This year, many oil and gas companies reported negative income, but positive free cash flow (FCF). While some investors may suspect that this is a result of creative accounting, that’s usually not the case. But it does warrant some explanation.

The issue relates to one of the most fundamental valuation indicators for an oil and gas company: the value of  the oil and gas deposits it controls. Each year the Securities and Exchange Commission (SEC) requires energy producers to estimate the year-end value of their proved reserves in the annual report (10-K filing). This calculation is called the standardized measure (SM).  

The SM is the present value of the future cash flows from proved oil, natural gas liquids (NGLs) and natural gas reserves, net of development costs, income taxes and exploration costs, discounted at 10% annually. The SM must be calculated according to specific guidelines set by the SEC, and is a GAAP measure. (GAAP stands for generally accepted accounting principles, the most formal and inflexible set of rules for assessing a company’s finances.) All oil and gas firms traded on a U.S. exchange must provide the standardized measure in filings with the SEC.

The SM is calculated based on the average prices received over the past 12 months for oil, NGLs and natural gas. At year end 2014, these prices were still quite high. In fact, most companies used an oil price above $90/bbl and gas price well above $3/MMBtu for last year’s SM calculation.

The sharp drop in oil and gas prices this year has two effects on the standardized measure of oil and gas companies. First and most obviously, future cash flows assuming a selling price of $45/bbl are obviously going to be much lower than using an oil price twice that high. Second, the volumes of the proved reserves securing those future cash flows are also dependent on the assumptions about the realized price. Some reserves that might have been developed when oil was $90/bbl will not be exploited while oil is at $45/bbl.

These two factors are likely to lead to non-cash impairments on the industry’s upcoming income statements. Calculation of the impairment can be done in a couple of different ways, but the rules are set by the SEC. Notably, the commodity prices used to estimate future cash flows are based on the arithmetic average of the trailing 12 months’ first-of-month pricing.

Because crude prices really started to plummet during the third quarter of last year, this year’s recently ended third quarter now includes a full year of depressed pricing. Hence, there were a lot of substantial impairments following the end of the quarter. In fact, for the 585 energy companies I screened prior to this story, the Q3 impairments were 7.6 times greater than the Q2 impairments.   

These impairments are included in net income, but represent only a paper loss. They don’t affect cash flow but are rather a change in estimates of future cash flows. Thus, many oil and gas companies are currently reporting a net loss but positive free cash flow.

As an example, consider EOG Resources (NYSE: EOG). At the end of 2014, EOG reported a standardized measure — a discounted measure of its future cash flows — of $27.9 billion. But that was based on U.S. prices of $97.51/bbl for oil, $34.29 for NGLs, and $3.71/MMBtu for natural gas. The actual average price of West Texas Intermediate (WTI) in Q3 of this year was only $46.42 according to the Energy Information Administration. So EOG’s estimated future cash flows are now lower, and the company took an impairment of $6.3 billion in the quarter — nearly 23% of its previously estimated future cash flow.

EOG had net revenue in Q3 of $2.1 billion, and a cost of goods sold of $1.1 billion. But then the impairment of $6.3 billion was applied. This was the biggest factor in the $4.1 billion net loss EOG reported for the quarter. In calculating free cash flow for the quarter, the impairment was added back (as was depreciation). The reality is that EOG generated cash during the quarter, but the impairment means the outlook for future quarters is lower.

The appropriate level of concern about these impairments depends on many factors. If the impairment is substantial but the stock price doesn’t sufficiently account for it, it may have more downside risk. (Or vice versa). In EOG’s case, the 23% impairment of its estimated future cash flow is greater than its shares’ 11.3% decline over the past year. So that could be an indicator that EOG is somewhat more richly valued given its outlook than it was a year ago. (In its defense, I still consider EOG to be arguably the best oil company in the U.S.)

As the year draws to a close, we will be spending a lot of time poring over annual reports and evaluating the size of this year’s impairments. We will look for companies that are becoming relatively overvalued or undervalued on the basis of this shifting landscape.

Be sure to join us at The Energy Strategist as we seek to uncover risks and opportunities resulting from these impairments. In the next issue, I will be taking a deeper dive into impairments for specific companies, and I will also explain how such impairments can impact midstream companies, service companies and even refiners. I will also be discussing the potential impact of OPEC’s recent decision not to adjust production quotas.    

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