What Devon's Huge Write-Down Means for Natural Gas

For investors thinking about buying into natural gas company stocks right now, you might want to hold off for a few weeks until earnings season is over and done with. Devon Energy (DVN), an oil and natural gas producer, released 4th Quarter earnings on Wednesday morning and took a massive $7.1 Billion write-down in their oil and natural gas properties. To put this in perspective, it drops their book value from $57 range all the way down to the $38.50 range. The market strangely appears to have been caught off-guard by this development as Devon’s stock price has fallen about 5% since the release.

With the exception of Devon, most of the other natural gas producer stocks were up for the day. Yet, it stands to reason that if Devon took such a huge write-down, the other oil and natural gas companies will be required to absorb them as well. This would seem to be all but a certainty given the precipitous drop in gas prices over the past few months. Keep a close eye on Chesapeake (CHK), Petrohawk (HK), and Anadarko (APC) over the next few weeks to see how large the impact will be for those producers.

Long-term, there are lots of reasons to be bullish on natural gas stocks, but it appears that these stocks have gotten ahead of themselves a bit for the moment. Many believe that the Obama Administration will be good for natural gas, which has sparked a new round of bullishness. However, any hypothetical impact of the Obama Administration when it comes to natural gas prices has been exaggerated by the market. Petrohawk is up over 25% in just a few weeks’ time. That is partially explained by their recent press release regarding reserve levels, but it also seems to be a part of this mini-natural gas bull we have experienced over the past few weeks.

If you want to buy into natural gas producers right now, my advice is to watch out for falling asset prices over the next few weeks. If prices fall this month, as I expect they will, I will probably jump in on HK, CHK, or DVN. If you are already long on these stocks, they are still good long-term investments and I see no reason to panic. These write-downs are paper charges and do not affect the cash flows for any of the companies. Just be prepared for some short-term ugliness as the market seems to suddenly realize that natural gas asset prices have fallen.

It has been noted that Anadarko (APC) uses "successful efforts" accounting as opposed to full-cost accounting. The former method is more conservative and hence, APC was not required to absorb significant impairment charges for their 4th Quarter results.

Disclosures: Author has no current position on any natural gas companies, but may choose to go long on HK, DVN, or CHK within the next month.

Comments

[Augustus:]

Tme market in Europe will take all of the LNG capacity. They have a general shortage and are supplied by the fairly high cost Ruskies.

Feb 05 11:51 AM

[ripskii:]

I noticed that a newly constructed north American LNG terminal recently diverted a major portion of their long term contracted LNG delivery to foreign destinations because they could sell it there for higher prices. Higher world prices will attract supply to those locations where lower cost local supply does not exist. The recent disruption in gas supply to Europe from Russia suggests they might consider diversifying their supplies via LNG to other sources.

Feb 05 12:05 PM

[H.J. Huneycutt:]

Jim,

It's true that these write-downs are all non-cash, but given that the financial statements are the best picture one has of a company's assets, they are quite significant to stock price and valuation. I have a degree in accounting (albeit I have less than one year experience, work more in financial analysis, and do not have my CPA yet) and I did not realize that APC was using a different accounting method than the others. Most investors probably don't know this, either.

Think of all the valuation metrics that use balance sheet accounts: Price-to-Book, Discounted Cash Flows, ROA, etc. The write-downs are pretty significant if you ask me because suddenly, DVN goes from have a P/B ratio of 1.0 to having one of 1.5. Suddenly, it looks a lot less attractive to investors. If I'm not missing anything, it appears that CHK and HK both use the more aggressive full cost accounting method, too.

I'm thankful you pointed this out one way or another. Every time I look at oil & gas producers (or any other similiar type commodity stock), I'm going to check to see which accounting method they are using to value their resource properties.

