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Eva Pao – Understanding The Reserve Life Index

People like to come up with stories to explain stock price performance. Good stories if the stock is up and bearish stories if the stock is down. One common story is to dig up and dust off an industry metric to explain valuation differences among similar companies. Reserve Life Index (“reserve life” or RLI) is the number of years a natural resource will last if no further investments are made to sustain or grow the asset. This metric has gotten attention recently to explain the valuation of energy companies. One story as of late centers around RLI and whether that explains the seemingly persistent valuation discount of Shell PLC (Shell), a global energy company. The story goes, Shell has an RLI of 8.8 years, so it makes sense it’s trading a 5-6x earnings because if it’s only going to be around for 8 years, given the time value of money, it should trade at 5-6x.

RLI is a simple calculation that divides oil and gas reserves by annual production. The calculation does not consider that these companies are going concerns and usually have numerous opportunities to profitably invest in sustaining or growing production. Shell’s reserve life was 12 years in 2013 (9 years ago). That does not mean that Shell’s reserve life is 3 years now. More importantly, it ignores that reserves are an artifact of the economics of the business. The most economic reserves will get drilled first and usually have shorter RLIs because the payback is faster, while the reserves that are the least economic tend to have higher RLIs because they can’t compete for drilling expenditures. That is why, for example, light sweet oil (shorter reserve life) reserves will be developed before heavy oil (very long reserve life) – it has a faster payback, but “depresses” the reserve life.

The value that an energy company creates is converting undeveloped resources to reserves, not producing the reserves. Once the reserve is proved up and developed, the oil and gas will come out of the ground and sold without much risk or value added. While the Reserve Life Index may be a more significant indicator of opportunity for a company that only produces oil or gas from 1 or 2 basins, it lacks meaning for a company like an international major that maintains a large and diverse portfolio of undeveloped resources.

The discussion of companies as it relates to this topic are for informational purposes only and not a recommendation to buy or sell a particular security or securities. The discussion contains opinions that are based on assumptions and may change at any time without notice.

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