Prospective Resources are the energy sector's equivalent of a treasure map—they represent estimated quantities of oil and gas that could potentially be recovered from undiscovered accumulations. This is the most speculative category of petroleum resources. Unlike Reserves, which have been discovered and are commercially viable, prospective resources are purely conceptual. They are identified through indirect evidence like geological surveys and seismic data, which suggest that oil or gas might exist in a particular location, known as a 'prospect'. Think of it as an educated guess. The crucial word here is undiscovered. No well has been drilled to confirm their existence. According to the industry-standard Petroleum Resources Management System (PRMS), they sit at the very bottom of the resource hierarchy, carrying the highest risk and the highest potential reward. An investment thesis built on these is a bet on successful exploration, a high-stakes game where many players walk away with nothing but expensive holes in the ground.
To understand the immense risk associated with Prospective Resources, it's helpful to visualize the hierarchy of petroleum assets as a pyramid. The higher you go, the lower the risk and the more certain the value.
This is the wide, uncertain base of the pyramid. It represents all the potential oil and gas that might be found in undrilled prospects. The volumes can be enormous on paper, but the probability of ever converting them into cash flow is very low. This is the land of “what ifs” and geological dreams.
Once a company drills an exploration well and makes a discovery, the resource moves up the pyramid to the “Contingent” category. The oil or gas is now proven to exist! However, a significant hurdle remains: commercial viability. The company has not yet committed to developing the project. This could be due to low oil prices, high development costs, political instability, or the need for new technology. The treasure is found, but it's not yet clear if you can afford to get it home.
This is the pinnacle of the pyramid and what investors should prize most. Reserves are resources that are not only discovered but are also deemed commercially and technically recoverable. A firm commitment has been made to produce them. Reserves are often broken down by their level of certainty:
Prospective Resources are the feedstock for future reserves, but the journey from base to peak is long, expensive, and fraught with failure.
For a value investing purist, a business whose valuation is propped up by Prospective Resources is a flashing red light. It's speculation, not investment. However, a savvy investor can find value in companies that hold these assets, provided they approach it with extreme caution and a healthy dose of skepticism.
The allure is undeniable. A successful exploration well that proves a large prospective resource can cause a company's stock to multiply in value overnight. These “ten-bagger” stories attract speculators like moths to a flame. The danger, however, is that for every spectacular success, there are dozens of “dusters,” or dry holes, where companies spend hundreds of millions of dollars and find nothing. Relying on a successful drill bit for your investment returns is a gamble, not a strategy. It violates the core principle of margin of safety.
Instead of betting on the drill bit, a value investor looks for situations where Prospective Resources are a “free call option” on top of an already sound business. Here’s what to ask when evaluating a company with exploration upside: