Over the years, the world has become familiar with oil price fluctuations and the impact they have on oil and gas financial reporting. The supply of oil is affected by numerous factors including wars, growing economies, regulations, new discoveries, etc. In 2014, we saw crude oil prices cut in half in just a few months. Starting in August, prices began falling and, by year-end, they were at their lowest point in over five years.
2014 is now behind us and many entities are preparing their financial statements. As oil and gas exploration companies go through this process, it’s important to keep in mind that the unusual fourth quarter we experienced could result in major financial reporting issues. This article presents a list of five areas for oil and gas companies to consider in their 2014 financial statements.
- Impairment of Oil and Gas Properties
- Full Cost Companies: SEC rules require full-cost companies to limit the carrying value of their oil and gas properties to the value of estimated reserves. That value should be calculated based on an un-weighted arithmetic average of the price posted on the first day of each month for the last 12 months, discounted to present value. With the price drop happening so precipitously at the end of the year, reserves may be reported at a significantly higher value than they are currently worth. Further, as the 12-month rolling average decreases in 2015, quarterly calculations may result in write downs.
- Successful Efforts Companies: US GAAP requires a two-tiered approach for assessing impairment. First, management estimates undiscounted future net cash flows from the asset group and compares that amount to the net book value of their oil and gas properties. Next, if the net book value exceeds the estimated undiscounted future net cash flows, the entity then reduces the carrying value by recording an impairment charge measured as the difference between net book value and estimated fair value for each property. These estimates should include an assessment of the future net cash flows using reasonable pricing assumptions giving effect to the current commodity price environment.
- Five-Year Rule on Proved Undeveloped Properties (PUDs)
SEC rules limit an entity’s ability to classify reserves as proved undeveloped (PUD). An entity must show substantial commitment and ability to develop PUD reserves in order to classify those reserves as proved. The falling price of oil could affect the economic feasibility of developing resources currently classified as PUD, and the price drop can also limit the amount of resources a business has at its disposal to develop PUDs within the five-year time-frame. If either of these circumstances leads to the reclassification of resources from PUD to unproved, the reclassification can have a cascading effect on the business, as many lenders set borrowing bases in part on proved reserves.
- Liquidity Concerns
As the price of oil declines, the value of reserves based on that price also declines. Lenders may become more concerned about granting waivers on debt covenants, and companies already facing liquidity problems due to falling prices may see problems caused by decreased operating cash flows compounded by the unwillingness of financial institutions to extend credit while the price remains low.
- Collectability of Joint Interest Billings
An entity with amounts receivable from joint interest partners will need to consider whether those amounts are collectable. All entities engaged in oil and gas producing activities are facing the same commodity price environment as discussed herein. The collectability of receivables may not be as reliable as it would be in a more positive pricing environment. Entities should be watching the aging of receivables closely and working to identify problems in this area as early as possible.
Many oil and gas companies protect themselves against fluctuations in commodity prices by entering into contracts that provide a fixed price for oil extracted in the future. Price decreases have resulted in significant gains on the contracts, but this could diminish. With the drop in the futures market as well, new contracts will not be as favorable.
The oil price changes in 2014 have created a number of economic conditions that few people could reliably forecast. As energy producers work hard to adjust their business models to this scenario, it’s easy to overlook the impact that these changes may have on 2014 financial statements. If you have any questions about how oil price fluctuations may affect your business, you should reach out to your financial statement preparer as soon as possible. For more information, contact Matt Rolland, Partner, at email@example.com or Bill Gaskins, Senior Manager, at firstname.lastname@example.org at Hein & Associates, or call (303) 298-9600.