Probable (2P) Reserves

Probable (2P) Reserves is a classification used primarily in the Energy Sector and mining industries to estimate the volume of recoverable resources, such as oil, gas, or minerals. Think of it as the “likely” amount a company will be able to extract. Specifically, 2P is the sum of Proven reserves (the most certain category) and Probable reserves. According to international standards like the Petroleum Resources Management System (PRMS), the “Probable” label means there is at least a 50% probability that the actual quantity of resources recovered will meet or exceed the 2P estimate. While not as bankable as Proven Reserves (1P), which have a 90% certainty, 2P reserves provide a more comprehensive and often more realistic picture of a company’s asset base. It's the go-to figure for many analysts and company managers when they talk about a project's potential.

To understand 2P, you need to know its neighbors on the resource “certainty ladder.” Geologists and engineers classify reserves based on how confident they are that the resources can be commercially extracted. It's a spectrum from a sure thing to a long shot.

• Proven (1P) Reserves: This is the black gold in the bank. These are resources that geological and engineering data show with reasonable certainty (at least a 90% probability) can be recovered under existing economic and operating conditions. A value investor sees 1P reserves as the bedrock of a company's valuation.
• Probable (2P) Reserves: This is the “very likely” category. It represents the sum of Proven reserves plus Probable reserves. The Probable portion itself is less certain than Proven, but combined, the 2P estimate has a 50% chance of being met or exceeded. It’s like a year-end bonus you're pretty sure is coming, but you don't count it as cash in hand until the check clears.
• Possible (3P) Reserves: This is the “maybe” pile. It's the sum of Proven, Probable, and Possible reserves. Possible Reserves (3P) have a low chance of being recovered, typically around 10%. This is the lottery ticket of reserves—great if it pays off, but you certainly wouldn't base your retirement on it.

For a value investor digging into an oil or mining company, understanding the nuances of reserve reporting is crucial. It’s the difference between buying a treasure chest and an empty box.

Relying solely on 1P reserves can be overly conservative. Companies are constantly working to turn less certain resources into proven ones through further drilling, testing, and technological improvements. The 2P figure gives an investor a forward-looking glimpse into a company's potential growth pipeline. A company with a strong track record of converting Probable reserves into Proven ones is demonstrating its operational skill and de-risking its assets, which is a big green flag for any investor.

Analysts and savvy investors often use 2P reserves as the primary basis for valuing an energy company. However, they don't treat all barrels equally. Here’s the value investing approach:

1. Discounting for Uncertainty: While 1P reserves might be valued close to the current market price (minus extraction costs), the Probable portion of 2P reserves should be valued with a higher Discount Rate. This haircut accounts for the risk that the reserves might prove uneconomical, or that the geology is more complex than initially thought.
2. Spotting Management Quality: Watch the reserve reports year over year. Is the company growing its 2P reserves through new discoveries? More importantly, is it successfully upgrading those 2P reserves to the 1P category? Consistent upgrades signal a competent technical team and a high-quality asset base.

Imagine you're analyzing Wildcat Oil Co. Its annual report states:

• 1P Reserves: 100 million barrels of oil.
• 2P Reserves: 150 million barrels of oil.

From this, you can deduce that Wildcat has 100 million barrels of Proven reserves and an additional 50 million barrels of Probable reserves (150 million 2P - 100 million 1P = 50 million Probable). A very conservative analysis might only value the 100 million Proven barrels. However, a value investor would look at the entire 150 million 2P barrels but might say, “I'll value the 100 million Proven barrels at $50 each, but I'll only value the 50 million Probable barrels at $25 each to account for the risk.” This risk-adjusted approach allows you to capture potential upside without paying full price for uncertainty.