In last week’s Energy Letter I discussed the impact of impairments on oil and gas companies. Today I want to explore that topic in further detail, investigating the companies that have taken impairments but which may not have those impairments adequately reflected in their share price.

As the year comes to a close and companies begin to publish annual reports, the effect of these commodity price-driven impairments will be examined closely in order to reevaluate which companies have become undervalued or overvalued relative to the rest of the sector.

To review, one of the most fundamental valuation indicators for an oil and gas company 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 is a function of commodity prices, and therefore as commodity prices change the SM can go up or down.  

The past year’s sharp drop in oil and gas prices has depressed the SM in two ways. First, the product is selling for a lower price, but also proved reserves may need to come off the books if they are no longer worth developing as a result of lower prices. Thus, companies reporting impairments have reduced the future outlook for their cash flows, and their stock price should reflect that. Of course when oil and gas prices recover, those reserves can go back on the books and the SM will go back up to reflect this.

Bloomberg has a recent story on the same topic: Billions of Barrels of Oil Vanish in a Puff of Accounting Smoke. The gist is that a lot of oil reserves are about to be erased from the books as a result of lower prices.

While I think we will begin to see commodity prices recover next year, for this exercise I am more interested in whether recent impairments by particular companies are adequately reflected in their share prices. Note that while these impairments obviously and most directly impact the oil and gas producers, they can also affect other sectors.

Because producers have curtailed drilling in the face of a commodity price slump, they have less need for drilling rigs and related oilfield services. The assets of midstream companies may be impaired by the likelihood of a decline in production, which could lead to lower gathering and processing volumes. Refiners with significant crude inventories may have acquired it at much higher prices; a year ago a few were forced to write down some of the value of their feedstocks.

With that preface, I screened for energy companies that have taken significant impairments to their oil and gas properties in the past four quarters, and compared that with the change in the share price over the past year, as well as their enterprise value (EV). Of the 584 companies I screened for this exercise, 157 reported at least some impairment since the third quarter of last year. In the aggregate, these companies wrote off $79.4 billion, or $506 million on average.

The largest industry impairments were seen in Q3 of this year ($35.1 billion) and Q4 of last year ($27.4 billion). Some companies that I am certain will have to take impairments this year have yet to do so, so I expect to see a large overall impairment for the sector in Q4.

As expected, the impairments were taken primarily by exploration and production (E&P) companies ($53.4 billion) and integrated oil and gas companies ($24.7 billion). The largest overall impairment was taken by Occidental Petroleum (NYSE: OXY), at $9.6 billion. This is equivalent to 16.7% of OXY’s current EV, and is 31.9% of last year’s SM. Thus, an OXY shareholder might be concerned that its share price has become relatively overvalued because it only declined by 8.7% over the last year. But we have to keep in mind that OXY is an integrated company with significant assets other than those that produce oil and gas, and therefore the impairment has less impact on the overall financial performance than it would for a pure oil and gas producer.

The only other integrated company with an impairment that was in the double digits when compared to EV and SM was Canadian producer Husky Energy (TSX: HSE). Husky’s $4.5 billion impairment was taken mostly in Q3, and amounted to 40.5% of its 2014 SM and 27.2% of its current EV.

In comparison, BP (NYSE: BP) took a $2.6 billion impairment (in addition to the impact of the Gulf oil spill), but that’s only about 2% of its SM and EV. That was typical of most integrated producers.

But the real action was among the pure E&Ps, so I will provide that information as a table. Of 229 E&Ps that this screen evaluated, 130 reported impairments over the previous four quarters. I suspect that, as the Q4 numbers come in, that number will climb sharply. Here are the E&P companies that reported impairments and reported a Standardized Measure (required for companies trading on a U.S. exchange) at the end of 2014, along with some key financial metrics:

• EV = Enterprise value in millions as of Dec. 10
• EBITDA = Earnings before interest, tax, depreciation and amortization for the trailing 12 months (TTM), in millions
• Debt/EBITDA = Net debt at the end of Q3 divided by TTM EBITDA
• Impair/SM = Impairment as a percentage of the 2014 year-end SM
• FCF (TTM) = Levered free cash flow for the TTM in millions
• 1 Yr Ret = Total return for the TTM

A lot of caveats need to be applied to this sort of data mining exercise. This list includes master limited partnerships (MLPs), companies that are predominantly oil producers, those that are predominantly gas producers and companies collecting mineral royalties. It also includes some penny stocks, and two that had IPOs this year (BSM and ATLS) and therefore don’t have a full year of performance to evaluate. So you need to exercise caution when making comparisons.

For me, this list is an idea generator — only the first step in due diligence. Here is how I would use this list as a first-pass screener on whether a company’s value is increasing or decreasing given the underlying fundamentals. Again, there are many value metrics, and I am focusing primarily on one for this exercise. If we consider that an E&P company’s value should reflect the expected cash flows from future oil and gas operations, we should expect impairments to correlate to the performance in share price. If it doesn’t — and there are valid reasons that it may not — then we should investigate in more detail.

For example, consider Sanchez Production Partners (NYSE: SPP). It is admittedly a special case for a couple of reasons, so I use it merely for illustrative purposes. We can see from the table that the company has taken impairments this year that were equivalent to 75.2% of its expected future cash flows. Yet the share price is only down by 17.8% over that time period. This is the sort of discrepancy that can be a first indicator that the value has gotten out of whack with the underlying fundamentals. In the case of Sanchez, a bit of digging would show a couple of other variables influencing the price, one of which is that it took a pretty sharp dive just over a year ago. So the time frame doesn’t completely capture the decline since the deterioration in the company’s prospects became obvious.

On the other end of the spectrum we see a stock like Rice Energy (NYSE: RICE). Over the past four quarters the company has only taken impairments of 0.2% of last year’s reported SM, yet the share price has dropped 43.1%. This is a reflection of the market’s outlook for this predominantly Marcellus and Utica natural gas producer, which has yet to be reflected in the company’s calculated future cash flows. At least according to this metric, its shares have been unduly punished.

Of course there are always other factors that can explain such discrepancies. A company could have a lot of debt, or it could have been fundamentally overvalued at the beginning of the time period. It could also be that a company just hasn’t reported a major impairment yet, and Q4 is often the time when that happens. Additional due diligence can then flesh out whether there are reasonable explanations for such discrepancies, or whether it actually represents a threat or opportunity.

We will continue to monitor companies that seem to be diverging in share price from the underlying value, especially as year-end standardized measures are reported.    

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