Feb 05 12:17 PM

[Jim/ Longte...:]

H.J. This is exactually what I am suggesting that you do not do. Make comparison based on price to book ratio amoung oil and gas explorers because the booked value changes based on their accounting method. Also as long as companies pass the ceiling test, they can carry the value of their reserves anywhere below that ceiling that they want for full cost accounting. For successful efforts accounting companies, they can set the ceiling anywhere they want basis on their projections where NG or Oil prices are heading. Price to Book is not a meaningful measurement for E&P companies in my opinion. i think that you would be better to write about free cash flow versus market value for the short term and reserves and reserve growth versus today's production..i.e. are they adding more reserves than they are producing in years and by how much. Jim


On Feb 05 11:42 AM H.J. Huneycutt wrote:

> Hmmm ... so looking at this again, if APC is valued using "successful
> efforts" accounting and the other natty gas players (HK, CHK, DVN)
> are valued using full cost accounting, it would appear that APC is
> the most undervalued of the bunch.
>
> Price-to-book for APC is around 1.
>
> For DVN, it is still around 1.5
>
> HK is difficult because their new reserves and they haven't reported
> yet, but according to their most recent 10-Q, P/B is 1.36 and that
> doesn't include a potential write-down, which could easily make it
> jump over 1.6
>
> CHK is closer to 0.6-0.7, but they have heavy leverage so a drop
> in their asset values will have a more profound impact on their equity.
> I'd have to look at their financials closer to make any estimation
> on how large a potential write-down could be.

Feb 05 12:26 PM

[H.J. Huneycutt:]

Jim, I don't actually disagree with you. I value natural gas stocks based primarily on proven reserves. I look at other measures, too, but I consider that the most reliable and consistent method. However, just because I value the stocks using that method doesn't mean that everyone does. Hence, why I'm not so quick to dismiss the write-downs as having no affect on the stock prices. And regardless, on some level, asset accounts are important to look at; even if there is fuzzy accounting.

I'd argue that free cash flow (while ignoring assets) is actually more meaningless than price-to-book for gas producers. The problem is --- how do you realistically determine future FCFs given how erratic they tend to be? Moreover, many of the natural gas producers have been making Capital Expenditures like there is no tomorrow, which further distorts past FCFs.

To me, using proven reserves is the best method of valuation, but taking BV and trying to ascertain a realistic discount or premium on it is the next best method of valuation. Going solely by P/B makes no sense if you know the assets will be written-down; I've been expecting as much for months in both the oil & gas industries and in some other industries (e.g. drybulk shipping).

I'm not so sure that I agree with you that the market dismissed the write-down on DVN. From my perspective, the earnings were better than I expected and I saw any profit as a good profit. Of course, I also see the fact that the gas companies are still profitable as potentially a mildly bearish sign.

Feb 05 12:45 PM

[H.J. Huneycutt:]

To further this line of thought, it's all about availability of information. It would be absolutely spectacular to always be able to value by proven reserves, but for a company like Petrohawk that has been aggressively increasing reserves, how do you do that 11 months after their last 10-K?

They just released proven reserve figures the other day (and I haven't had a chance to analyze them yet), but before that, if you lack the information and you know that FCFs are highly distorted based on the current market environment and other factors (aggressive CapEx, inconsistency), then how do you value the stocks?

For almost every company I look at, I use multiple valuation metrics and gas companies are no exception. In my head, I have ideal valuation metrics and less ideal ones. Having valuation metrics that are not perfect is not necessarily a killer, so long as you know the weaknesses in that method. Hence, why I don't think using P/B is that bad if you take into account likely asset price drops. It's never perfect, but no valuation metric taken by itself is.

Feb 05 12:52 PM

[searcher:]

These mark to market balance sheet protocols are important in so far as they may breach debt covenants and impare access to new or refunded capital.

Feb 05 01:51 PM

[Jim/ Longte...:]

Searcher, I agree that this is an important point. In DVN's case their bank credit agreements are only tied to one significant covenent, maximum debt to cap ratio of less than 65%. Since non-cash charges are added back to DVN's capitalization, this reflects the banks agreement that these accounting adjustments do not impact the underlying value of DVN. For the purpose of DVN's credit agreements, DVN's debt to Cap is somewhere around 20%. I think that most E&P companies would use debt to cap versus price to book ratio. However, maybe there is someone out there that has a covenent tied to price to book. If so, I am positive that they would use the less conservative successful efforts accounting. IMO. Jim


On Feb 05 01:51 PM searcher wrote:

> These mark to market balance sheet protocols are important in so
> far as they may breach debt covenants and impare access to new or
> refunded capital.

