Several recent media reports have highlighted upcoming impairments to be taken by E&P companies as they report their 2019 results.
Many of those articles incorrectly categorize what an impairment is and is not, with implications that impairments will be widespread and severe.
Those media reports largely ignore the fact that different impairment standards for Full Cost and Successful Efforts accounting exist, with vastly different results.
Annual and cumulative impairments for the period from 2009-18 are summarized and the results discussed.
Identification and explanations surrounding certain myths about impairments are provided.
Welcome, ladies and gents! When I struggle to come up with titles for my articles, I know there is nothing that will attract readers like …. accounting!? Some of you may have decided to read this, not knowing that it would be about boring stuff like balance sheets and fruit bowls, while others of you may be simply looking for adventure.
You've come to the right place for adventure, that is for sure! We are all fortunate that "Doctor Who" has recently returned, and because the Doc and I are such good friends (we go WABAC, for older investors that prefer that reference from their days sitting in front of the TV watching cartoons as a child), she has offered me the use of her TARDIS to help explain the (brief, I promise!) history of three (three!) different, primary methods for accounting for impairments in the E&P industry.
On our journey through time, we will also extract and discuss some very interesting recent data, and discuss how usage of a great many valuation metrics by investors are actually comparing apples to oranges to pears, similar to picking out random pieces of fruit from a fruit bowl mixture. So, just as the TARDIS looks small on the outside but is "bigger on the inside," inside this article that looks to be about accounting is actually something that is a much bigger subject … valuation!
OK, enough with the mixed metaphors. What follows reflects my own opinions and experiences only. It is intended primarily for educational purposes, but do not mistake my attempts at levity for indifference; this is a very serious subject to those of us who are interested in company fundamentals. The data contained herein has been taken directly from company financial statements, but I care less about the actual numbers than what the numbers themselves reveal; there may be errors and omissions in my data, since over 70 companies are involved. No investment recommendations are made by me herein, and investors are advised to do their own research and analysis before investing in any company, based on their own philosophy or style, with appropriate sizing, risk tolerance, time horizon, etc.
Before launching into the discussion, many of you may be asking, "Why even write this article in the first place?" The answer to that one is pretty simple. Like my most recent articles ("U.S. E&P Debt 2020: Borrowing Base Reviews, Debt Maturities and the Search for Holes in the Wall" and "U.S. E&P Debt 2020, Part 2: The Debt Playbook and 2019 Company Actions"), the genesis for this article is the recent appearance of headlines like these (registration and/or subscription may be required):
- "BP faces up to $3bn impairment charge after sale of US assets"
- "Shell Writes Down Up to $2.3 Billion on Weaker Economic Outlook"
- "Spanish Energy Giant Repsol Writes Down Oil, Gas Assets
- "Equinor's US shale writedowns hit $9.2bn"
- "Chevron to take $10B write-down on US shale-related assets, mulls divestitures"
- "Chevron's charge points to billions more in U.S. gas writedowns; analysts"
- "Range Resources expects to book asset impairment charge in fourth quarter"
As it turns out, there is one thing in common between all of the companies mentioned above, as will be discussed below. It is not simply big dollar amounts, and it is not shale as an extraction method.
Be advised that the background discussion and any opinions expressed herein are my own, and the data in the charts and the text have also been compiled by me, from public sources such as company press releases, financial reports, etc. No specific investment recommendations are made in this article, and readers should perform their own research and due diligence before making an investment decision based on their individual style and strategy, with appropriate sizing, percentage ownership, loss tolerances, etc.
As we enter the TARDIS, please put on the green eyeshades that have been given to you. Our first stop is the early 1960s, not quite the time of the dinosaurs but close enough for these purposes. No-Doze will also be supplied, but I promise to keep this as short as possible, despite the complexity of the subject matter; I am not an accountant, so I will try to explain as much as possible in layman's terms.
Successful Efforts (SE) accounting was the only method in use in the 1960s, but another method, Full Cost (FC) came into wider use during the 1970s. During that time period, most companies grew their reserves through exploration; SE companies expensed their exploratory costs that did not result in successful additions of proved reserves, while FC companies added all costs, even those resulting from unsuccessful exploration (i.e., dry holes), into their property, or full cost, pool. SE practices were deemed more conservative because of their impact on the income statement.
