H.J. Huneycutt

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

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!

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

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?

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

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.

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

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.

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

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.

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

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.

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

It appears that both CHK and HK use full cost accounting, as well. APC changed accounting methods in 2007 to "successful efforts" so the write-downs will probably affect all the producers other than APC.

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

Mmarrkk, I haven't necessarily recommended an investment in natural gas. In fact, the only thing I did was provide links to those who have, but they were not put into the article by the editors strangely enough. Nor have I claimed to have any great knowledge concerning CHK as I've only read DVN and HK's financials. My only point was that the other natural gas producers were likely to absord write-downs, as well, but apparently they aren't using the same method of accounting.

I don't agree that this does not affect investor perception. Price-to-book and other related valuation figures use these numbers all the time, so a write-down does affect the stock price on some level, even if it has no affect on the operations of the company.

As far as the hedges go, they aren't exactly the most important factor if you're a long-term investor. Nor was the article about hedging. Gas prices are going to stay suppressed for awhile due to supply, so if you really want to make a decent return on these stocks, the trick is to buy low and wait for the next spike in prices, which will probably be several years down the road.

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

Jim,

How does the "success based cost accounting" differ precisely? I know the full cost accounting is based on the "ceiling test." What differs in the other method?

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

Ah, good explanation. Of course, their earnings included the charge-off for the write-down, correct?

Actually, it does appear that APC did book an impairment charge, but it was rather small in comparison.


On Feb 05 08:45 AM Jim/ Longterminvestor wrote:

> I writedown for DVN was triggered by two things: price of NG at 12/31/08
> and full cost accounting. APC does not use full cost accounting,
> thus they are under different accounting rules. APC has already announced
> 2008 earnings that there was not a writedown. FYI SEC changed the
> accounting rules that the writedown in 2009 would be based on the
> average yearly price of NG , but the single day ending price on 12/31st.
> This rule change kicks in for 2009. If this change was made for 2008,
> DVN would not have any writedown. The market reacted to DVN's miss
> of earnings versus the analyst estimate. It had little to do with
> the writedown. Jim

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

Prairiedog,

I see that as highly unlikely. With the sharp drop in prices, they are simply not competitive. I have LNG on my death-watch list.


Jim/Longterminvestor,

Good catch. I scanned for their results yesterday and must have overlooked them. It appears they got a positive headline about profitability tripling but it's deceiving because the increase was totally based on the sale of an oil field in Brazil and non-cash hedging gains.

It appears they had no major write-downs despite dramatically reduced profitability potential. I'm not sure if that's because of their derivative hedges or not. If so, then HK might be spared, too - but both should theoretically get hit eventually.

Admittedly, I'm unsure if CHK uses hedges.