--Be cautious of oil stocks until they report first quarter results.
--Because of falling oil prices, oil companies must write down the value of their assets due to accounting requirements set by the Securities and Exchange Commission.
--Companies like SandRidge Energy will lose substantial book value due to the big drop in oil prices.
A little-known accounting requirement is going to force oil companies to write down the value of their proven reserves.
Investors may want to stay away from oil stocks until they report first quarter earnings. At that time, they will show the market value of their proven reserves.
Very few reporters have written about this issue. Here is aBloomberg article about this accounting requirement:
"The U.S. Securities and Exchange Commission requires drillers to calculate the value of their oil reserves every year using average prices from the first trading days in each of the previous 12 months. Because oil didn't start its free-fall to about $45 till after the OPEC meeting in late November, companies in their latest regulatory filings used $95 a barrel to figure out how much oil they could profitably produce and what it's worth. Of the 12 days that went into the fourth-quarter average, crude was above $90 a barrel on 10 of them."
The average price on the first trading days of January, February and March was $51.28 a barrel, Bloomberg reported.
A markdown from $95.00 per barrel to $51.28 per barrel is a drop of 46%.
At SandRidge Energy (NYSE:SD), the company reported the weighted average prices of its proven oil reserves at $91.65 per barrel, natural gas liquids at $32.79 per barrel and natural gas at $3.61 per Mcf on Dec. 31, 2014.
SandRidge said total estimated proved reserves on Dec. 31, 2014, were 515.9 MMBoe (Million Barrels of Oil Equivalents), of which approximately 65% were proved developed, according to the company's annual report. Those reserves include oil, natural gas and liquefied natural gas.
The company's book value on Dec. 31, 2014, was $4.07 per share. That value will come down substantially at the end of the first quarter.
SandRidge's estimated proven reserves and the future net revenues were determined using prices calculated as a 12-month unweighted average of the first-day-of-the-month index price for each month of each year. See chart on Page 10 of annual report
SandRidge's annual report shows 35% of proved reserves was not developed.
Charles A. Adams, an oil investor in Kansas, said SandRidge's undeveloped reserves will eventually cost the company money to hold onto depending on the terms of the lease agreements. Management probably will divest the acres, which means someone will buy these lease agreements at a discount or the acres will just go back to the landowners. Loss of acreage will further de-value the company.
"If oil, natural gas and NGL prices fail to recover significantly in the near term, and without other mitigating circumstances, the company will experience additional losses of future net revenues, including losses attributable to quantities that cannot be economically produced at lower prices, which would likely cause the company to record additional write-downs of capitalized costs of its oil and natural gas properties and non-cash charges against future earnings. The amount of such future write-downs and non-cash charges could be substantial. Further, the borrowing base under the company's senior credit facility is calculated by reference to the value of the company's oil and natural gas reserves, as determined by the lenders under the senior credit facility, and declines in the value of such reserves as a result of sustained low commodity prices could reduce the amount available to be borrowed by the company under its senior credit facility."
These write-downs will hurt the balance sheet, and may slaughter oil stock prices. If the market value of reserves are cut dramatically, the company indicated the mark-downs could trigger violation of debt covenants.
Bullish investors may say the drop in reserves is already priced into the stock of SandRidge. At $1.56 per share, SandRidge is trading at 37% of its Dec. 31 book value.
Oil prices may stay down for a long time due to the huge glut of oil in storage. Oil and gas inventories are near record levels. Oil drillers could not shut off wells that just had been drilled and started producing. As a result, oil reserves are likely to remain high in the near-term.
Total debt at SandRidge was $3.2 billion on Dec. 31, plus it had preferred stock with a liquidation preference of $565 million. The company reported $181.25 million in cash on Dec. 31.
"The company's substantial level of indebtedness and the dividends associated with its outstanding preferred stock increases the possibility that it may be unable to generate cash sufficient to pay, when due, the principal of, interest on or other amounts due in respect of the company's indebtedness and/or the preferred stock dividends. "
Two or three quarters of low oil prices may put this company on death's doors.
I don't short stocks, but SandRidge be a good candidate. I wouldn't touch the stock because it faces major write-down of assets, it has too much debt and faces declining earnings. Bullish oil investors who plunged into oil stocks in January and February may want to rethink their positions before first quarter earnings are released.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.