3P Reserves

3P reserves (also known as 'Proved plus Probable plus Possible reserves') is a classification used in the oil and gas industry to quantify the total potential volume of hydrocarbons that can be recovered from a reservoir. Think of it as the most optimistic estimate of a company's underground treasure. It's the sum of three distinct categories of reserves, each with a different level of certainty: Proved (P1), Probable (P2), and Possible (P3). Proved reserves are the most certain, with a high degree of confidence (typically over 90%) that they can be commercially recovered under current economic and technological conditions. Probable reserves are less certain but still have a reasonable chance (over 50%) of being recovered. Possible reserves are the most speculative, with only a small chance (over 10%) of being recovered. Summing them all up gives you the 3P figure, which represents the total upside potential of an oil or gas field, combining the sure bets with the long shots.

To truly understand an energy company's assets, you need to break down the 3P number into its components. Each 'P' tells a different story about risk and reward.

These are the crown jewels. 1P reserves (or Proved reserves) are the quantities of oil and gas that geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions. The U.S. SEC has very strict rules for what qualifies as “proved.” Think of this as the money that's already in the bank. It has a high probability of recovery (90% or more), and it's the figure that banks will use to lend against and what conservative investors focus on most.

This category, 2P reserves, is the sum of Proved and Probable reserves. Probable reserves are those that are not yet “proved” but are considered likely to be recoverable based on the available data, with a 50% or higher probability of success. So, 2P represents a more realistic upside scenario than 1P alone. While not as bankable as 1P, many industry analysts and company managers use the 2P figure for internal planning and valuation, as it gives a fuller picture of a company's likely future production.

This is the full enchilada, the “blue-sky” scenario. The 3P figure is the sum of Proved, Probable, and Possible reserves. Possible reserves are the most speculative of the bunch. They represent a potential upside with a low probability of being recovered (typically estimated at 10% to 50%). While exciting, these reserves are highly uncertain and depend on future technological breakthroughs, favorable price changes, or further exploratory success. Companies might tout their large 3P reserves to generate excitement, but they carry significant risk.

For a value investor, understanding the difference between the 'P's is crucial for avoiding hype and finding genuine value.

A huge 3P number might look impressive, but as a student of Benjamin Graham, you should greet it with healthy skepticism. Valuing a company based on its 3P reserves is like counting your chickens not only before they hatch, but before you've even bought the eggs. The core principle of Margin of Safety dictates that you should pay for certainty and get potential for free. Focusing on 1P reserves provides the greatest margin of safety. You are paying for what is demonstrably there. The value of 2P and 3P reserves is in their potential to be converted into the 1P category. A management team with a stellar track record of doing just that is far more valuable than one that simply sits on a large, stagnant pile of “possible” resources.

When analyzing an oil and gas company, don't just look at the headline 3P number. Dig deeper.

• Start with 1P: This is your foundation. How much does it cost the company to find and produce these reserves? Is the value of these reserves, after accounting for all costs and debt, greater than the company's market capitalization? This is classic value investing.
• Use 2P for Growth: Look at the 2P figure to gauge the company's reasonable growth potential. A company that is steadily converting its probable reserves into proved reserves is a sign of operational competence.
• Treat 3P with Caution: Consider 3P reserves as a lottery ticket—a nice bonus if it pays off, but not something you should pay for. A massive gap between 1P and 3P reserves can be a red flag, suggesting overly promotional management. However, for a sophisticated investor, it could also signal a deep value opportunity if you have strong reasons to believe the “possible” will become “proved.”
• Check the RRR: Look at the reserve replacement ratio (RRR). This ratio tells you if a company is adding more reserves than it's producing. A company with a strong RRR that is driven by converting 2P and 3P reserves into 1P, rather than expensive acquisitions, is often a very well-run machine.