How the SEC Can Take Trillions of Cubic Feet of Natural Gas From 1 Company

Editors Note: In a previous version of this article, the author wrote that the proved reserve value for a company would be reflected in its tangible book value. While a company is forced to write-down its assets in the event that low prices would make certain reserves unattainable, it is not required to include those assets if those reserves become attainable again. The article has been corrected for this mistake. The Fool regrets the error. 

Between Dec. 31, 2011, and the same date a year later, Chesapeake Energy (NYSE: CHK  ) saw 1.7 trillion cubic feet of natural gas equivalent simply disappear from its proven reserves. No, it wasn't from selling off a boatload of assets to cover its financial obligations, nor was it from production. The Securities and Exchange Commission took it -- sort of.

How does that work? Let's take a deeper look at what happened to Chesapeake's reserves and how this rule affects your energy investments.

Source: Chesapeake Energy Investor Relations.

Proving proven reserves
There are lots of ways companies can describe the oil and gas they have on the acreage they hold, but they can only describe proven reserves in one way. The SEC's definition of proven oil and gas is very specific:

[Q]uantities 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 -- prior to the time at which contracts providing the right to operate expire, unless evidence indicates that renewal is reasonably certain, regardless of whether deterministic or probabilistic methods are used for the estimation. ... [A] company must use a 12-month average price, calculated as the unweighted arithmetic average of the first-day-of-the-month price for each month within the 12-month period prior to the end of the reporting period, unless prices are defined by contractual arrangements, excluding escalations based upon future conditions.

If you fell asleep halfway through that long-winded explanation, what it's trying to say is that proven reserves are calculated based on the oil or gas in place, the technology available to extract it, and the average price on that resource from the past 12 months. So when there is a massive drop in price for natural gas or oil, companies need to adjust the amount of proven reserves on their books to reflect how much can be economically extracted based on the lower price.

2012 makes so much more sense now
Last year we saw many exploration and production companies post extremely abnormal loss numbers. Probably the most egregious example was Ultra Petroleum (NYSE: UPL  ) . Before Q2 2012, the company's previous four quarters had resulted in net profits of about $468 million, and then in that dubious quarter the company lost an astounding $1.18 billion. Almost all of that loss was attributed to the $1.8 billion asset writedown during the quarter. We also saw Southwestern Energy (NYSE: SWN  ) , Exco Resources (NYSE: XCO  ) , and Chesapeake Energy each write down assets by more than $1.5 billion throughout 2012.

Do you notice the common trend among all of these companies? All of these companies have very natural gas heavy-reserves. So as natural gas prices slumped all the way below $2.00 at times throughout the year, these companies needed to write down their reserves for the SEC. When each of these companies reported reserves in their annual report, proven reserves were all at least 15% lower than what they were a year prior.

So now that we know what proven reserve pricing means, how can we use it as a tool to invest going forward? The first thing to consider is that these asset writedowns are non-cash operations, so they don't have a direct effect on the companies' operations. Many of these companies also have assets that are worth much more than what's on the books. Let's take Southwestern's assets, for example: At the end of 2011, proven reserves were 5,893 billion cubic feet equivalent of natural gas with a price average of $4.38, but in 2012 those reserves dropped to 4,937 bcfe with and average price of $2.76. With Southwestern realizing gas prices of $3.65 so far this year, the company will be able to put a good chunk of those lost assets back on the books. You also need to include the company's new assets. In 2012 the company drilled 670 exploratory and development wells, and only 1% of them came up as duds.

Unless a company voluntarily discloses its proven reserves, you will need to wait to dig into the company's next 10-k. Keep in mind that if those reserves appreciate in value after they have been written-down, they do not get added back to the company's assets. So investors who want to do some digging into balance sheets could find the proven reserves of a company are not what they seem on the balance sheet. 