Still, usage of FC accounting increased in the 1970s, primarily because it allowed firms to attract capital they might not otherwise have been able to attract if their net income from quarter-to-quarter showed extreme volatility, based on the results of a small number of exploratory failures, even if overall results were successful. "Purists" insisted that the smoothing effect of FC income statement practices went against proper accounting theory.
During the 1970s, two other major events occurred as well. First, the Federal Standards Accounting Board (FASB) was established to, well, set standards for accounting firms. They conducted surveys and studies that came to the conclusion that the SE method should be the appropriate method used in the E&P sector. Of course, most of the major firms and significant clients used the SE method.
As these studies were being conducted, the Arab Oil Embargo drove oil prices skyward, and much antagonism towards oil companies and skepticism regarding their reporting practices developed, culminating in a law signed into effect in 1975 by President Ford that required the SEC to either prescribe rules or be assured that effective rules were in place regarding reporting of oil company results. Of course, SE firms wanted to retain their accounting method, in no large part to deflect criticism about their profitability (since deducting their exploration expenses reduced net income).
The SEC issued rules in late 1977 requiring companies to use SE, but after intense political pressure over the next year, then relented to allow both FC and SE accounting methods to be used. At the same time, it required FC companies to perform what is now commonly referred to as a "ceiling test," comparing the present value of future net cash flows from proved reserves, discounted at 10%, to their net book value, and to deduct any shortfall in reserve valuation as an expense.
SE firms, though, had no such requirement, only a footnote disclosure if a shortfall existed between the undiscounted net cash flows were less than their net book value. In the meantime, usage of FC and SE became split roughly 50/50 in terms of the number of firms using each, but with SE firms representing more like 90% of production.
... never in the history of accounting has the choice of an accounting method attracted so much attention as the controversy over full versus successful efforts costing. (Ijiri, 1979)
In the mid-1980s, many firms elected to switch their accounting method from FC to SE. The reason? The crash in oil prices was projected to result in significant FC ceiling test impairments, as well as possible bank loan covenant violations, for FC firms. I remember sitting in meetings at the time with our independent Big 8 accounting firm, wherein they stated they were advising all of their E&P clients to switch from FC to SE if they expected an impairment, since SE had no impairment requirement, only a footnote disclosure. Unfortunately, I did not keep a record of the names of companies who switched; we did not.
Fast forward a bit more, and after much discussion and debate, in 1995 SE companies were first required to include an impairment in their actual financial statements if the undiscounted net cash flows from are less than net book value. Unlike the FC test, SE companies determine impairment on an asset group basis (as opposed to a single book value cost center), using not only proved reserves but risk-adjusted probable and possible reserves as well. Pricing assumptions need to be "reasonable" but need not conform to the constant price FC impairment test. Finally, after assessing that an impairment might be necessary, SE companies can determine the fair market value of the assets and reduce net book value to that FMV, if less than the current net book value. I occasionally refer to the SE method as a "kitchen sink" approach to avoiding impairment, due to the amount of management discretion involved in the valuation.
It used to be that, in determining prices for oil and gas, only the prices on Dec. 31 were considered. This raised considerable objections from companies who believed that the singular price might be very temporary, and result in an impairment that would not have been necessary, had any other method been used.
As a result, in 2009, the SEC adopted a rule that now requires firms to use the prices on the first day of each month, for the trailing 12-month period, in the determination. Reference prices are published, with each company required to confirm the differentials for quality, transportation charges, etc. back to each well. In addition, a rule that limits inclusion of PUD reserves to those the company reasonably plans to drill within 5 years was added.
Like in the 1980s, I did not keep a list of companies who converted from FC to successful efforts in the 1980s, when oil prices again crashed, not once but twice. Even with the internet, I have been unable to locate such a list; I only know that the migration continued and that my company was one of those that finally did switch.
