GEOL. CROAT. 
I 

49/2 277 . 281 1 Fig. ZAGREB 1996 I 

NCl'iew paper 

Hydrocarbon Reserves - Estimation, Classification and 
Importance in Evaluation of Exploration Projects 

Zvonimir NADJAKOVIC, Josip SECEN and Antun BAUK 
PROCEEDINGS 

Key words: Hydrocarbon reserves, Classification of 
reserves, Evaluation of exploration projects. 

Abstract 
One of the key problems encoun tered by oil companies from 

couIltries in transition approaching the world market is in understand­
ing the cOllcept of reserves, their estimation lind classification. As 
reserves afC the basic valuc of a company , il is imperative that busi ­
ne ss policy includes continuous replacement of reserves. The study 
illustrates the usc of esti mated reserves in the evalu ation of ex plo­
rat ion areas, and lhe imporlance of reserves in business decision s and 
a company' s fulure. 

1. INTRODUCTION 

The concept of market economy necessarily 

requires the valuation of each asset held by a company. 
For compan ies registered in some of the stock markets, 
i.e. public co mpani es, reporting the annual economic 
state is mandatory. The value of an oil company lies in 
the value or its oil and gas reserves. Tn order to make 
the reserves of various companies mutually compara­
ble, a more or less similar classification system has 
been accepted in thc world of market economy. The 
basic characteristic of the system is that only those 
quantities of hydrocarbons that can be profitably recov­
ered using existing tech nology arc estimated as 
reserves. In reserves estimation the real production 
behaviour is emphasised, i.e. production decline curves 
or mathematical modelling arc used, as well as practical 
experience gained from similar field s. When gas fields 
are in question, the material balance method has been 
accepted as reliable. The consequence of such an 
approach is a conservative estimate of reserves that 
results in frequent upward revisions. 

In the fonner socia list block countries, including the 
form er Yugoslavia, a system was adopted which aimed 
at determination of theoretically recoverable quantities 
of hydrocarbons. Such an approach has resulted in more 
optim istic es timates, and with some exceptions it is still 
used in practice today. Moreover, they developed a 
classification system for mineral energy resources only, 
and nol rcservcs. Though il gives a good insight into thc 

lNA -Naftaplin, Subiceva 29 . HR- l 0000 Zagreb, Croa lia. 

Kljucne rijeCi: zalihe ugljikovodika, klasifikacija zali­
ha, vrednovanje istrazivackih projekata. 

Saictak 
Jed'l n od kljucnih problema naflnih kompanija iz zemalja 1I 

tranziciji pri prislupanju svjelskom lrziSlU jesl razumijevanje pojma 
zaliha, njihovog procjenjivanja i razvrstavallja. Za lihe su lemeljna 
vrijednosl nafln e kompanije. Irnperativ poslovne pol it ik e je slalno 
obnavljanjc zaliha. Prikazano je kako se procijenjene zalihe korisle za 
vrednovanje istrazivackih lokalitela, odnosno koliki znacaj im,~ill pri 
donosenju poslovnih odluka, pa i za buducnosl same kompallije. 

mineral resource potential of a certain country, it cannot 
be used ei ther in conducting the business policy of a 
company at an operational levcl or in the real estimalion 

of its financial position. 
When approaching the world market, each company 

should present its annual financial report. As hydrocar­
bon reserves represent the most important part of oil 
company assets, their classification and estimation 
should conform with international stratcgy rules. As the 
term "markel" implicitly includes every market, e .g . 
money market, hydrocarbon reserves market or explo­
ration areas market , the internationally acceptable 
reserves classification and estimation system becomes a 
neccssity. It must bc mentioncd here that in the evalua­
tion of a certain exploration prospect or one exploration 
well , the start point is ei ther undiscovered potential 
reserves or future in itial rescrvcs, which arc cstimated 
in a similar way as for proven reserves. 

