Successes in the oil and gas industry are all about the drill bit, but given today’s subdued economic environment, Bernstein Research E & P analysts add a caveat: Success is also about who can add oil and natural gas reserves most cost-effectively.

"The ability to add oil and gas reserves cheaply is what can make or break an E & P company, and this year’s reserve numbers will reveal which E & Ps have succeeded in a difficult environment," reports Ben Dell, senior E & P analyst.

"On the one hand, service costs fell dramatically in 2009 as utilization fell, which should help lower F & D (finding and development) costs. But at the same time, gas E & Ps will continue to struggle with price-related revisions."

As a result of new SEC reserve-reporting rules, calculations of reserves reflect 12-month average prices, not year-end prices, meaning oil-weighted producers’ reserves will be based on a price 39% higher than a year earlier, report Dell and Noam Lockshin, associate analyst.

But falling gas prices result in an average 2009 price of $3.94 per million Btu, 30% lower than the 2008 year-end price. This could result in consecutive annual write-downs for gas-weighted producers such as Petrohawk Energy Corp., Newfield Exploration Co., Ultra Petroleum Corp., Chesapeake Energy Corp. and Southwestern Energy Co.

As for F & D costs, Dell expects lower averages because proven undeveloped reserves (PUDs) can be booked under the new rules, "but when we look at PDP F & D it will be apparent that costs are still high for some.

"While revisions will likely be severe for some companies, the more serious reserve-rule changes will relate to the definition of proved reserves. As we have argued before, the changes to reserve rules will be confusing for investors and as a result they will need to concentrate on proved developed producing reserves (PDPs) rather than total reserves, for the purposes of calculating F & D.

"Looking at the past three years of data, we find that only five of the 16 E & Ps we cover had PDP F & D that was lower than total organic F & D––meaning that they added proportionally more PDP reserves than PUD reserves," Dell adds.

"With this in mind, it should be possible to interpret the year-end reserve numbers using PDP F & D. In particular, for those companies that increased PUDs as a percentage of total reserves, the overall F & D numbers will be largely meaningless and investors will have to focus on PDP F & D. For companies whose ratio of PDP to total reserves doesn’t change, then the change in overall F & D will be more relevant," Dell reports.

Dell and Lockshin forecast that the five companies with the lowest PDP F & D for 2009 will be Southwestern, Ultra, Cenovus Energy Inc., Chesapeake and EOG Resources Inc. They believe that Anadarko’s F & D may also be very competitive due to its drilling results in Ghana, although very little of that will be considered PDP reserves.

Interestingly, Dell and Lockshin point out that the new rules mean F & D costs and recycle ratios will diminish significantly. Specifically, the level of PUD bookings across the peer group could vary widely, raising a sticky question: Are all proved reserves created equal?

Investors should also examine the results of smaller E & P companies. "Given how fragmented the E & P industry is, smaller players actually produce more gas in total than the large-cap E & Ps, and often their cost structures are materially different from those of the larger E & Ps."