Managers of publicly held companies often face pressures that can tempt even the most principled to push the envelope of credibility in efforts to buoy investor confidence and thus increase stock value. In an age of instant gratification and inflated expectations of return on equity, companies often struggle with long range strategic planning while at the same time striving to meet expectations of the next quarterly earnings report. The quest for increased market capitalization often leads these harried managers to look under every stone for anything that will entice more investors to buy into their company.
The assets of oil and gas companies consist mostly of hydrocarbons in the ground – reserves. In typical annual reports one often finds proved oil and gas reserves stated in very precise terms. These reserve numbers are, in reality, very imprecise because of the variability and uncertainty in the earth and in the industrial and economic world. This is why the industry is moving increasingly away from deterministic reserve estimates to probabilistic, or stochastic, reserve estimates. Ironically, it is the very uncertainty associated with reserves that has enabled and preserved a practice that has, over the last twenty years, destroyed value and led many investors down the primrose path – reserve overbooking.
Reserve overbooking occurs for many reasons, among them poor estimating practices, misguided incentives, ignorance, competition for investors, and lack of professionalism. Any temporary benefits companies may derive from overstating reserves disappear whenever reserves must be de-booked. The resulting loss of confidence by investors and analysts is often made more painful by the fact that it could have been avoided. Reserve overbooking is a problem that may be solved through consistent, professional reserve estimating and reporting, and leadership, professionalism and accountability by informed and knowledgeable managers.