2. THE CONCEPT OF RESERVES, IlOTH IN 
CROATIA AND INTERNATIONALLY 

The Croalian "By-law on data gathcring, thc manner 
of recording and es tablishing reserves of mineral 
resources as well as the preparation of balancc shcet for 
these reservcs" clearly dcfines what is mcant by 
reservcs. It is obvious that it refers to the volume of 
mineral resources found in a reservoir. Dcpending on 
the degree of ccrtainty, these quantities are classified 
inlo the A, B, C I , C2, D I and D 2 catcgories but by the 
deterministic approach. Not all the quantities of mineral 
rcsources in a reservoir can be produced, and only some 



27~ 

can be profitably produced. It seems, the refo re, that the 
te rm "reserves" is inadeq uate. However, in order to 
repon vol umcs that can be profitably produccd the A, B 
and C 1 categories are classified i l110 economicall y and 
uneconomica lly recoverable reserves. The economical­
ly recoverable reserves are oil and gas volumes that can 
be profitab ly recovered, and they, in fact, represent the 
reserves. 

As the By-law docs not defi ne the method 1'01' es ti­
mating the profitability of rese rves, a static method is 
most frequen tl y used for these estimates, in contrasttQ 
the rules applied in market economies that require cash 
flo w ca lculati on, i.e. d iscounted cash fl ow anal ys is . 
Besidcs, the degree of cerlainty of so de te rmi ned 
reserves, is not unique. 

In the majority of countr ies with market economics, 
minera l resources a re divided in to di scovered and 
undiscovered, and those discovered arc furt her d ivided 
into reserves (initial) and un recoverable quantit ies. \Ve 
shall focus ou r attention on the reserves. A cl ass ifi ca­
tion o f reserves is presented on Fig. l. 

The remai ning reserves arc class ified according to 
th e degree of certainty which indicates the techni ca l 
and eco nomic probability of recoveri ng the c lassified 
volumes or reserves. 1n the determin ist ic approach to 
reserve es timation, the degree of certainty is reported 
descr ipti ve ly. The evaluator, according to his profes­
siona l judgement, classifies the reserves in compliance 
wit h the c riteria accept ed by the Socic ty of Pet roleum 
Engineers (e.g. SOCIETY OF PETROLEUM EVALU­
AT ION ENGINEERS , 1988, and T HE PETROLEUM 
SOCIETY Or: T I-IE CANADIAN INSTITUTE OF MI­
N ING, METALLURGY AND PETROLEUM , 1994). 
Some <w thors consider the certa inty of proven rese rves 
10 be almosl 100%, probable 50% and possible 10%. In 
the probability approach to reserve es timates, the 
degree of certaint y will be assigned nUllle rica l values 
<I nd, depending on the country and company, proven 
reserves would be th ose dete rmi ned with a re liability 
grea ter than 80% or 90%, probable from 40% or 50% to 
80% or 90% and possible from 10% to 40% or 50 % 
(CALD WELL el al. 1993). 

Gcologb Croatie:! '19[2 

Fig. I A c las~ i ficalio ll of reserves. 

T he basic charac tc risti c of pro ve n developed 
reserves is thai they are those quantiti es of hyd roca r­
bons tha t can be recovered from ex isting wells and sup­
p lied to the market by existi ng gat hering and tran s­
portation systems. Undeve loped reserves a rc the 
reserves the prod uction o f which req uires significant 
inves tment, but projects or studi es con firmin g thei r eco­
nom ic .iustifi ca ti on are already available. In co ntrast to 
this, the recoverable reserves in Croatia, in addi tion to a 
d ilTerent level of technica l reliability, a re o nly roughly 
es timated. Conce rni ng old fie lds wit h co mple ted pro­
jec ts and proven profitability, those reserves arc close 
or identi cal with proven reserves. In new fie lds, for 
which the project or study has yet to be prepared, the 
reserves might bc categorised as p robable or possible, 
dependi ng on the degree o r certain ty. In other wo rds, 
addit iona l well s shou ld somctimes be dr illed and com­
ple ted in these new fi elds and a ll the necessary infra­
struc ture, as well as the gathe rin g and transportation 
sys tem, construc ted. All thi s requires large investment 
that has to be justified in order to c lass ify hydrocarbon 
quantities 10 be recovered frolll these fields into proven, 
but undeve loped rese rves. T here fore, th e reserves of 
non-producing fi e lds categori sed acco rdi ng to the By­
law as recoverable reserves, shou ld be cons idered prob­
able or possible, depending 011 the degree of certainty. 

