6 Key Considerations E&P Companies Should Address Navigating Low-Oil Price Environment
Find out what E&P companies need to know as they navigate through the impact of a negative and/or depressed oil and gas commodity pricing environment.
On Monday, April 20, 2020, U.S. crude oil prices traded below zero for the first time ever, meaning producers or traders were essentially paying buyers to take crude oil off their hands. WTI opened for trading on Monday, April 20, 2020, at $18/bbl. By the end of the trading day it had dropped to as low as minus $40/bbl.
The price crash came as the U.S. benchmark oil contract, West Texas Intermediate (WTI), headed towards its expiry date for May physical delivery, the month when lack of demand from lockdowns and travel restrictions was expected to peak. Analysts believed that a lack of available physical storage capacity at the WTI contract’s Cushing, Oklahoma delivery point set off panic among traders holding derivative contracts. Oil futures require that holders of a derivative contract take delivery of a physical barrel when that contract expires. However, no one wanted to get crude oil delivered to them in May when physical storage capacity of the commodity was expected to be unavailable.
Although production has been curtailed, we may see negative oil again. These price disruptions will impact not only traders, but E&P companies, midstream companies and first purchaser companies as well. To that end, we anticipate this prolonged uncertainty will likely trigger several accounting, regulatory, financial reporting and lease-related issues.
Below are six key areas that companies should consider as they navigate through the impact of negative and/or depressed oil and gas commodity pricing.
1) Revenue & Regulatory
Revenue accounting and accruals
Negative prices would trigger considerations around how to account for revenues and revenue accruals. The price typically used for recording monthly revenue and accruals is based on:
- A monthly average
- The month-end spot price, or
- An index price, depending on what the sales contract stipulates. One-day negative price would only have a 1/30th impact on the monthly price, which is not expected to be material.
There could be a situation where even if the gross commodity price is not negative; the differentials could be equal to or higher than the low commodity price, resulting in a net zero, or negative price. Another consideration for revenue accruals would be the volumes. It is typical to use an average of the last three month’s volumes to arrive at the volumes to be accrued, but with an expected increase in shut-ins (discussed later in the article), that may no longer be a reliable measure. Companies will need to consider the shut-ins when arriving at quantities to be accrued.
"Shutting in a well may require capital spend at the outset, as well as restart costs when production is restored. This results in fixed operational expenditure (OPEX) burden, which may not have necessarily been planned."
A negative commodity price, either due to a negative gross price or a negative net price (with the differentials being higher than the gross price), does not necessarily mean the royalty owners would be burdened by the operator for the impact thereof. Royalty owners may be burdened, depending on what the lease stipulates. The working interest owners, however, may be burdened, depending on the provisions of the Joint Operating Agreement (JOA).
Companies will have to evaluate their leases and JOAs to better understand their legal obligations related to this matter.
Shut-ins will also cause companies to pay the minimum volume commitments (or MVCs) on their midstream contracts, which they could burden the working interest owners with, depending on the JOA. On the regulatory reporting front, companies will be required to continue to submit monthly/annual production and/or other regulatory reporting (GLO, ONRR, state, federal), severance taxes, etc. even if there is no production, unless regulatory authorities announce any relaxation.
2) Potential Shut-In
If current price trends continue, we will see producers starting to shut in wells. Regulatory bodies are issuing orders that allow operators to halt production without breaking contracts. In part, these efforts will allow operators to hold leases when production is halted due to it being considered an “economic waste”.
The New Mexico State Land Commissioner and the Oklahoma Corporation Commission recently announced relaxed guidelines regarding shutting in wells, and other regulatory agencies such as the Texas Railroad Commission and the North Dakota Industrial Commission are expected to issue guidance soon. This will trigger considerations around a variety of land and legal matters, including, but not limited to, lease and contract review, owner and royalty communications and shut-in payment issuance.
We may also see acreage write-offs with companies no longer finding it feasible to hold the leases and the underlying acreage as they expire, or decide it is no longer economical to drill on a certain acreage. Conversely, some companies may see this as a potential investment opportunity because they would be able to acquire some leases at a much lower price in this environment.
Shutting in a well may require capital spend at the outset, as well as restart costs when production is restored. This results in fixed operational expenditure (OPEX) burden, which may not have necessarily been planned.
3) Derivatives & Hedging
Lower commodity prices will have a ripple effect in company financial statements and risk management strategies. The current pricing will lead to large upward swings in valuation, leading to companies reflecting corresponding significant, unrealized gains in their financial statements.
Financial commodity derivatives are intended to be an effective hedge of forecasted physical production sales. However, the current market is facing locational supply and demand imbalances. This has led to significant basis volatility causing once highly effective risk management strategies to be less effective.
"The current pricing will lead to large upward swings in valuation, leading to companies reflecting corresponding significant, unrealized gains in their financial statements."
