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Financial Reporting Impairment Considerations for Oil and Gas Companies in the Low-Price Environment

The decrease in oil demand as a result of the COVID-19 pandemic, along with the worldwide pendulum of supply and demand, has put many energy companies in financially difficult positions, including evaluations of operating efficiencies of their overhead and capital development projects, as well as constraints on cash flow and liquidity concerns with credit facilities or other sources of financing. 

Accounting for the financial reporting effects of these events and circumstances should be considered whether reporting on quarterly results or evaluating year-end financial statements.

When the pandemic first began shaking up the global economy, many public companies had limited information to quantify the financial impact on their operations, either through quarterly reporting or annual reporting. 

Now that the dust has begun to settle and prices are showing signs of stabilization, albeit at depressed levels, energy companies need to continue to evaluate the longer-term impact of lower commodity pricing environments and the impact of financial reporting. 

For energy companies preparing quarterly financial reports or considerations for year-end reporting, here are some areas to consider:

Impairment and Recoverability of Assets

When evaluating oil and gas assets for impairment, management needs to consider whether circumstances related to the lower priced commodity environment represent indicators that an asset may be impaired. Evaluating oil and gas assets for impairment falls under ASC 360-10-35 (Reg S-X 4-10 for full cost method companies), which includes proved properties, equipment, facilities and would include any midstream operations such as processing plants, pipelines or related facilities. Unproved properties are evaluated for impairment under ASC 932-360-35. 

Proved Property

The first step for evaluating impairment is whether any events or changes in circumstances indicate the assets carrying amount my not be recoverable. Such events or changes may include change in regulation, revisions to reserve estimates, and lower than expected commodity pricing, among others. 

Successful Efforts Method

Under this method, impairment is evaluated by field first by estimating the undiscounted pretax projected cash flows, and risk adjusted probable and possible reserves maybe included in certain situations. Forward strip pricing curves are typically considered, along with management’s best estimates, for evaluating the reserve value. Companies should ensure that any completion or service costs, if they have had any revisions, are included in the net cash flows. If there are any indictors in which the asset’s carrying amount exceeds the undiscounted cash flows, discounted cash flows are typically used to determine the effect of the impairment charge to adjust the properties to fair value. However, other methods are allowed for management’s determination of fair value. 

Full Cost Method

Under this method at a high level, impairment is evaluated using the ceiling test approach for reserves at 12-month, first day of month SEC pricing, discounted at 10%, with the frequency being either on a quarterly or annual basis. With the current pricing model known for the first six months of 2020, a company would have a reasonable basis to determine whether there is an impairment or to expect an impairment based on the trailing 12-month SEC pricing average, along with expected pricing for the remainder of 2020. 

Proved undeveloped reserves, under either method, should only be included in reserve reporting for a development plan able to be drilled within five years, and companies need to consider whether they have the corresponding ability and access to capital to develop and include those proved undeveloped reserves based upon the current economic circumstances. 

Based on current West Texas Intermediate (WTI) pricing from January 2020 through June 2020, the SEC 12-month average pricing would be expected to range from ~$35/bbl to ~$40/bbl (considering six months of actual pricing and flat futures strip deck prices for the rest of 2020 at $35/bbl and $45/bbl).

For natural gas, Henry Hub (HH) pricing from January 2020 through June 2020, the SEC 12-month average pricing would be expected to range from ~$1.7/mmbtu to ~$2.1/mmbtu (considering six months of actual pricing and flat futures strip deck prices for the rest of 2020 at $1.6/mmbtu and $2.5/mmbtu).

Unproved Property

Unproved property is required to be tested at least annually for impairment to determine whether the book value is greater than current assessed value either at individual property basis or group basis, and an impairment should be taken. With decreased commodity pricing and expected delays or reduction in capital development plans, companies need to evaluate whether their unproved property is recoverable. 

These and other factors should be included in the evaluation of whether the unproved acreage should be impaired:

  • considerations of lease renewals and extensions 
  • other wells drilled in the corresponding area or on neighboring operators’ leases
  • economics 
  • considerations of any exploratory drilling in the area
  • changes in capital deployment plans 
  • the ability of access of capital to develop and extend current leases 

Midstream and Other Considerations

Midstream companies and energy companies that aren’t reserve based follow the guidance in ASC 360-10-35, whereas indicators are evaluated whether or not the asset’s carrying amount may not be recoverable. Companies should evaluate whether the carrying amount of their property, plant and equipment, typically using an undiscounted cash flow model if there are changes in pricing or timing of cash flows, supports the carrying basis of the property as recoverable. 

Also, energy companies with oil inventories, goodwill, equity method investments, accounts receivable and other intangibles should evaluate whether any indicators resulting from lower commodity prices would indicate an impairment for financial reporting purposes, in accordance with other corresponding GAAP treatment. 

Headline photo courtesy of Worksite LTD

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