Lei us emphasise once more the di/Terence in cate­
gori sing the hydrocarbon reserves in marke t or iented 
and social ist economies. In marke t economics the term 
reserves applies Lo those volumes that can actually be 
supplied to the market. It means that a ll the real prob­
lems of production arc taken in to consideration, from a 
damaged ncar well bore zo ne, throug h the imperfec­
tions of fl uid lifling and transpo rt clli on sys tems to Ihe 
untimely and somet imes ine ffecti veness of workover 
operations. All these arc theorctically unpred ic tab le. 
Thi s is why, for reserve est imatcs, a real fi e ld perfor­
mance is used or so call ed " producti on decl ine curve" 
or analogy wit h a similar fi e ld. Contrary to this, in for­
mer socialist countries emphasis was placed on theoret­
ically recoverable vo lumes at reservoir level. TL means 
that in predicting the future behaviour very sophis ticat-



Nadj; lk ov ic, SeCell & l3:wk: I !yclrocarboll Rcscryc~ · I~slimalioll, Clnssirication and !mportance ... 279 

cd calculations are sometimes used, to calcu late theo­
retically recoverable volumes, but they cannot reflect 
<:II[ the complexities of real production. 

3. ECONOMIC EVALUATION 

1n this study, discussion of economic evalu<:Ition is 
separated although in the m<:lrket economy it is an 
inseparable part of the eSlim<:llion or both the degree of 
certainty and quantity of" reserves. This is due to the fact 
th<:lt only lhe quantities that can be profitably produced 
and supplied to the market under definite technical and 
economic conditions are considcred as reserves. The 
By-law or the reserves classific<:ltion issued by the 
Republic of Croatia requests only a rough economic 
evaluation. Such evaluation cannot be used either as a 
basis of investment or for estimating the profitably 
recoverable quantities of hydrocarbons, i.e. reserves. 

The economic evaluation in the market economy is 
based upon criteria accepted by the Stock Exchange 
Commission, and the same criteria arc incorporated into 
fnt ern<:l tional Accounting Standards. The economic val­
ue is determined by applying the method of cash flow 
calculation at constant prices and costs at the end of the 
previous year and a 10% discount rate (FINANCIAL 
ACCOUNTING STANDARDS BOARD. 1982). The 
result of such an approach arc various indices of the 
project erfieieney and reserves esti mation. Among the 
indices arc payout time, return on investment , rate of 
return and net present value. With a correct prediction 
of future ficld performance and all futurc costs, one can 
obtain an evaluation which is a good basis for making 
business decisions. There is no need to describe in 
detail the ca lculation methods, as they arc already well 
known. When making the economic evaluation it is 
very important to properly determine the investment 
risks. In the process of es tablishing the risk, the evalua­
tion or geological and technical uncertainty is , in princi­
ple, less prob lematic than that of political and economic 
uncertainty, but they have to be evaluated too, as they 
can substantially affect the final result. 

4. EVALUATION OF EXPLORATION AREAS 
AND WELLS 

Every enterprise, regardless of type and size must , 
ror the sake or survival and development, continuously 
eval uate business efficiency. For oil companies there is 
an additional impera tive, i.e. the replacement of pro­
duced quantities or hydrocarbons by newly discovered 
reserves. Both requirements have to be compatible 
regardless of the exploration and production conditions. 

The basic principle or success ful business is that 
income must exceed expenditure. The success of any 
bus iness can be expressed by the simple equation: 

PRO"IT ~ VOLUME x (PRICE - VARIABL E / UNIT 

COSTS) - FIXED COSTS - TAXES 

The volume of hydrocarbons is dilTicult to quant i­
fy. ]1 is est imated by means or various methods at d if­
fe rent stages of exploration or development. The accu­
racy of estimation increases with the number and relia­
bi li ty of the available data on the reservoir geological 
model, fluid and rock properties as well as the recov­
ered fluid volumes. 

The price of hydrocarbons is beyond company con­
trol and prediction of fu ture prices represents a large 
unknown when defining basic long term objectives. 

Costs, including overheads, can and must be con­
trolled by the business policy of the company and ind i­
viduals. 

