can be moved around the world if needed. As the last two years have shown it’s rather risky to have 100% of your wealth tied up in just one commodity. Even riskier if most of that wealth is tied up in a single oilfield.

    I’m sure everyone has seen Goldfinger.

    It’s events that are going to drive the outcome of all this though. It looks like Trump is going to be a hyperactive POTUS, signing off on all manner of legislation.

    I expect to see Obama’s decisions on Keystone XL, the North Slope, the Paris Accord all being upended within 6 months.

    Trump also wants to shut down Iran again and has previously spoken about his regrets that the US didn’t permanently seize the oilfields of Iraq.

    Trumps sees all of Obama’s decisions through the prism of American jobs, and has decided that most of Obama’s decisions are wrong because they hurt US job prospects.

    I imagine most of the people who lost their jobs in the shale bust voted for Trump.

    I honestly believe that by the time Trump is sworn in the Dow Jones will be 20,000 and everyone at the NYSE will be wearing little red caps with “#MAGA” on the front.

    The US is changing posture towards a huge economic expansion fueled by public debt. Trump has promised a $1 trillion spending plan and also $4 trillion of tax cuts. The US deficit is going to explode. But for the next 4/5 years there is going to be a massive economic expansion.

    Donald Trump is going to turn loose the biggest bull of all time and then he is going to disappear into his 80’s. Inflation is going to rip higher and UST10 yields are already blowing out in expectation.

    Everything has changed.

    • Greg Kaan says:

      Interesting conclusion since the Aramco IPO has been slated for many months while Trump was an outsider for the Republican nomination let alone the presidential race.

      You could spin your underlying reasoning as a hedge against a Clinton / establishment Republican win continuing the debt bubble, that has been forming since Greenspan “rescued” the markets from the dot com collapse, with the resulting massive US deficit blowout over the past 16 years

  9. Richard Kleeman says:

    Euan,

    If you give me your email I will forward the data on the 59 largest Saudi Oil Fields from the Worlds Giant Oil Fields stored at the A.A.P.G. This shows Saudi reserves at less then 45 billion BO

    RK

  10. This article, and many others like it, starts from the false premise that Aramco owns all petroleum reserves in Saudi Arabia. However, like in most other countries in the world, the state holds full sovereignty over the sub-soil and all the minerals within (this means the King in Saudi’s case).

    Moreover, a number of modifications to the Minerals law in Saudi is opening investment opportunities to foreign companies. Therefore it is most certain that Aramco will not exploit all the reserves that may be still left in the kingdom.

    An accurate evaluation of Aramco must be solely based on the resources to which the company is contracted.

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