It has been a rough year for energy companies amid substantially depressed commodity prices. Not only does this situation impact these companies' cash flow, but it also hits the asset value of oil and gas properties. Falling asset values could force companies to write down the carrying value of these assets. This could have an effect on the first-quarter earnings numbers from SandRidge Energy Inc. (UNKNOWN:SD.DL), which already hinted in its 2014 annual report that a writedown might be on the horizon.
Value is in the eye of the beholder
SandRidge Energy had been using relatively high oil prices to fuel rapid growth in its oil and gas reserves. It ended 2014 with proved reserves totaling 516 million barrels of oil equivalent, which was 37% higher than the prior year. Moreover, these reserves were valued at $5.5 billion by using the SEC PV-10 value. That was 34% higher than the prior year and demonstrated the power of the company's drilling program to create value:
That sounds fantastic, until we read the fine print. These values are based on 12-month average index prices, which were $91.48 for oil and $4.35 for gas. As most investors know, the value of oil and gas fell substantially over the last half of 2014, which has dramatically affected the current value of these reserves. In fact, if the company's reserve reports were based on the recent strip pricing it would yield a PV-10 value of just $3.3 billion.
This weaker value could have a big impact on the company going forward. For example, the borrowing base on its credit facility is based on proved reserves, which SandRidge noted in its annual report:
[T]he borrowing base under the Company's senior credit facility is calculated by reference to the value of the Company's oil and natural gas reserves, as determined by the lenders under the senior credit facility, and declines in the value of such reserves as a result of sustained low commodity prices could reduce the amount available to be borrowed by the Company under its senior credit facility.
Because the value of its reserves are falling along with commodity prices, SandRidge's $900 million borrowing base on its credit facility could fall as well, which would impair future liquidity.
In addition to the fact that the company's current PV-10 value is $2.2 billion less than the value listed in its annual report, the asset side of the company's balance sheet might not reflect its true current value. The company pointed that out in its annual report when it said that "future price declines may result in reductions of the asset carrying values of the Company's oil and natural gas properties." Last year this forced the company to write down the value of $164.8 million in assets due to a number of factors, including weak oil and gas prices.
However, with oil and gas prices now materially weaker, the company could be forced to take more writedowns. As SandRidge said in the annual report:
If oil, natural gas and NGL prices fail to recover significantly in the near term, and without other mitigating circumstances, the Company will experience additional losses of future net revenues, including losses attributable to quantities that cannot be economically produced at lower prices, which would likely cause the Company to record additional writedowns of capitalized costs of its oil and natural gas properties and non-cash charges against future earnings. The amount of such future writedowns and non-cash charges could be substantial.
Put another way, the company may have been forced to make major writedowns in the first quarter because the value of its oil and gas properties has declined along with commodity prices. Depending on the size of the writedown, investors could become rattled and sell off the stock.
The writing appears to be on the wall that an asset writedown is coming in the earnings report. SandRidge Energy's assets are clearly not worth what they were when commodity prices were higher, and that is likely to take some value off the books. The big concern here as that a really big writedown could impact the company's borrowing base and therefore its liquidity, so this is something investors should monitor in 2015.
Matt DiLallo owns shares of SandRidge Energy. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.