This is the first of two posts in which we will investigate the different values placed on oil and gas reserves in a GAAP, Non-GAAP, IFRS, and fair market value context. As an example we will consider Exxon Mobil Corp., the nation’s largest energy company, which is under investigation for its lack of asset write-downs amid falling oil and gas prices.
The Exploration and Production sector focuses on finding and using oil and gas reserves; thus the value of an E&P company exists in the value of its reserves. For many companies, such as professional service firms and tech start-ups, book value is meaningless from a valuation perspective because the true value of the company is not reflected on the balance sheet. But, because E&P companies’ value lies in the value of their reserves, investors often look to book value in order gauge future performance. In order to protect investors from misleading information, the SEC, FASB, and IFRS have specific rules for reporting and accounting for proved reserves.
When we talk about reserve values there is a difference between the fair market value of reserves, the value of reserves as shown on a company’s 10-K, and the GAAP standard measure for oil and gas reserves. The SEC uses a reported value known as PV-10 in order to make proved reserves comparable across companies. PV-10 is the value of reserves calculated as the present value of estimated future revenues less direct expenses discounted at an annual rate of 10%. But, PV-10 is a non-GAAP accepted measure. The FASB’s ASC 932 requires a similar standardized measure for the value of proved reserves called SMOG (standardized measure of oil and gas). SMOG is calculated with the same methodology as PV-10 but deducts income taxes whereas PV-10 does not.
Both PV-10 and SMOG require (1): reserve estimates (2): a sales price and (3): an estimate of cost.
- All reserve estimates involve some degree of uncertainty, which can be minimized with dependable geological and engineering data and proper interpretation of the data. There are two methods of reserve estimates. While both are based on geological, engineering, and economic data, a deterministic estimate is single estimated value while a probabilistic estimate is a range of values given with their associated probabilities.
- The price of oil/natural gas used to calculate future income must be the twelve-month average price not the year end spot price.
- While the SEC and FASB provide guidelines for what should be included as a direct expense, costs, realistically, are estimated differently by every company leading to some inconsistency in these standardized values across firms.
The SEC’s Modernization of Oil and Gas Reporting requires that PUDs only include wells that are “economically producible” within five years. As the price of oil dropped in 2014, companies had to revise revenue estimates for many of their wells and some wells were no longer considered economically viable during the SEC’s five year time period. Thus many companies had to reclassify certain proved reserves as probable or possible reserves.
Bradley Olson, of the Wall Street Journal, reported:
With low crude oil and natural gas prices, billions of barrels of fuel in the ground cannot be tapped cost effectively, making reserves revisions and write-downs staples of oil-patch earnings in recent years, and helping push energy company losses to record levels.
Competitors of Exxon have booked over $200 billion of write downs since oil prices collapsed in 2014, but Exxon has not recorded losses associated with reserve write downs. Exxon says that they have not written down the value of their reserves because they use conservative accounting techniques when they initially book the value of new fields and wells. Unlike its competitors, Exxon’s proved reserves only consist of fields in which “management has made significant funding commitments toward the development of the reserves.” Exxon’s CEO challenges management to make sure that capital expenditure projects will be viable even in a low price environment. Thus, when the price of oil fell Exxon claimed that they still had the necessary funding to develop its PUDs and did not have to write down the value of its reserves. However, if a 60% drop in oil prices did not impair reserve values, then maybe Exxon’s reserves were undervalued before.
The SEC recently broadened the definition of proved reserves as:
those quantities of oil and gas, which, by analysis of geoscience and engineering data, can be estimated with reasonable certainty to be economically producible—from a given date forward, from known reservoirs, and under existing economic conditions, operating methods, and government regulations[… ]
The SEC elaborates on many details such as what is a reasonable time frame, what part of the reservoir is included as proved, and when can improved recovery techniques be used to estimate future production. But there is still room for interpretation. Although Exxon executive, Alan Jeffers said that Exxon is confident that its financial reporting is legal, it is clear that Exxon has used the somewhat ambiguous definition of proved reserves to do something different than many of its peers. Additionally, this investigation overlaps with another investigation into Exxon’s asset values in consideration of the future cost of environmental regulations and the global response to climate change.
Just as there are differences in reporting standards when determining the value of proved reserves, there are differences in the way companies determine if reserves are impaired. Companies that have overseas operations often keep two sets of books because they must also follow International Financial Reporting Standards (IFRS). Both GAAP and IFRS have the same goal of making sure that assets are not reported above the value that could be recovered from liquidating the asset, but they have different methodologies to determine if an asset is impaired. Under IFRS, future discounted cash flows are compared to the book value of the asset, while under GAAP, undiscounted future cash flows are compared to book value. Although the threshold of impairment is higher under GAAP, GAAP write downs cannot be reversed when economic conditions recover, unlike IFRS write downs which are reversible. In order to write down assets, discounted cash flows are used by both IFRS and GAAP.
It is important to remember, especially, in a low oil price environment that the reserve values presented on company’s 10-Ks may not be an accurate representation of fair market value. Fair market value represents the price at which property would change hands between a hypothetical buyer and seller. Next time we will discuss how to determine the fair market value of oil and gas reserves.
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