E&P Impairments Looming - Editorial
Lower commodity prices will impact industry throughout 2015
Josh Sherman, Wade Stubblefield, Stephen Patton Opportune, Houston
After an unprecedented number of initial public offerings and acquisitions in 2014, the oil and gas industry is now reeling from the subsequent decline in commodity prices. As of Jan. 9, 2015, spot crude oil and natural gas prices have respectively decreased 54% and 33% since June 2014 and have decreased 47% and 28%, respectively, since the start of the fourth quarter of 2014. The industry last saw such pricing changes in 2008.
With the significant decline in commodity prices, it's not just E&P companies' operations, finance and treasury functions that find themselves having to rethink their 2015 capital, leverage and liquidity plans - accounting teams must also refresh their understanding of the rules surrounding impairment calculations and reporting reserves. The recent price changes are likely to result in significant accounting and financial reporting implications for the industry as of Dec. 31, 2014 and for each quarter in 2015.
Key financial reporting considerations: impairments
For companies following the Successful Efforts method of accounting, the rules governing impairment are specified in ASC 932-360 and ASC 360-10. Note that these rules are very different from all depletion calculations and the Full Cost ceiling-test.1
The Successful Efforts impairment calculation is a two-part test requiring further evaluation if reserves' undiscounted cash flows are less than book value (Step 1), in which case, an impairment is calculated by comparing the reserves' book value to their fair value (Step 2, discounted cash flows). Unlike a depletion calculation, a Successful Efforts impairment test requires cash flows to be valued using a forward market strip price curve and a company's credit-adjusted market discount rate as of the measurement date (e.g., quarter- or year-end).
The cash flows should consider proved reserves as well as risk-adjusted probable and possible reserves based on the company's development plans. The estimates and development plans utilized in such determination should be reasonable in relation to the assumptions used by the entity for other purposes (e.g., internal budgets, projections regarding the realization of deferred tax assets, and information communicated to the company's board of directors). Under Successful Efforts, hedge-adjusted prices are not considered. Also note that unevaluated properties should be assessed on a property-by-property basis, and if not practical, companies should assess in the aggregate or by groups.
For companies following the Full Cost method of accounting, the "ceiling test" under Rule 4-10 of SEC Regulation S-X specifies that evaluated properties' capitalized costs, less accumulated amortization and related deferred income taxes (the "Full Cost Pool"), should be compared to a formulaic limitation (the "Ceiling") each quarter.
The Ceiling is equal to the following: present value of proved reserves' estimated future net revenues; plus • lower cost or estimated fair value of unproven properties included in the costs being amortized; and cost of properties not being amortized; • less, the book-tax differences related to, and any NOL's generated by, oil and gas properties currently included in the company's depletion calculation.
The reserve pricing utilized in calculating the Ceiling is the arithmetic average of the trailing 12 months' first-of-month pricing ("SEC Pricing"), which will potentially delay impairments until prices from early 2014 roll-out of the 12-month average and are replaced with lower pricing from 2015. Cash flows must be discounted at 10% ("PV10"). Hedge-adjusted pricing is only available to Full Cost companies if the derivatives were formally designated as cash flow hedges for accounting purposes.
If the company's Full Cost Pool exceeds the Ceiling, an impairment must be recorded. Unevaluated properties are assessed on a property-by-property basis, and if not practical, companies should assess in the aggregate or by groups.
All other factors being equal, using forward strip pricing rather than a historical average may result in Successful Efforts companies reporting impairments sooner than Full Cost companies. Of course, not all factors are equal and additional nuances exist within industry reporting requirements. Industry stakeholders should also consider the effects such differences may have on footnotes, borrowing base determinations and management's discussion and analysis.
Oil and natural gas reserves
ASC 932 stipulates publicly-traded companies apply a standard measure for supplementally disclosing oil and gas reserve volumes and present value (the "Standardized Measure"). Although the Standardized Measure requirements are intended to provide a common reporting framework by which to compare all public oil and gas companies, confusion may still exist among financial statement preparers and users.
The commodity price (SEC Pricing) and discounting methodologies (PV10) used in the Standardized Measure mirror those applied by Full Cost companies; therefore, Successful Efforts companies may record impairments that may not be apparent in SEC disclosures. The passing of the SEC Modernization of Oil & Gas Reporting, effective Jan. 1, 2010 and applied for fiscal years ending or after Dec. 31, 2009 (the "SEC Modernization"), also means that some current Standardized Measure rules were not in effect during the industry's previous commodity price crisis in 2008.