Feb 05 03:35 PM

[Jim/ Longte...:]

OK HJ, do what you think is best on book value. I do agree 100% proven reserves are extremely important. It is the volume and growth of these reserves, not the book value for accounting purposes. Proven reserves are established and audited by outside experts. These experts establish the volume of these reserves in BCF's or Barrels. They do not know or care how much value in $ per BCF or barrel that DVN is carrying these reserves on their books. Good Luck. Jim


On Feb 05 12:45 PM H.J. Huneycutt wrote:

> Jim, I don't actually disagree with you. I value natural gas stocks
> based primarily on proven reserves. I look at other measures, too,
> but I consider that the most reliable and consistent method. However,
> just because I value the stocks using that method doesn't mean that
> everyone does. Hence, why I'm not so quick to dismiss the write-downs
> as having no affect on the stock prices. And regardless, on some
> level, asset accounts are important to look at; even if there is
> fuzzy accounting.
>
> I'd argue that free cash flow (while ignoring assets) is actually
> more meaningless than price-to-book for gas producers. The problem
> is --- how do you realistically determine future FCFs given how erratic
> they tend to be? Moreover, many of the natural gas producers have
> been making Capital Expenditures like there is no tomorrow, which
> further distorts past FCFs.
>
> To me, using proven reserves is the best method of valuation, but
> taking BV and trying to ascertain a realistic discount or premium
> on it is the next best method of valuation. Going solely by P/B makes
> no sense if you know the assets will be written-down; I've been expecting
> as much for months in both the oil & gas industries and in some
> other industries (e.g. drybulk shipping).
>
> I'm not so sure that I agree with you that the market dismissed the
> write-down on DVN. From my perspective, the earnings were better
> than I expected and I saw any profit as a good profit. Of course,
> I also see the fact that the gas companies are still profitable as
> potentially a mildly bearish sign.

Feb 05 03:44 PM

[Mmarrkk:]

Times are changing on LNG and the supply of LNG out on the open seas is getting r4eady to ratchet up. This LNG will find its way into the US market, mark my words. This will impact pricing in US. Expect LNG imports to top 3 BCF/day in late 2009/early 2010 vs 1.5 right now. Over supply and demand cratering in the Far East and Europe. If the Ruskies don't go all Rambo on EU markets. Plus all of the new plants coming on line in Australia will push Qatar gas out of the Far East and that gas has to go somewhere and the US is the place as it helps support their crude price linkages.

Feb 05 04:00 PM

[uptick_rule...:]

CHK and HK, among others, have already announced tentative write downs. I guess the surprise for DVN holders was the fact it did not preannounce the likelihood of the adjustments.

Feb 05 09:27 PM

[Heaven, Hel...:]

@ Jim/Longterminvestor

Excellant point on the differences between full cost and successful efforts accounting, especially the pricing assumptions. In addition to what you have already mentioned, the successful efforts method allows for inclusion of probable and possible reserves, while the full cost calculation is limited to only proved reserves. Also, there is some flexibility as to the timing of successful efforts impairment tests whereas full cost accounting mandates that the ceiling test be applied at quarter end and year-end.

Feb 06 09:17 AM

[levin70:]

It has been noted that Anadarko (APC) uses "successful efforts" accounting as opposed to full-cost accounting. The former method is more conservative and hence, APC was not required to absorb significant impairment charges for their 4th Quarter results.

I just want to respond to this comment. For full disclosure I am a partner at a CPA firm and I have a number of O&G Clients.

One method is not "more conservative than another".

Under successful efforts accounting, the unit of measure is generally at the field level. Thus costs to explore and develop a field are accumulated and tested for impairment as one unit. If a field is a failure, its costs are impaired. This generally leads to more numerous, but smaller impairments when prices decline, as fields with more expensive costs impair first, while older fields that were less costsly are not impaired, except in the case of the very big majors where their largest fields are of course massive.

Under full cost accounting, the unit of measure is an entire country. Thus, as long as you have existing production in that country, a field failure just goes into the pool and isn't impaired. The entire coutnry is tested for impairment. This leads to a buildup of non performing costs that are not impaired during the good times (existing fields cover the newer field failures). Thus, instead of smaller more numerous write downs during periods of falling prices, older fields with lower production costs offset both dead fields and newer fields that are more costly, thus full cost generally results in large writedowns later in the cycle at tipping points where the lower cost older fields no longer can support the higher cost newer fields and dead fields.

At the end of the day, over the entire economic lifespan, you get to the same place, it just takes different routes.

Hope this helps

Kind Regards

Feb 06 11:42 AM

[H.J. Huneycutt:]

Levin70,

Great explanation!