What a Fool believes
Things like proven reserves go to show that you should never completely trust the numbers for their face value. Sometimes you need to dig deeper to understand the context. Those who do may unearth some truths that others in the market are overlooking and will make you a smarter investor because of it. For most of the companies I've mentioned, 2012 was the perfect environment for sinking profits, but it wasn't completely their doing. Be sure to do your homework, and you may find one of these companies might just be ready to rebound in a big way. 

Smart investors buy smart companies, and one smart behind-the-scenes energy company is even making the entire industry smarter. This company's innovative way of approaching the extraction of oil and gas is changing the industry, and this major disruptor has been named "The Motley Fool's Top Stock for 2013." Our chief investment officer has put together a comprehensive report on what makes this company a game-changer, and you can get the name of this company and free access to this valuable report by simply clicking here.


Read/Post Comments (7) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 21, 2013, at 4:03 PM, SHolly76 wrote:

    "big change in asset value ...will be accounted for in the annual report at the end of the year."

    I think that's wrong. While you're required to write down the asset, you're never allowed to write them back up. Tangible book value stays down, rendering that metric meaningless in oil & gas accounting. Right?

  • Report this Comment On September 22, 2013, at 4:38 PM, Bshaef wrote:

    SHolly76 you are right. The asset value of the reserves is never added back to the "books". (They were never there in the first place) However, the quarterly DD&A expense will be lower because the companies have a larger reserve base as volumes are added back to the DD&A formula. Another example of why Motley Fool and Seeking Alpha articles about the oil industry should never be relied on.

  • Report this Comment On September 23, 2013, at 9:18 AM, TMFDirtyBird wrote:

    @SHolly76 and @Bshaef

    I went back through the SEC regulations over the weekend and you guys are right. Companies are required to disclose their proved reserves (both developed and undeveloped). Also, companies give a monetary value to those assets through an after-tax, 10-year net present value calculation, which is the GAAP standardized methodology for reporting value of a reserve. Although it's not required.

    What I mis-read was that the PV-10 value was not carried onto the property, plant, and equipment section of the balance sheet, but rather is a stand alone valuation that has no bearing on book value for the company.

    I deeply apologize for the mistake. Great catch!

    --Tyler

  • Report this Comment On September 25, 2013, at 6:20 PM, 1righteousF00L wrote:

    useful article for posting and explaining the definition of proven reserves.

    novice investor. long xco. buying more as price drops.

    a quick question. if xco and the others have had to write-down large amounts of proven reserves--an accounting measure which may obscure a lot of hidden value--the amount of the proven reserves stays the same; when nat gas prices go back up will these written-off reserves increase greatly in value?

  • Report this Comment On September 26, 2013, at 9:14 AM, TMFDirtyBird wrote:

    @1righteousF00L

    When a company writes down reserves, they are basically saying "we cannot make a profit from this acreage based on the current economic environment". Since proved reserves disclosed to the SEC are predicated on the price of the commodity, then proved reserves do change. As prices rise, those reserves may be economical again, but it won't be accounted for on the balance sheet.

    Hope that helps.

  • Report this Comment On September 26, 2013, at 9:57 AM, 1righteousF00L wrote:

    TMFDirtyBird

    thanks for the reply. yes that does help. it gets me incrementally closer to the answer.

    if the company continues to hold the proved reserves, and the proved reserves remain a fixed quantity (understandably not at a fixed price) than the quantity remains with the company; since the accounting for it is "off balance sheet" its remains with the company as an asset whose real value is temporarily obscured by the accounting rules and which, when the price goes up, could be sitting there "valueless" but in reality having enormous potential real value.

    is that right?

  • Report this Comment On September 26, 2013, at 6:06 PM, TMFDirtyBird wrote:

    @1righteousF00L

    You nailed it. These assets can be hiding because they are not on the books, so be sure to look at company disclosures and presentations. Several of them will actually provide reserve sensitivity charts that let's you know how much gas it can monetize based on various prices.

    --Tyler

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