In addition to SEC Pricing changing from the company's realized price as of the balance sheet date (as compared to the arithmetic 12-month average in use today), the SEC Modernization now requires that proved undeveloped ("PUD") reserves include only those wells that the company plans and has the financial ability to drill within five years of the balance sheet date.
Companies may be forced to reassess the classification of certain reserves sooner than expected as commodity prices change well economics and drilling plans. While companies have considerable latitude in what wells are included in their capital plans, expect the SEC and independent auditors to closely monitor and question the "five-year life" of PUDs and companies' ability to finance such drilling.
Income tax ramifications
In most cases, tax law does not follow GAAP in allowing a current year tax deduction for impairments due to more stringent rules for "losses." As such, the impairment expense is often treated as an unfavorable temporary difference in the period recorded. The change in the deferred tax liability from this unfavorable temporary difference should be recorded using the marginal tax rate applicable to the book-tax basis difference in properties (and not the estimated annual effective tax rate). While this in and of itself does not have a direct impact on an entity's effective tax rate, preparers of financial statements must consider the need to record a valuation allowance at that time if the impairment causes the (impaired) book carrying value of the properties to exceed their (unimpaired) tax bases. The SEC staff tends to interpret the ASC 740 literature rather conservatively in this area. The presence of a valuation allowance would reduce the expected tax benefit to record at the time of the impairment.
Borrowing base determinations
There are no common rules applied across all lenders and, as default risk increases along with commodity price decreases, it should be expected that the borrowing base inputs employed by lenders may not be consistent from period-to-period. The valuation inputs and methodology used in a reserve-based borrowing base determination are more closely aligned with the fair value metrics used in a Successful Efforts impairment calculation, but all companies may experience downward borrowing base revisions that were not apparent from their impairment calculations and Standardized Measure disclosures. The discount rate used by banks is almost always 9%. In addition, the price curve used by banks is typically fairly flat and below the current spot price. Although lenders give companies credit for hedge pricing, note that cross-default provisions may result in a liquidity covenant default terminating the same derivative instruments designed to protect the company.
Management's discussion & analysis: Market & liquidity risk disclosures
The current price environment will continue to have significant disclosure impacts on the oil and gas industry throughout 2015 and at least the 2nd quarter of 2016, but the proper understanding, consideration and expanded disclosure of the accounting rules will assist in eliminating reporting and liquidity surprises.
Consider including risk disclosures within MD&A based on an assumption that current prices persist through 2015. We suggest describing the potential amount, timing, and probability of the following events occurring in future periods, as well as management's plans to remedy any liquidity or going concern issues:
- ceiling-test write-downs, particularly as higher prices roll-out of the average used to calculate SEC Prices;
- material revisions to the volumes and PV10 disclosed in the Standardized Measure;
- covenant defaults and/or borrowing base adjustments;
- cash flow and production risks associated with non-operated properties;
- loss of value in carried interests or other joint venture arrangements when there is a limited time to execute on properties not held by production; and
- changes in time to realize a reversion in net profits or overriding royalty interests, or to repay volume-based or dollar-denominated variable production payments.
NOTE: This article does not discuss the costs that may be capitalized under the Successful Efforts vs. Full Cost methods of accounting.
Also featured in the Oil & Gas Financial Journal March 2015 Issue - Page 24ABOUT THE AUTHORS
Josh Sherman is the partner in charge of Opportune's complex financial reporting group. He has more than 16 years' experience providing clients across the energy spectrum with technical research, capital markets, and SEC reporting assistance. Sherman specializes in IPOs, variable interest entities, purchase price allocations, energy trading, and derivatives, stock-based compensation and oil and gas disclosures.
Wade Stubblefield is a managing director in the corporate finance and complex financial reporting practices of Opportune. He has 25 years' experience in corporate finance and technical accounting with experience across the energy spectrum (upstream, midstream, downstream and wholesale and retail energy trading and marketing). Stubblefield has served in a number of industry roles from CFO to CAO and controller.
Stephen Patton is a director in Opportune's complex financial reporting group. He has more than 12 years' experience, including financial statement and internal control audits, technical accounting, and SEC regulations. Prior to joining Opportune, Patton was a senior manager in the audit and enterprise risk services department at Deloitte & Touche.