Replacement Reserves

Chevron Corp.'s (CVX) dramatically low 2007 reserve replacement announced last Friday may be the first in a series of disappointing results reported by major oil companies in the coming weeks.

Chevron announced Friday that it replaced just 10% to 15% of its reserves in 2007, a rate lower than the already pessimistic 50% to 60% analysts estimated. And although Chevron's report is expected to be the weakest among the oil giants, analysts also expect ConocoPhillips (COP), Exxon Mobil Corp. (XOM), and Royal Dutch Shell PLC (RDSA) to report reserves replacement shy of 100%. BP PLC (BP), which reported 120% reserve replacement on Tuesday, has so far bucked the trend.

Although Wall Street has shown more tolerance towards weak reserve replacement in recent years, in part due to the industry's strong financial position, some analysts are losing patience with the under-performance. Reserves replacement remains a key benchmark that informs whether a company is replenishing its assets as it produces oil and gas.

"I try to look at the long term, but the biggest problem with Chevron is that it's the fourth year they are reporting disappointing rates," said Phil Weiss, equity analyst at Argus Research in New York. "It's time for them to offer something more tangible. I'm not throwing in the towel yet, but I have some concerns."

Chevron's Friday report followed three years of low rates. In 2004, the company broke its 11-year streak of replacing more than 100% of reserves while in 2005 it had a rate close to zero after discounting the reserves Chevron booked from its acquisition of Unocal. In 2006, the company replaced less than 80% of its reserves.

Despite Chevron's weak reserve replacement - and the company's confirmation that its 2008 output would be lower than prior expectations - the company wasn't heavily penalized. On Friday, shares dropped 76 cents to $82.49 on a weak day for petroleum equities.

Chevron officials attributed the lower reserves in part to the 2007 rise in oil prices, which lowers the reserves that can be booked under production- sharing contracts with foreign governments. These kinds of agreements allow more reserves to national oil companies - and less to international oil companies - when oil prices rise. Chevron estimated that this rule lowered reserves by 30%.

Project timing was another major factor, the company said.

Chevron couldn't include reserves related to its Tengiz project expansion in Kazakhstan, its liquefied natural gas project in Angola or its production extension in the Gulf of Thailand. Although most of these projects were announced at the end of 2007, Chevron officials said administrative hurdles, such us the requirement of the U.S. Securities and Exchange Commission to obtain third-party verification of the reserves estimates, didn't allow the company to add them in.

Chevron Chief Executive Dave O'Reilly acknowledged the company's reserve replacement rate has been much more "choppy" in recent years. But O'Reilly said analysts will see higher reserve replacement once major projects come on line in the next few years. Chevron is spending a whopping $22.9 billion in 2008 to advance a number of mega-projects that company officials expect to enable 100% reserve replacement in future years.

Will Exxon Stand Out Again?

But the problems that hit Chevron in 2007 are symptomatic of industry-wide challenges facing major oil companies as the sector seeks to replace reserves, analysts said.

"The situation is not getting better," said Lysle Brinker, vice president at John S. Herold's Equity Research in Connecticut. "The environment has gotten much more challenging for these companies, and we expect the whole group will fall short."

From 2004 to 2006, big oil as a group replaced just 75% of its reserves, not including growth through acquisitions, according to their financial statements.

Shell and ConocoPhillips officials avoided disclosing their companies' 2007 reserve replacement rates during recent earnings conference calls. But analysts from Credit Suisse said Shell has already hinted at very bad results to come mainly because of it couldn't prove reserves from 11 material discoveries the company had last year.

Conoco is expected to cut reserves after exiting its heavy oil ventures in Venezuela, said Fadel Gheit, analyst at Oppenheimer & Co.

Reserves are a sensitive issue for Shell after the company downgraded its reserves several times in 2004 and 2005, leading to a shakeup of senior management, a share price slump and fines by U.S. and British regulators.

But a low rate would be particularly noteworthy for ExxonMobil, the only oil major to report more than 100% reserve replacement each year from 2004-2006. Analysts said ExxonMobil is challenged by the rise in crude prices because it garners about 20% of its production from production-sharing contracts.

"The next piece of news from Exxon Mobil is likely to be the 2007 reserve replacement," said Mark Flannery, analyst at Credit Suisse in a note to investors last week. "Exxon has a chance to outperform its peers, but is suffering from many of the same issues as the other big oils are, just perhaps to a lesser extent. Same disease, better doctors."

Oil companies may soon be able to book more reserves if the SEC eases its rules, which the oil companies regard as obsolete. The SEC took a first step toward a possible rules update in December, but hasn't announced any definitive change. The industry has been aggressively lobbying for such an overhaul in recent years.