Taxes are also beyond the control of a company as 
they are controlled by the state depend ing on ils inter­
ests and needs. 

Accordingly, this cquation indicates that making 
profit involves several unfavourable factors and may be 
controlled mainly by costs. 

Geologists and petroleum engineers can contribute 
to this business in two ways: 

increasing and maintaining volumes; 

reducing or controlling costs per unit volumc pro­
duced. 

While the other indices from this equa tion depend 
on the economic, political and social conditions of a 
certain country, the explorationist should also take into 
account and direct the activities toward conditions 
which are Jllore favourable for the company. These are 
general principles of profitable hydrocarbon reserves 
exploration, and lheir clements will be discussed latcr 
in more details. 

The procedure for estimating the value of any given 
exp loration area commences with determination of the 
undiscovered potential reserves value. This is deter­
mined by calculating the cash flow. Costs of failure 
should a lso be estimated, e.g. those of a dry well. or 
particular importance is determination of the probabili­
ty of a success. By these means a predicted cash value 
is calcu lated, which may be simply represented as: 

EMV ~ [VR x PS] - [CF x (I-PS)] 

where VR is value of rese rves , PS probability of suc­
cess, cr costs of failure and EMV expected money 
value. 

An ex ploration well can be evaluated in a sim ilar 
way. There is also the possibility for comparing the 
exploration well results in a ratio obtained by dividing 
the expected cash now value by th e dry well cost. 
Another index, which can be Llscd in project ranking, is 
obtained by dividing the expected cash flow value by 
current investment value. This index gives an expected 
income per unit of investment. The approach, method­
ologically identical to this , applied in the proven 
reserves estimate, facilitates the evaluat ion of the 
exploration projects. This evaluation is to be made not 
only at the very start of the process, but also during 



2XO 

each phase when changes occur due 10 either new tech­
nical perceptions or new econom ic conditions. 111 this 
manner condilions will be created which would make it 
possible 10 conduct the exploration operations in an 
extremely profitable way, and 10 achieve Ihe optimum 
results by invcsting into hydrocarbon exp loration. 

Various methods and rules arc used in the determi­
nation of the effects of inves tment s, which are applied 
by oil companies when making decisions on investing 
into exploration projects. Some of the si mple criteria 
frequently used in world practice in exploration area 
evaluation (JONES, 1992) may be considered: 

1. If the llndiscollnted gross value of total produc­
tion from the hydrocarbon accumula tion docs nol 
exceed al least 40 times the discovery costs (land pur­
chasing and drilling costs) the project is not cost effec­
tive and should bc abandoned. Thcre is a suggestion [or 
the rotio to be evcn 50: I (HA RDIN , 1958). 

2. A project must not be started in any case when 
the rate of return is not greater than certain values 
cstablished in advance: 

• For a high risk area 

• For a medium risk area 

• For a low risk area 

30-40% 

20-30% 

15-25% 

Unfortunalely praclica l experience ind icates the fact 
that cxplorationists have a poor perception of ri sk, i.e. 
low-risk projects fail more orten than expected. In spite 
or this imperfection, some eva luat ors of explora ti o n 
areas find this approach very viable. 

3. If the project will not payout in less than "x" 
years, it should not be started. 

• Individual wells in 2-2.5 years 

• New field in 4-5 years, depending on size 

This rulc is particularly applicable to smaller fields 
ncar large ones, where pipelines and othcr facilities 
alrcady exist. Howcver, discounted payout may be a 
more realistic measure. 

4. The average discovery costs (includi ng devclop­
ment) in 1989 in the USA were approximately: 

·31.5 USDjlll] (5 USD/bbl) for oil, 

·27 USD/IOOO m] (0.75 USD IMc!) (or gas . 

Similar figure s are given in Herold's Annual 
Reserve Replacement Cost Analysis for world wide 
opef<!tions , 1993. Hi gher costs make the project unprof­
itable. Costs of discovery include all dry hole costs, and 
should be divided by the probabili ty of success to adjust 
the risk and allow valid comparison with other projects. 

5. Any gas explorati on and production project 
should not be started if it will not return at least 35 
USDjlOOO m] (I mil. USD/billion cuft ) . This also 
inc ludes development drilling costs. 

