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.
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 (NASDAQ: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.