A unique aspect of the 2000s has been the development of the shale plays, which have largely changed most company strategies (at least for US companies) away from true exploration. This means fewer exploration expenses for both FC and SE companies, whether reported in the income statement (for SE) or as capitalized costs (for FC). Assuming that is true, that leaves impairment testing as the primary difference between the two methods, at least in my opinion, and especially where valuation is concerned. More later …
Unlike for prior periods, for the 2000s I do have several examples of companies that switched from FC to SE, including:
- Anadarko Petroleum (2007)
- Apache Corp. (2016)
- Devon Energy (2017)
- Sanchez Energy (2018)
- Chesapeake Energy (2019)
- Grizzly Energy (2019)
I have linked the names of the companies above to their conversion presentations or discussions for those readers who wish to view concrete examples of how the differences between FC and SE accounting impacted their financials. My particular favorite is APA, which added almost $15 billion to its properties' net book value due to the elimination of former impairments; their net addition to shareholders' equity was $5 billion once all of the differences were tallied. Same company, same assets, a difference of $15 billion in property value and $5 billion in shareholders' equity simply by changing its accounting method.
By comparison to APA, DVN looks like a piker company, with only $3.6 billion in additional property net book value and a $1.6 billion writeup to shareholders' equity in their conversion. CHK added a meaningful, to them, $1.55 billion to shareholders' equity after reversing proved property impairments of $11 billion, offset by increased exploration expenses (largely impairments of undeveloped acreage) of $12 billion.
You will notice in the chart below that 13 public companies in it use FC accounting today, vs. 36 who now use SE (73%). I excluded companies that have recently been merged or will be merging with others (CRZO, JAG, SRCI) and companies that have already been through bankruptcy.
Fresh Start Accounting
My reason for excluding companies that have already gone through bankruptcy is that there are special rules for such companies, in terms of valuation of their assets for financial purposes. Such firms usually use the enterprise and/or equity valuation numbers that their bankruptcy financial advisors come up with to create a new financial picture for the company after bankruptcy.
The impact of this is equivalent to an impairment that is not based on either FC or SE accounting methods. The restatement may actually come up with property values that are less than either method would have provided, so in my mind it is less important which method such companies take up upon exit. Over time that may not be true, but for purposes of defining them here as SE or FC, it makes much less difference than it does for companies who have not been through bankruptcy.
At the beginning of this article, I stated that there were 3 primary accounting methods. The 2 US GAAP methods were discussed above; the 3rd method is called the International Financial Reporting Standards (IFRS) method. You will note in the chart that the European companies use those standards, as do Canadian companies.
The purpose of this article is not to get into further discussion of IFRS, other than to note that it compares most closely to SE. The impairment test is only a one-step calculation, rather than SE's two-parter, but unlike SE (and FC), IFRS companies have the ability to reverse impairments made in one year in subsequent years, making it more like a "mark-to-market" approach.
Although they have not provided details for their upcoming impairments, the major companies listed above may not be impairing specifically because their calculations of value would require them if they were to retain the properties, but may rather be writedowns on properties they plan to sell. If IFRS companies become aware of a likely impairment (i.e., because sales proceeds are expected to be less than the net book value of the properties to be sold), they must book the impairment first. Readers may see companies in the US do the same.
All of the foreign companies listed earlier invested in US shale plays in their infancy; CVX buying Atlas Energy for $4.3 billion, Shell buying East Resources for $4.7 billion, and Equinor (formerly Statoil, the Norwegian company) entering into a Marcellus JV with CHK, an EagleFord JV with Talisman (now Repsol) and buying Brigham Exploration (Bakken) for $4.4 billion. Repsol also had a $1.1 billion conventional JV with Sandridge Energy. The fact that they are only reporting impairments now should come as no surprise to those who understand how flexible (lax) the SE impairment standard is, in my opinion.
Critics will quickly point to the fact that these impairments may be largely due to participation in shale plays. I am not sure I agree with the WSJ's conclusion that more impairments are coming for other majors due to shale, which is merely an extraction method. One of the big factors in impairment is likely to be based on price deterioration, with natural gas prices of close to $10 and oil prices of up to $140 during "the shale era." Any reserve shortfalls are likely to be dwarfed by the price impact.
