Commodities, Inventory & Collectibles

How to Underwrite Oil and Gas Reserves

Underwrite oil and gas reserves by discounting engineered production forecasts at a conservative price deck and giving most credit to proved developed producing (PDP) reserves. The metrics that matter most are PDP PV-10 under the bank price deck, reserve mix between PDP and PUD, hedge coverage of near-term production and leverage on EBITDAX.

What makes oil and gas reserves underwriting different

Oil and gas reserves are depleting assets. Each well produces on a decline curve, so value equals the discounted cash flow from remaining production after operating costs, severance taxes, differentials and the capital needed to drill undeveloped locations. Proved developed producing reserves are already flowing and carry the least risk, while proved undeveloped and probable reserves require drilling capital and execution. Value depends heavily on commodity prices, realized differentials to benchmarks, decline rates and the accuracy of engineering estimates. Risks include price collapses, steeper than forecast declines in shale wells, plugging and abandonment obligations, environmental liabilities, gathering constraints and title defects.

Reserve-based lenders size a borrowing base to the present value of reserves under their own conservative price deck, advance mostly against PDP, require hedging and take mortgages over most proved value, then redetermine the borrowing base semiannually. Equity investors underwrite development inventory, operational improvement and acquisitions priced at a discount to the futures strip. They often pay for PUD and probable locations that lenders discount heavily, and their returns depend on drilling results, cost control and price. Lenders want cash flow from producing wells that can repay debt even if no new wells are drilled.

Key metrics

PDP PV-10 at bank price deck

The present value of producing reserves at a 10% discount anchors borrowing base sizing.

Reserve-based lenders commonly size the borrowing base so outstanding debt is covered by a multiple of PDP value.

Reserve mix (PDP, PDNP, PUD)

PDP is low risk, while PUD depends on capital, timing and execution.

Lenders typically give most borrowing base credit to PDP and limited credit to PUD.

Hedge coverage

Hedges protect cash flow and borrowing base value through price downturns.

Lenders commonly require a meaningful share of expected PDP production to be hedged over the next one to two years.

Leverage on EBITDAX

Debt relative to cash flow before exploration expense shows repayment capacity.

Decline rate and reserve life

Steep early declines in unconventional wells require ongoing drilling to hold production flat.

Realized price differentials

Basin-specific discounts to benchmark prices reduce realized revenue and must be modeled explicitly.

How to underwrite it, step by step

Obtain an independent reserve report categorizing PDP, PDNP, PUD and probable reserves.
Compare decline curves and type curves to actual well performance and prior reserve reports.
Apply the bank price deck, differentials, operating costs and taxes to calculate PV by category.
Diligence title, leases, working and net revenue interests on wells representing most of the value.
Quantify plugging and abandonment, environmental and regulatory liabilities.
Review hedge positions, counterparties and the borrower's hedging policy.
Set the borrowing base with advance rates by reserve category and an appropriate covenant package.

Due diligence checklist

Independent reserve report
Production history by well
Lease operating statements
Title opinions and lease records
Hedge agreements and mark-to-market reports
Plugging and abandonment estimates
Environmental compliance and spill records
Gathering, processing and marketing contracts
Capital budget and development plan
Audited financial statements

Key risks and mitigants

Commodity price collapse

Use conservative price decks, require hedging and redetermine the borrowing base regularly with deficiency cure periods.

Reserve overstatement

Use independent engineers and track forecast accuracy against actual production over time.

Development execution failure

Limit credit for PUD and add value only as wells are drilled and producing.

Plugging, abandonment and environmental liabilities

Quantify obligations in the PV calculation and require bonding or reserves where material.

Title defects

Obtain title opinions covering a large majority of PV and mortgage coverage on most proved value.

Typical financing and deal structure

Reserve-based lending facilities are senior secured revolvers whose borrowing base is redetermined twice a year using an updated reserve report and the bank price deck. Lenders take mortgages over most proved reserves, require hedging and impose covenants such as maximum leverage on EBITDAX and a minimum current ratio. Second lien term loans, unitranche facilities and volumetric production payments provide additional capital beyond the borrowing base. Larger producers access the high-yield bond market, and some producing assets are financed through PDP securitizations that amortize with production. Acquisitions combine RBL availability with private equity and sometimes contingent payments tied to future prices. Development drilling is funded from cash flow, equity or drilling partnerships.

Red flags

Reserve report prepared internally without independent engineering review.
Wells declining faster than the type curve used in the reserve report.
Large PUD share in the collateral relative to PDP.
No hedges in place for near-term production.
Material plugging and abandonment liabilities with no bonding or reserve.

Frequently asked questions

What is PV-10?

PV-10 is the present value of estimated future net revenue from proved oil and gas reserves, discounted at 10% per year, before income taxes. It is a standard industry measure. Lenders calculate their own version using their price deck and apply different advance rates by reserve category to determine borrowing base availability.

What is the difference between PDP and PUD reserves?

PDP reserves are proved, developed and producing, meaning wells are drilled, completed and flowing. PUD reserves are proved but undeveloped and require new wells and capital to produce. PDP carries less risk and receives most lender credit, while PUD value depends on capital spending, drilling results and timing.

How does a borrowing base redetermination work?

Lenders recalculate the borrowing base, typically twice a year, using an updated reserve report, the current bank price deck and hedge positions. If the new borrowing base is below outstanding loans, the borrower must repay the deficiency, often in installments over several months, or pledge additional reserves as collateral.

Why do reserve-based lenders require hedging?

Hedging locks in prices on part of expected production, protecting cash flow and collateral value if prices fall. It reduces the chance of a borrowing base deficiency at the next redetermination. Lenders often require minimum hedge levels on PDP volumes and give borrowing base credit for in-the-money hedges with acceptable counterparties.

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Educational content, not investment, credit, legal or tax advice. Benchmarks are common practitioner rules of thumb and vary by lender, market and cycle.