But here's my question: why do you believe the latter (full cost) is not more aggressive? Even from your explanation, it sounds to me as if the full-cost method creates greater volatility in asset values. Hence, I would still consider it the more aggressive accounting route (if I'm interpreting correctly) since it create larger swings in the stock prices (and I whole-heartedly disagree with everyone saying that it doesn't matter since it doesn't affect cash flows).

I guess it doesn't make a lot of sense to me why two different methods are allowed here. Obviously, even if they theoretically 'get you to the same place', there will be differences and the companies will often select a method based on which one they perceive to be more advantageous to them, rather than based on which might be better from an academic accounting perspective.

Why might APC have switched methods in 2007? And what might be an advantage to each system?

Feb 06 11:59 AM

[MattGigEm:]

Paultaut,

" If any kind of LNG transportation occurs, it will be from the US not to the US."

I could be wrong but I don't think the US has any LNG liquifaction terminals for export. Theoritically they could export the current inventory at import terminals but I don't think this has ever been done. Unless an export terminal gets built in Alaska I don't think we will see LNG export from the US for a long time if ever.

Feb 06 01:01 PM

[drone:]

I'm bullish on the technology for capturing natural gas, not the gas itself. There is a lot of it released into the atmosphere by living things as a result of the digestive process. Who needs expensive shale plays and horizontal drilling? Just stick a hose up a cow's ass and you have all the gas you need.

Feb 06 01:16 PM

[levin70:]

H.J.

I can understand why you might think from one perspective that successful efforts is more conservative in that it forces you to take writedowns up front. But that isn't necessarily "conservative". I guess its how you look at it.

The full cost method is actually only allowed for US Public Companies, as the method was developed by the SEC in the 70's in response to criticisms of successful effort. Only SEC Registrants may use it. Private companies must use successful efforts.

Full cost method is the "easy button" of methods. One cost pool you re-measure for impairment on a quarterly basis. Once costs go into the full cost pool, you don't need to distinguish costs for wells/fields from each other. A lot less manpower/horsepower is needed on the accounting side for the full cost method. There are also major differences before you get to the point of drilling that differentiate the two methods. Pre-drill costs like seismic and other mapping costs are expensed immediately under successful efforts, while they are capitalized under full cost (one of the major gripes that led to full cost method)

Btw - no full cost method under IFRS, just a modified version of the successful efforts method.

Hope this helps

Kind Regards

Feb 06 02:57 PM

[H.J. Huneycutt:]

Levin,

That makes sense. So the companies using full-cost are using it because it (a) cuts costs in that they need less personnel to track it and (b) pre-drill costs are capitalized.

Admittedly, I am a fan of accounting forcing companies to expense immediately things like pre-drill costs. I consider it a "non-real asset" in that it doesn't exist any more (I don't like "Goodwill" either for that matter). If the costs were beneficial to the company, I think it makes more sense for the rewards to be reaped later on for earnings purposes. But I can see good argument for going the opposite direction, too.

That's interesting that IFRS would eliminate the full cost method. So I guess it's completely possible they'll all be using successful efforts soon. Maybe that was part of the reason APC switched.

Thanks once again for all the useful info!

Feb 06 03:34 PM

[Conan the B...:]

Matgigem: Cheniere Energy, (Symbol is LNG) has asked the FERC for permission to re-ship Liq. NG out of the US. To send back to sender. But it could also be applied to excess NG. Apparently there are rules against this.

The stock has started to move up in anticipation of a favorable ruling.

My opinion.

Feb 07 01:19 AM

[Mmarrkk:]

Paul: Cheniere's application is what Matgigem referred to...re-export of cargoes that were being stored in Cheniere's tanks. Basically the LNG is never "re-gassed"; it stays in its liquid state in a storage tank until it is exported back out. To truly get into the export business, one would need to build a multi-billion dollar liquification plant and there are already too many of those around.

BTW, there is a small scale liquification/export plant already built up in Kenai Alaska. Phillips, now COP, built it 20 years ago and its still working. But very small scale.

Getting export permits from the US will be very very difficult as most Northeast Congressmen do not want NG leaving the US; they want an oversupplied market to drive prices down for their constituents. Eventually that little game drives to gluts then shortages then gluts then shortages.

Feb 09 09:42 AM