Contrary to common use of the terms, our resource definitions allow for the paradoxical situation in which reserves remain “economically producible” while the project as a whole is “uneconomic” and “noncommercial.” The idea may seem contradictory because the definitions do not explicitly treat this late-life dynamic, but it follows from the clear and simple definitions.
The difference between economically producible and economic lies in decommissioning costs and, thus, on the expectation of ultimate profits. The resource definitions are explicit about the need to treat decommissioning costs in initial evaluations but less clear about developed projects. Nevertheless, the dramatic effect on overall profit for many producing projects makes the need for treatment as clear as it is hard.
The Petroleum Resource Management System (PRMS) endorsed across our industry recognizes “Abandonment, Decommissioning, and Restoration (ADR)” as the “process (and associated costs) of returning part or all of a project to a safe and environmentally compliant condition when operations cease” (Glossary, 3.1.2). And the system explicitly requires that an undeveloped project cannot be initially deemed “commercial” unless the returns suffice also to pay for the ADR costs (Glossary, 2.1.2).
In practice, evaluations of undeveloped resources focus on financial returns and on the ability to execute, but it only makes sense that qualification must include other considerations: “Also, there must be evidence … the essential social, environmental, economic, political, legal, regulatory, decision criteria, and contractual conditions are met” (2.1.2).
To demonstrate the test of commerciality, the “Guidelines for Application of the Petroleum Resources Management System” (Rev. July 2022) includes an example cash flow reproduced in Fig. 1, a notional offshore development presumably designed with representative assumptions. The bars show the net cash flow of each year while the line represents the undiscounted cumulative total of net cash flow on the other axis. The gray region shows the time period during which this example maintains the paradox of economically producible reserves while being uneconomic and noncommercial as a project.
Section 3.1.2.1 of PRMS defines the three relevant terms. “Economically producible” applies when “net revenue from an ongoing producing project exceeds the net expenses” explicitly excluding ADR costs. However, the definition of “economic” looks at total remaining cash flow without exclusion; the term applies to “a project with a positive undiscounted cumulative net cash flow.” A project is not economic when its remaining undiscounted cumulative net cash flow is not positive.
The definition of “commerciality” requires meeting the definition of economic plus other terms: “A project is commercial when it is economic, and it meets the criteria discussed in Section 2.1.2.” Thus, no uneconomic project can be commercial.
Applying these terms to the PRMS example, decommissioning costs paid at the end of life equal the projected net cash flow from the last 13 years of operations, assuming no funds have been set aside for the obligation. (Because the PRMS explicitly prescribes evaluation at a project level, the corporate balance sheet does not affect the characterization of an individual project.) During the shaded years (Fig. 1) the volumes continue to qualify as reserves because they remain economically viable to produce while, at the same time, the undiscounted future cash flow is negative.
Thus, despite having volumes characterized as reserves, the project as a whole is financially uneconomic and thus noncommercial, to the extent the term applies to producing projects. In fact, this demonstrative project is uneconomic and noncommercial for more than half of its operating life.
My reproduction of the example cash flow shows that the present value discounted at 10% does not become negative until there are 9 years of life remaining. Thus, a buyer could pay PV10% to purchase a property during mid-life, operate it profitably for many years, and then pay decommissioning costs greater than all its historical proceeds.
Over the period of ownership, the “investor” would lose not only their entire purchase price but also all of proceeds of operations. The concepts of present value and rate of return have very different meanings when the investor loses money at the end of the day. And that is the reason that decommissioning costs must be included and explained in economic evaluations. (For a fuller discussion, see SPE 210226, “Economic Yardsticks for the End of Economic Life: Holdback and Its Adjuncts.”
PRMS—and all the other standards for evaluations published by our Society—serve the same purpose: to clearly, accurately, and consistently reflect reality. In the case when “social, environmental, economic, political, legal, [and] regulatory” requirements meaningfully affect cash flow expectations, decommissioning costs become an issue of ethics. Not including decommissioning costs, not evaluating them for reasonableness, and not explaining their significance can all lead to substantially misleading projections.
In my opinion, decommissioning costs should be treated with the same duty and diligence as operating costs. The PRMS can become more explicit, but in the meantime professional engineers can honor the economic significance of decommissioning under the yoke and the aegis of professional ethics. It may be bad news, hard to hear. But it is clearly our responsibility to differentiate become economic and uneconomic projects.
For Further Reading
SPE 210226 Economic Yardsticks for the End of Economic Life: Holdback and Its Adjuncts by D. Purvis.