6. The ['irsl well should "earn" enough to pay for 
land, seismic surveys and drilling. 

7. No new field wildcat vel1lure should bc taken if, 
after [he wildcat which proves to be successful, drilling 

Geologia Croaliea 49/2 

of at least three offset development wells is not feasi­
ble. 

This represents "some rules of thumb" used mostly 
in the USA in evaluating exploration areas. 

A realist ic approach to the valuation of exploration 
prospects, for the Croatian oil company , becomcs a 
necessity under conditions of fairly stable prices and in 
a highly explored operational area. Evaluation of the 
exploration area as much obj ectively as possible 
becomes imperative under conditions of comparative ly 
stab le prices of hydrocarbons in an area prev iou sly 
highly explored. Today one cannot rely on ci t her a sig­
nificant price increase or large discoveries. Por these 
reasons it is necessary to evaluate the exploration pro­
jects as rationally as possible. 

In the foreseeable future hydrocarbons remain the 
inevitable energy resource and mineral reserve to be 
used in the chem ical indu stry. This means that th e 
process of exploring, discovering and putting into pro­
duction new reserves is continuous, but under consider­
ably more difficult technical and economi c condi tions, 
as is constantly reite rated by the leading people of big 
oil compan ies . Thi s could a lso be applied to Ihe oil 
companies in the former soc iali s t countries, in the 
maj ority of which exploration operation s were rather 
extensive, and during transition into the market econo ­
my the rationalisation of the explo rat ion processes, as 
well as other act iviti es of oil companies was more 
strongly emphasised. 

5. INA-NAFTAPLIN AND THE TREND OF THE 
MARKET ECONOMY 

Analysis of the reserves management at INA-Nafta­
plin encounters al l the problems indicated in th is study. 

The remain ing oil reserves are contained in old 
fields with high production costs. When estimating Ihe 
remaining rcserves according 10 standards common to 
western countries, it has become certain tha t production 
costs will considerably reduce the remaining economic 
production life of the fields. It is a lso certain that recov­
e rable (techn ical) reserves, due to a long productive 
life, wjJl generally meet the criteria introduced by the 
new evaluation approach. 

In order to increase the rcmaining reserves produc­
tion cos ts must be reduced, i.e. to make detailed analy­
ses of each item loading these costs. Another method of 
improving th e cost effectiveness of each field is to 
increase the well productivity by introducing new tech­
nologies adequate to the rield conditions. 

The world price of oil products and an aspiration to 

enter the petroleum business world presumes thai all 
the costs of our activ ities arc brought as soon as possi­
ble to the world level. It requires not only the definition 
of the company from thc organisational point of view, 
but also it's streaml ining. 

In thi s process, the non st rateg ic, financ iall y mar­
ginal and other undesirable investmen ts should be cl im-



i\,utj:ll-oviC. Scccn & Baul-: Ilydrocarbon l{c~erve.~ - E~lilllalion. Cta:.~ific;nion and imtlOrl:mcc ... 281 

in<llcd, with a pa ralle l rcstructuring and reorgan isa tion 
per formed whil e pl nn nin g the strategic growth of the 
company. 

1n con trast to thi s there is an option for the company 
to downsize by reducing all acti vities by a certain per­
centage, withou t any c lear plan of growth . 

H the fi rs t opt ion is to be applied, i.e. the concept of 
g rowth, regula r rep lacement o f rese rves should be 
ach ieved through care ful planning of all ac tivities in 
accordance with the company potel11ial. 

The reserves can be res tored by con tinuing explo­
ration in the country and ab road, by acqui sition of 
reserves and il11roduci ng the add itiona l recovery meth­
ods aimed al inc reasing the recovery of the remaining 
reserves in old oi l fi elds. 

There is a high probability that the remaini ng poten­
tial of the Pannon ian exp loration area in Croatia can 
ensure discoveries and new reserves for replacement or 
only a fraction of currcnt production. 

Exploration ope rations abroad must be the basis of 
long term reserves replacement. The results achieved so 
fa r a rc encouraging, but future activ ities shou ld involve 
al l the human resources in orde r to se lec t thc most 
prospective prospects. 

