GAAP Energy Earnings Are Worthless

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 (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.

Comments

[Richard Wen...:]

You are 100% right in how the media exploits stocks like CHK. They manipulate the news in order to help the specialist system and the New York Stock Exchange media spin machine manipulate stock prices. For more information on how this is done click on my site and read about how both the media and specialists manipulate prices of stocks for their benefit at the cost of investors.

Investors could care less if the reserve price fell 6 billion or rose 6 billion. They are only interested in the actual numbers that the company posts for profits or loss. Not fictitious numbers.

Richard

May 10 09:35 AM

[erniem:]

Unfortunately CHK is a stock that is mired in debt and depends on future earnings heavily to get out of that debt. McClendon bought, bought, bought, bought and bought, and now "owns" some of the most highly leveraged NG in the US. It's hard to get around that.

May 10 11:27 AM

[uptick_rule...:]

I would like to verify if future NG price increases will allow CHK to return some of those losses to their books as profits (reducing the impairments). I see it referenced in the article above. I was told last week by soneome from a publicly traded firm (another oil and gas firm) that current impairments are not added back to "earnings" when NG prices rise. I was told that the only benefit to the firm in the future is reduced DD&A from having had lower reserve "full costs" on its books. However, now that they take the impairments, the net worth of the firm (on their books) is so low after impairments that they will not have future growth for many years to offset these huge reductions from current curtailments. Any thoughts you experts have on the subject. Whic is right. I was hoping the energy firms could reverse the impairments over time as NG prices rise.

May 10 06:56 PM

[bfras921:]

>. The most important point is that these losses are non-cash losses

You are wrong, its non cash for this qtr because they spent the cash in a previous qtr.

Thats like telling your wife you didnt lose money when you wrote down your investment in chk from 70 ( your purchase price) say 1000 shares cost 70,000 to 20,000 and you say honey dont worry the 50 k was a non cash lost!

They bought assets at the peak and when oil and ng prices fall they have to write them down to todays price

You argument might hold water if you challenge how its calculate which is a point in time price

That will change with new rules and then one can use the one year strip

But my dear friend, they didnt get the assets for free. They paid cold hard cash, and when those assets are written down, the cash flew out the door

May 11 01:14 AM

[bfras921:]

uptick rule...

what happens is when you write down the assets, the dda rate is lowered.

Sorry, you dont get to write the assets back up but your pl will look better as the dda rate is lowered.

Lets say they write off all assets to 0. then they have no dda expense and its pure profit

May 11 01:16 AM

[searcher:]

If you have an interest in this sector then the 'conspiracy' of the headline writers and 'Specialists' is irrelevant to your consideration. Much ado about nothing. Really have a problem with ascribing much, if any, market action to these 'abuses'. Anyone who has the slightest interest in the sector and doesn't look at the source of the numbers needs to be spending their time playing Gin or on E-bay.

May 11 01:48 PM

[Bullish Ban...:]

Thanks a lot for the comments guys.

The point of the article was really to shed light for investors that don't have a huge background in energy investing. Bfras921's argument that some of these assets were bought at much higher prices is true, but there were also a great number of assets that were bought at prices well below even these current levels. The question still remains, why would you want to price commodities that aren't being sold in the front month at front month prices?

May 25 07:09 PM