While financial commodity derivatives are intended to protect producers’ cash flows, there may be other factors that lead producers to shut-in wells (i.e., storage constraints, significant basis discounts, etc.). In the event of well shut-ins, companies should evaluate their hedge coverage to ensure that they do not become over hedged.
Companies with three-way collars find themselves lacking adequate cash flow protection as current commodity prices have fallen well below many companies’ sold put strike prices. Lenders often require companies to hedge a portion of forecasted production. In this environment, as companies look to mitigate future risk, they will need to ensure that restrictive lending covenants are not broken, or work with their lending institutions to ease these covenants.
4) Asset Retirement & Environmental Obligations
As operators look to shut-in wells, they should research and review relevant state laws, rules and regulations regarding shut-in of wells. Each state is different, so it is important to research the implications. In today’s environment, we do not want to create an issue where we are required to incur expense to plug a well when operationally it is not necessary. Companies will look for statutory relief from their respective state regulatory agencies.
5) Reserve-Based Lending (RBL)
Most companies with RBLs in place are currently or soon will be working with financial institutions as the RBL is being reset based, in part, on revised reserve studies. This is going to cause further disruption as many companies are either at or close to their current debt capacity.
6) Impairment Considerations
Accounting Standards Codification Topic 350, Intangibles: Goodwill and Other (ASC 350), requires goodwill and other indefinite-lived intangible assets to be tested for impairment at least annually or when a triggering event occurs. Accounting Standards Codification Topic 360, Property, Plant and Equipment (ASC 360), requires long-lived assets to be tested for impairment when a triggering event occurs.
"In this environment, as companies look to mitigate future risk, they will need to ensure that restrictive lending covenants are not broken, or work with their lending institutions to ease these covenants."
The market forces that have impacted the worldwide economy during Q1 of 2020 will qualify as a triggering event for both goodwill and/or long-lived asset impairment testing for some companies. As such, the longer COVID-19 disrupts businesses, the more companies will experience triggering events. As a result, more impairment charges will be taken on the financial statements of these companies.
While most segments of the economy have been hit hard by the impact of COVID-19, the energy industry has been hit even harder in recent weeks, which would result in energy-specific triggering event considerations. Full-cost companies can expect ceiling test impairments starting in Q1 and potentially even through Q4 2020 due to lower pre-tax PV10. Successful efforts companies will be impacted by the forward curve immediately. Large impairments are likely to occur in Q1 and Q2 2020.
About the Authors:
Raza Rizvi is the Vice President of Accounting at Opportune Outsourcing based in Houston, with over 20 years of experience in operational accounting, financial reporting and internal controls for the upstream oil and gas sector. Raza oversees all aspects of Opportune’s outsourcing services with a focus on quality and efficiency of transactional processes and reporting. He leads teams responsible for quarterly and annual SEC financial reporting and SOX implementation and compliance. Prior to joining Opportune, Raza was a Senior Manager in Ernst & Young’s Assurance practice where he served both public and privately held multinational companies in the oil and gas industry. Raza earned his Bachelor’s degree in Finance and Accounting and Master’s degree in Economics from Karachi University. Raza is a CPA licensed in Texas and California and is also a Fellow Member of the Institute of Chartered Accountants of Pakistan. He is fluent in Arabic and Urdu.
Amy Stutzman is a Managing Director in Opportune LLP’s Complex Financial Reporting group with 20 years of experience in technical accounting and SEC reporting. Amy leads teams that support executive management in understanding the structure and implications of complex transactions such as IPOs and acquisitions. She has strong technical skills and analytical ability and is the firm leader on all U.S. GAAP advisory matters. Prior to joining Opportune, Amy managed the financial reporting group for Apache Corp. in Buenos Aires, Argentina, and was an audit manager in PwC’s energy practice. Outside of Opportune, Amy is an active member of the Tulsa Energy Council and the Women’s Energy Network. She is a speaker for industry groups such as the AICPA, OSCPA, Women’s Energy Network and University of Tulsa’s Master of Energy Business Program. She serves as Chair of Board of Directors for Street School Inc., a high school for at-risk youth. She is fluent in Spanish.
Ken Nollsch is a Controller in the Outsourcing group at Opportune. He has over 15 years of experience in technical accounting and operational accounting, with representative “hands-on” industry experience serving as a Controller for mid-growth companies. Ken began his career at Hein & Associates, serving as a Manager in the company’s energy practice. Ken has developed broad experience in financial reporting, financial modeling, operational accounting and strategic planning. He brings expertise in compliance with the reporting requirements of the U.S. Securities and Exchange Commission, including reporting on Forms 10-Q and 10-K. Ken recently served as the Interim Controller at Jonah Energy LLC. Ken is a Certified Public Accountant and a member of the AICPA.