Then too, impairments are nothing new to E&P. In the 2000-2010 period, impairments were based primarily on natural gas price declines late in the decade, and most companies were natural gas producers, not oil producers. Companies only switched over to oil in time for the oil price crash, leading some to suggest that excess capital has been the major problem, not simply shale. Excess capital leading to excess supply leading to lower prices. Even that is not new in E&P, as ConocoPhillips' (COP) $36 billion pre-tax impairment in 2009 ($27 billion after-tax) illustrates. COP was forced to take impairments of assets and goodwill from its acquisitions of Phillips Petroleum and Burlington Resources earlier in the decade.
In hindsight, there has been a lot of inefficient capex invested in the past 10+ years in the E&P industry. My theory all along, as I have written about several times in the past, is that the true level of impairment to E&P's balance sheets, if not to their asset valuations, was partially obscured in the case of SE companies by their weak impairment standards. Actually, this was less a concern to me from an accounting standpoint than it was from a valuation standpoint (see here: "E&P Impairments 2015 and Beyond: WARNING - The Tsunami Wave Train Rolls On").
For this article, I compiled the table below from public sources like 10-Ks and 10-Qs. The term impairment is meant to include not only impairments of proved reserves and acreage, but exploration expenses (for SE companies) and goodwill. In my vernacular, goodwill is equivalent to a deferred impairment, since E&P companies rarely, if ever, have anything that could be classified as true goodwill worth paying for. Writedowns by Whiting Petroleum (1 year after their acquisition of Kodiak, Denbury's impairment of its Encore Acquisition deal, Grizzly's (Vanguard Natural's) impairment of its LR Energy and EROC acquisitions are illustrative of recent such impairments, with COP's 2009 impairment another example.
The purpose isn't simply to compile the impairments by year or cumulatively since 2010, although that is very interesting to me. It is to take the net result of those changes, as well as others, and then be able to assess companies' current net book value to their SEC numbers, to see how accounting methods for impairing excess accumulated costs compare. Although often expressed with a disclaimer to the effect that SEC prices are not intended to reflect FMV, historically the relationship has been fairly close.
This analysis is not going to render companies clearly under- or over-valued in the market. Other factors, and particularly acreage valuations, also enter into the picture and are effectively valued at their net book value in the chart; midstream values might also have low net book values compared to their FMV. However, the lifeblood of most E&P companies is their proved reserves.
In the chart above, Columns E-O contain the impairments by year as well as cumulative impairments since Dec. 31, 2009 (2019 figures will be published shortly). I am less interested in the absolute size of the impairments, which total almost $500 billion during the past decade, as I am in what % of properties were written off and what the net shareholder equity change was for the period. Obviously, readers might expect the 2014-2015 period to be the biggest in terms of impairments, and that is the case.
FC companies had major impairments in that period due to the impact of the FC ceiling test, while SE companies tended to have smaller impairments due to the facts that they were calculated on a property-by-property basis and that the impairment standard is so lax. Excluding companies like APA, CHK and DVN from the SE list, because they were FC companies at the time, would skew the numbers even further. SE "impairments" were actually due to relatively high exploration expenses as well, items that were capitalized by FC companies, subject to ceiling test standards.
Column T reflects the sum of cumulative impacts plus the net book value at YE '18, on the theory that if the impairments had not occurred the net book value would have been higher; the % therefore becomes the % of asset value written off. Using this method, a simplifying metric only, approximately 2X as much was written off by FC companies as for SE companies, on a % of asset basis (66% for FC vs. 38% for SE).
Just as telling is the fact that YE '18 SEC values were 1.6X their net book value for FC companies and 1.0X for SE companies (Column S). Since FC companies were required to calculate impairments at prices as low as $42/bbl. for oil a couple of years ago, it is not surprising that their net book value is so low. Conversely, because SE companies would only have been required to impair their net book value if their future net revenues dropped by roughly 50% (Column Q), it is not surprising that there were few SE impairments in '18. If SE companies had been required to impair assets if they fell below 1.0X their FC ceiling (Column R), several more impairments would have had to be reported.
Columns U-Z give details on shareholder capital and retained earnings for '18 and for '09, to illustrate changes in the "shale decade." Excluding companies like XOM and CVX who reduced capital via dividends and stock repurchases, something like $50 billion in new equity was contributed, and retained earnings fell substantially, in large part because impairments exceeded net income that would have been reported otherwise.