There is no poss ibilit y for the short tc rm st abilis a­
tion of reserves without purchasing already d iscovered 
rese rves or field s in production on the open marke t. It is 
a new act ivity for the company and many diffi culties 
arc ex pected , but if we wish to initiate a new cycle of 
compan y growth , it is mo rc impera tive than optional. 
All these activities assume co-operati on with foreign oi l 
companies as we ll as the application of the Illost rcccnt 
technical achi evemen ts in all stages of the oil and gas 
ex ploration and production process. 

6. CONCLUS ION 

The hydrocarbon reserves of the Republ ic of Croat­
ia, de fin cd according to the By-law, a re not directly 
co mparabl e wit h the proven, probable and possib le, 
c lassi fi cation used internationally, due to a d ifferent 
nppronch to the es timation from the techni ca l and eco­
nomic point of view. T herefore, a new es timation and 
c lnssi fi cat ion scheme should be implemented in order 
to establi sh the rinanc ial position of an oil company in 
Croati a according to internationa l s tandards. A new By­
law (at leas t int e rnal ) about classifica tion or reserves 
should be prepared , which would take into co nsidera­
tion internati onal standards, i.e. be based upon the mar­
ke t approach. The reserves es timated and c lass ified in 
this manner would be the bas is for approaching the 
world marke t. It docs not mean that mineral energy 

reSources should not bc repo rted. On the cont ra ry, they 
shou ld be assigned to loca lit ies, i. e. concession blocks, 
and the potential reserves es timated accordin g to the 
adopt ed rul es but taking into consideration the ri sk. A 
continuo lls reva luation of potential rese rves should be 
perfo rmed during explora tion, as all changes in costs or 
prices o f hydrocarbons could affeel the ir req uired vol­
ume, and by thi s could di rect ly affec t the cont inuat ion 
of works or their terminati on in case or unprofit ab ility. 

INA Naftaplin is faci ng the necessity o f the optimi ­
sation o f the explorati on an d th e rationali sa ti on of 
deve lopment on the basis of the described valuation of 
reserves . Appl yi ng cri tc ria accepted wo rld w ide and 
me th ods o f va luation of prospects, more e ffi c ient 
exp loratio n at ho me and abroad should be ac hieved, 
which, together wi th the acqui s it ion of new reserves, 
should result in a hi ghe r reserves replacement ratio. A 
replacement ratio of 1 must be achived as soon as pos­
sible. 

7. REFER ENCES 

CA LDWELL. R.H. , GR ACE, lD. & I-lEATHER , D.1. 
( 1993): Comparative reserves definition s : USA, 
Europe, and the Former Sov iet Uilion. - Journ a l of 
Petroleum Technology, 45/9. 866-872. 

FI NANCIAL ACCOUNTING STANDARDS BOARD 
( 1982): Statement or fi nanc ia l accounting s tanda rds 
No. 69. - Financial Accounti ng Standards Board , 
Stamford, Connecticut , 1-49. 

HARDIN, G.c. ( 195 8) : Economic factors in Ihe geo­
log ical appraisal or wildcat prospects. - Gulf Coast 
Association of Geolog ical Societies Transacti ons, 8, 
14·19. 

JONES. D.R. (1992): Some bas ic bus iness concept s.· 
In: STEINMETZ. R. (cd. ): The business of petro le­
um exploration. AAPG Treatise of Pet roleum Geol­
ogy,7-12. 

SOCIETY OF PETROLEUM EV ALUATlON ENGI­
NEERS (1988 ): Gui delin es for application of th e 
de finition s for oil and gas reserves.- Soc ie ty o f 
Pe tro le lllll Eval uati on Eng ineers, Mon og raph , I, 
lIouston. Texas, 1-69. 

THE PETROLEUM SOCIETY OF THE CANAD IAN 
INSTITUTE OF M IN ING. METALLURGY AND 
PETROLEUM (1994) : De termination of o il and gas 
rese rves .- The Pet roleum Society of the Canad ian 
Instit ute of Mining , Metallurgy and Pe trol eum , 
Monograph, Calgary, 362 p. 



2X2 Geologia Croalica 49(2