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One of my biggest pet peeves every time energy earnings come around is how addicted the media is to the shock value that is associated with GAAP accounting standards in relation to the earnings release. I understand that the media has to make headlines that make your eyes jump out of your head in order to stay in business, but I find this type of reporting to only use select facts to make the case of the author.

Obviously this is very prevalent in the financial journalism industry and I myself am sure that I have done this on a multitude of occasions but I’d like to think that I rarely try to use these facts to make a situation seem more dire than it is in actuality. A great example of this is what happened to Chesapeake Energy (NYSE:CHK) last week after their earnings release after hours on Monday, May 4th.

Taking a look at Chesapeake’s earnings, you can see exactly how the situation could be easily manipulated. Chesapeake’s “earnings” came in at a loss of $5.75B dollars, or a loss of $9.63 per share if you use GAAP accounting metrics. These GAAP accounting metrics were used to add roughly $6B dollars in losses to Chesapeake’s quarter directly from the value of their unproduced reserves dropping due to the front month spot price of natural gas falling over the course of the quarter.

This makes absolutely no sense in my mind, and it seems that the market is catching on that these funny accounting metrics don’t work for energy companies (as well as a number of other sectors but that is a completely different story for another day). By the current GAAP accounting rules, exploration and production companies are taking writedowns for reserves that may or may not be produced for another 10 years or longer, marking these reserves to the current spot market prices for commodities. The most important point is that these losses are non-cash losses and do not have an effect on the continuing operations of these exploration and production companies. Chesapeake’s “real” operating results came in at $0.46 per diluted share when analysts were looking for $0.49 per diluted share, still a $0.03 miss but not a fictitious $10.12 miss from analyst estimates.

Chesapeake has and will remain a very volatile stock, but taking a look at what happened over the course of this week is laughable. Chesapeake closed last week at $20.89. Monday it shot up 9.24% to $22.82 in anticipation of the companies earnings release after the bell that day. After the “$10.12 miss” Chesapeake plummeted 10.60% on Tuesday all the way down to $20.40. From Tuesday’s close to the close on Friday Chesapeake moved all the way back to $23.84 for a gain of 16.86% from the bottom of the week on Tuesday and a gain of 14.12% overall on the week. This doesn’t sound like the normal pattern for a company who just “lost $6B” for the first quarter. Seems to me as if the market was fooled for one day, but quickly realized that the press got the tone of the earnings release entirely wrong.

I have two main ideas for how the market can deal with this problem. Firstly, they can considering not using GAAP accounting standards when it comes to the reserves of these exploration and production companies to avoid this huge misconception. This will be something to keep an eye on when energy prices do rise again and these exploration and production companies are reporting “gains” on their reserve values inflating their real earnings numbers. The other solution would be to make the GAAP accounting reserves pro-rated at the current spot market curve for the commodity. For example, instead of listing all of the natural gas reserves at $4.00 per Mcfe (thousand cubic feet equivalent), why not list this month's production at that spot price and the following month's production at the respective spot rates going into the future, which will generally be higher than the current front month contract. This method would be a much more accurate reflection of the reserves real value, but I still believe even this would be subpar because commodity spot prices are too volatile to use when valuing reserves. The key is to not believe everything you read and to make sure you are getting the real numbers when gathering your financial news.

- Charles W. Petredis

Disclosure: The fund the author manages, the author, and the author’s family are all long CHK.

Source: GAAP Energy Earnings Are Worthless