Calvetti Ferguson

Impairment – Delayed Reaction to Depressed Oil Prices

Impairment – Delayed Reaction to Depressed Oil Prices

As everyone is painfully aware, oil prices began to fall considerably in the 3rd quarter of 2014, a trend which continued through to the end of the year. The year-end price of NYMEX light sweet crude contracts had settled in the low-to-mid $50s – a significant contrast to the low $100s they had commanded early in the year. This raises the question: where were the impairments on the year-end 2014 financial statements? The short answer is that most were deferred to 2015, but that is just the beginning of what might turn into a long story.

In general, an impairment is recognized if the net book value of oil and natural gas properties exceeds the fair value, either discounted for full cost companies or undiscounted for successful efforts companies, of future net cash flows from proved reserves, including the effect of cash flow hedges when hedge accounting is applied, which is calculated using the unweighted arithmetic average of the first day of each month for the 12-month period ending at the balance sheet date. Impairments can be caused by a drop in fair value, among other things, which is what happened with the 2014 oil prices.

Prior to 2010, the current price used in reserve reports for financial reporting purposes was the price on the last day of the year. This method would have put the current price in the low $50s for 2014, resulting in an impairment for a lot of oil and gas companies. However, when prices became more volatile in the mid-2000s, more and more people felt that this was not an accurate measure for estimating reserve quantities for financial reporting purposes. As this price is used for calculating DD&A and impairment analysis, there was a need for a pricing methodology that would reduce the effects of short term volatility and seasonality. As a result, in 2009 the SEC came out with the Modernization of Oil and Gas Rules which were adopted by the FASB. The Modernization Rules mandated that the prices used in the reserve reports for financial statement purposes at the end of each reporting period would be the average of the prices on the first day of each month during the 12-month period before the ending date of the period covered by the report (i.e. the 12-month average price).

Using the 12-month average means that the current price was in the low-to-mid $90s for the 12-month period ended December 2014 and thus significant impairments were not triggered even though it was well known by March 1, 2015 that the 12-month average price used for Q1 2015 was going to be lower than the 12 month average price used for Q4 2014. Many of these impairments were recognized in Q1 2015, however the continued depression of commodity prices is resulting in still further impairments in Q2 2015, even for companies that already took an impairment in Q1.

In addition to being able to defer impairments on oil and gas properties held, companies using the full cost method of accounting for oil and gas properties are able to defer their loss on the sale of properties even when they are selling those assets below their carrying value. Under the full cost method, no gain or loss is recognized on the sale of oil and gas property – there is just a reduction in capitalized costs. The exception to that rule for full cost oil and gas companies is if the sale of the properties significantly alters the relationship between capitalized costs and proved reserves. Based on SEC guidance, a significant alteration occurs when 25% or more of reserve quantities for a given cost center are sold. If gain or loss is recognized on the sale, total capitalized costs within the cost center are allocated between the reserves sold and the reserves retained which could end up being a complicated calculation due to the difficulty in arriving at a fair value for the properties retained.

With oil prices only in the mid-to-upper $40s at the end of July 2015, be assured that we will continue to see impairments recognized in Q3 2015 as the 12-month average continues to slide. If commodity prices remain depressed, or worse, fall further, public companies should consider disclosing in their most recent MD&A what the subsequent pricing trends are and note that further write downs are possible in the near future. Impairments will likely continue to occur through Q4 2015 since future price changes are allowed to be considered in reserve report pricing for financial statement purposes only to the extent provided by contractual arrangements that are in existence at the reporting date.

So while saying that many impairments on year-end 2014 financial statements were deferred to 2015 is a truthful short answer, it does not tell the whole story. As long as oil prices remain low, we will continue to see impairments, which will have a great impact on many companies – especially smaller ones. In the end, it may be Q1 2016 or even later before we realize the full impact of the 2014 oil price drop.

If you have any questions regarding impairment or any other audit-related topic, please contact Erick Wegmann at EWegmann@calvettiferguson.com

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