Replacing reserves used up in production is a fundamental requirement of survival in the oil and gas industry. In a low oil price environment, as has been the situation since 1986, adding reserves at a low cost becomes imperative. The first part of this chapter examines reserve replacement costs for surviving and nonsurviving independent oil and gas producers in order to evaluate the effect of these costs on product markets' and capital markets' sorting of winners and losers in the oil and gas industry. The second part of this chapter compares the costs of adding to U.S. oil and gas reserves of the majors and the surviving independents. The resource development strategies of these two groups have been shown to be markedly different (see endnote 21). Consequently, their respective costs of adding reserves might differ. If the independents continue to expand their role in U.S. oil and gas development, then cost differences will tend to be amplified in the future.
A company can replace its oil and gas reserves by successful exploration and drilling, whereby formerly untapped deposits are added to productive capacity, or by outright purchase of proven reserves from another reserve owner. Since either method can be employed, measuring the costs to the company should account for both. One such measure that has been employed frequently within the oil and gas industry (see endnote 22) is termed reserve replacement costs. For a company, reserve replacement costs are measured by the ratio of expenditures (for unproved lease acquisitions, acquisition of proven reserves, exploration, and development) to barrels of oil and gas reserves (on a COE basis) added to the company's books (through extensions, discoveries, improved recovery, revisions of previous estimates, and purchase of proven reserves from other companies).
Since there can be lags between expenditures and associated reserve additions, reserve replacement costs are measured as three-year weighted averages. Reserve replacement costs are measured before tax effects. The overall effect of taxes on reserve replacement costs has been found to differ little between majors and nonmajors (see endnote 23). For the purposes of comparison, reserve replacement costs are computed for four categories of U.S. oil and gas producers: the majors (represented by the FRS companies), surviving independents (i.e., specialized companies that produced oil and/or gas in 1993), nonsurviving independents (i.e., specialized companies that produced U.S. oil and/or gas sometime prior to 1993 but did not exist in 1993), and other producers (refiners, pipelines, utilities, Canadian-based companies, and diversified companies).
In the 1990's, U.S. reserve replacement costs of the majors and surviving independents were nearly equal at about $5 per barrel of added reserves (in 1993 dollars) (Figure 9). Even in the late 1980's, reserve replacement costs of the two groups differed by only a few cents per barrel. Reserve replacement costs for independents that exited the industry were slightly higher at about the time of the oil price collapse. Thereafter, the costs for nonsurviving independents compared to surviving independents continued to grow, and by 1990-1992 were nearly $4 per barrel higher. Other producers (such as diversified companies) also incurred higher reserve replacement costs.
These results reinforce the view that the market forces to which U.S. oil and gas producers have been subject forced efficiency in resource development. That is, as the industry adjusted to the lower level of prices following the oil price collapse of the mid-1980's, the companies that competed successfully tended to incur lower costs of adding to their reserve bases than those companies that reduced or withdrew their asset commitments to U.S. oil and gas production.
Reserve replacement costs measure the cost to the company of adding to their reserve base, whether through the company's own exploration and development efforts or through outright purchase of proven reserves from another company. For the economy as a whole, though, reserve replacement costs may not be the most appropriate measure of the actual costs of adding to U.S. oil and gas reserves. Reserve replacement costs include expenditures for acquisitions of proven reserves as well as acquisitions of leases for unproven acreage.
However, for the economy as a whole, acquisitions represent only a transfer of ownership. Net additions to U.S. reserves from acquisitions are always zero. In order to ascertain if the structural changes in the U.S. oil and gas industry might affect the costs of adding to reserves for the economy as a whole, a different measure is needed.
Excluding expenditures for acreage acquisitions, whether proven or unproven, and excluding existing reserves gained through purchases will more accurately reflect the economywide costs of adding to U.S. oil and gas reserves. Thus, the ratio of exploration and development expenditures (excluding acquisitions of leases and proven acreage) to reserve additions (excluding purchases of proven reserves) will be used as the economywide cost measure, and will be termed, "overall finding costs" (see endnote 24). Figure 10 presents overall U.S. finding costs for two groups: majors and surviving independents.
Overall U.S. finding costs for surviving independents are clearly higher than the majors' overall U.S. finding costs. Most recently (1991-1993), surviving independents' costs were nearly $2 per barrel of added reserves (in 1993 dollars) more than the majors. In the mid-1980's, the difference was about $5 per barrel, so the gap has narrowed but not disappeared (see endnote 25).
This latter result should be interpreted very carefully. Beginning in the early 1980's, the costs of finding oil and gas have declined in the United States (see endnote 26). Technological change and market adjustments have over time reduced the costs of adding reserves. However, at any point in time, finding more oil and gas will typically entail ever higher costs. That is, finding oil and gas reserves is subject to diminishing returns. Consequently, there is a tendency for companies that are expanding their reserves base to have higher finding costs than companies that are contracting.
In the 1990's, the surviving independents, overall, have been increasing their investments in U.S. exploration and development. In contrast, the majors, overall, sharply reduced their U.S. exploration and development commitments until the early 1990's from which time they have leveled off. The higher overall finding costs of the surviving independents compared with the majors, in part, reflects both an expansion of the independents' U.S. oil and gas operations and a consolidation of the majors' operations.