SEC prices have already been established for YE '19 reports at $55.85 for oil and $2.58 for natural gas, before quality and transportation used to calculate price differentials back to the wellheads. Compared to YE '18 prices of roughly $65 and $3.10, the "19 prices represent reductions of roughly 15%. Because of fixed LOE and other costs, that should translate into SEC valuation reductions of 20-30+%, ignoring the impact of '19 activities. With '19 data being disclosed in the coming 6 weeks, we will see how many companies need to report impairments, and how many could be predicted with the use of the above chart.
Finding the Data
The data for the above chart comes directly from each company's 10-K. For example, Oasis Petroleum's table of capitalized costs for the previous 3 years, (Note 23, p. 148) appears below, along with summaries by year:
This shows the breakdown in cost between proved and unproved properties. Its SMOG table (Note 24, p. 152) appears below, showing the past 3 years of calculations for reserve values:
Some of the Myths
Looking at the tables above, it is easy to pick out the hits that companies have taken due to impairments over the past decade. If you are asking "so what?" here are some myths you may want to consider as well:
- Impairments are non-cash. This is one of the disclosures that is an example of a disclosure that is technically correct, but highly misleading. Impairments are in fact non-cash in the period being considered, but at some point, cash was or will be expended, so an impairment reduces the potential for that cash to be recovered. In fact, if debt was used to finance a capital expenditure that is being written off, that cash will have to be expended in the future even though the asset is gone.
- Impairments are temporary. Whether an impairment is temporary depends on what assets are impaired.
- If proved reserves are impaired for price reasons, only those reserves that exist in the future may benefit from future price increases, and with shale reserves producing most of their reserves within 5 years, as a hypothetical, prolonged price downturns of at least 5 years render the reserves essentially permanently impaired;
- If properties are impaired due to reserve revisions, they are never recovered;
- Properties that are sold after they are impaired, a very typical result, likewise do not benefit from price recoveries; and
- PUD reserves that are excluded under the SEC's 5-yr. window for development may be recovered as long as the leases remain in effect, but leases that expire will not benefit.
- Impairments impact bank borrowing bases. Impairments do not impact borrowing bases. Banks use their own price decks and reserve estimates, updated every 6 months, so their borrowing bases already reflect all but any current changes, not cumulative changes, all at once, based on reductions to historical cost.
- Impairments impact a company's reserves. Just as bank borrowing bases are not impacted by cumulative impairments, a company's reserves are impacted only by changes from the most recent reports. In fact, a company's reserves may show very little change from their most recent report, yet show a large impairment since the cumulative changes had not warranted an impairment previously (i.e., reserve reports and borrowing bases effectively mark reserves to market, while accounting adjusts on a cumulative basis).
- Impairments create "artificial" value estimates. It is true that accounting estimates are not intended to reflect FMV, but they are often very close for proved reserves if impairments have been taken and prices have changed little since doing so. Of course, readers can determine their own value estimates for reserves that incorporate other metrics such as multiples of cash flow, $/BOE, acreage value, $/flowing unit, etc.; the key is not to use accounting numbers without considering how they need to be adjusted to FMV.
No metric should be used without understanding what is behind it. Readers are cautioned never to use GAAP accounting methods without knowing what accounting method is involved, and never without making adjustments to convert accounting numbers to valuation metrics. I have seen studies costing thousands of dollars that make conclusions about profitability and valuation without even mentioning that companies may be using different accounting methods, and that those methods may be skewing results.
Over the course of the next 6 weeks, we will discover whether companies will be required to take impairments that cause them to trade at stock prices comparable to today, indicating that traders have already adjusted their numbers for lower prices, or whether stocks are currently undervalued based on updated reserves. While I am not particularly optimistic that the market has fully taken value impairments into account in setting current stock prices, I will be more than happy to watch and report on companies that seem to be unduly punished by the markets … if any do exist.
In any event, even if I do discover things I should have addressed in this article and/or wish to change the outcome of any stock price move, hopefully my relationship with "The Doctor" will allow me to go back and change the result whenever I choose.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.