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The Magic of Shales

Under the Securities and Exchange Commission’s (SEC) new rule for oil and gas, companies have been allowed much greater freedom to book reserves. On the surface, there is a good argument to be made for expanding the definition of allowable booked reserves. But in practice, this may have opened the door to false valuations of shale assets.

The SEC currently allows companies to book reserves as proved undeveloped, otherwise known as PUD’s. This was not allowed under the old rules. So as a safeguard for investors, the SEC stated that such reserves must be periodically assessed to ensure their viability. In short, the SEC does not want a company to claim assets that it has no intention of ever truly developing. That would give a false financial picture. So the SEC mandated that PUD’s must be developed within 5 years and this is known as the “5 year rule”.

Unfortunately since the rule change went into effect, anomalies regarding these PUD’s have cropped up at a rather alarming rate. In addition, it would appear that there have been some discrepancies as to reserves that were booked but perhaps should have been removed and rightly classified as contingent resources rather than PUD’s. And yet they weren’t.

And this is where the story gets interesting. The reason they may not have been re-classified as contingent resources is that this would have put some companies into default.

Interestingly, this phenomenon may have played a role in the recent massive impairment charge at BHP Billiton (BHP) on its US shale assets. BHP bought assets from Chesapeake Energy and PetroHawk. In the case of the Fayetteville assets bought from Chesapeake, over 50% of the purchase price was written off as an impairment within a matter of mere months by BHP.

How could this happen?

BHP claims they did thorough due diligence on the assets and the impairment is strictly due to the drop in the price of natural gas. But there is another possible scenario. And unfortunately it isn’t peculiar to the deal involving BHP. It is endemic to shales.

Suppose you have a company that is highly leveraged whose wells are underperforming. Cash flow, therefore, is negative. Such a company would have a serious problem because it desperately needs continued access to the capital markets to keep operations going. It can’t do it from cash flow. So how does management get access to funding? They book reserves…aggressively.

This keeps them from debt breach.

And interestingly, if the SEC had not changed the rules, it would have been much more difficult to engage in this exercise simply because the reserve definition was greatly expanded to include PUD’s. As it turns out, as much as 40% or more of booked reserves at some shale companies, including PetroHawk and Chesapeake, are actually PUD’s which weren’t allowed under the old rules.

Another aspect to this story may have been serendipitous for cash strapped operators. Since the rules for oil and gas were new, there was no precedent as to how they should be applied by operators. A certain amount of time was needed for the SEC to get a handle on just how the new rules would be applied.

It didn’t take long.

According to Ryder Scott in late 2011, 80% of the top 10-K oil and gas companies were issued comment letters by the SEC for anomalies in their public filings. Further, only 16% could show with reasonable certainty that their PUD’s would be developed in 5 years. That meant that 84% of the companies were not in compliance with the new SEC rule. In fact, some companies were apparently declaring PUD’s that were described as “mathematically impossible”.

According to company filings, the number of years shale companies would need to develop their PUD’s turns out to be significantly greater than 5 years.

According to the Oil and Gas Financial Journal:

Devon Energy. 9.1 years
Range Resources. 11.8
Chesapeake Energy 13.1
Apache Corp. 15.1

And just for a little comic relief:

W&T Offshore. 104.56

Not one of these companies is in compliance with the 5 year rule.

Equally problematic is that fact that such PUD’s accounted for nearly half of all reserves at companies like Chesapeake and PetroHawk. These are assets that according to company SEC filings would take almost 3 times longer than allowed to develop. So it raises the question, just how viable are such assets? And can an investor truly get a real picture of this company’s prospects and financial health? In a sense, it could be argued that this is the equivalent of smearing Vaseline over a camera lens. You can discern shapes but that is about it.

Now to go back to our original scenario, suppose this company has been aggressively booking PUD’s to maintain access to the capital markets. It still has extraordinarily high leverage. In fact, the leverage has even been increasing although the price for natural gas has tanked. Theoretically, how could one continue to finesse the economics?

It is really quite simple.

Let’s presume that you aggressively leased acreage in a play and then equally aggressively apply a public relation campaign to tout the enormous potential. (Note that the word aggressive is appearing on a regular basis). You drill a few wells and “prove up” the acreage. Only no one really knows at this point whether the wells are actually economically viable. Because under the new rule changes, the SEC does not require independent third party verification of reserves. (But even this would not be a fail-safe because, let’s be honest, who wants to bite the hand that feeds you if you are a reservoir analyst?). So if a company and it’s management are aggressive, they book these reserves. Indeed, we know now that they have significantly overbooked reserves.

But just as important, something else almost magical has happened. Because the acreage is now supposedly “proved up”, suddenly its value has increased. In some cases these companies begin to look for a buyer immediately to flip the acreage for multiples of its original cost based on this perceived rise in value.

But exactly what is it that underlies this rise in value?

The answer to that may be nothing more than smoke and mirrors.

Fast forward to third quarter 2012. What have we seen? A frenzy of asset sales and appalling impairment charges. Setting aside the public relations hoopla, if these assets were generating positive cash flow, these operators would not be selling. They wouldn’t need to! If they saw long term positive cash flow from their portfolio of wells, they could continue operations. Clearly they do not see this. So why should an investor assume it? At present, the only way some of these companies have been able to generate cash is through asset sales. Something is clearly very wrong here.

PetroHawk and Chesapeake appear quite “lucky” to have found a suitor. Perhaps so was XTO. Exxon Mobil has certainly taken a hit on its shale assets. This information has been conveniently buried within its massive balance sheet but it is there nonetheless.

The Financial Times wrote of a “sleight of hand” in shale company financials several years ago.

Bloomberg’s headline in January 2012 attests:

“U.S. shale bubble inflates after near record prices for untested fields”.

It is certainly magic when you can pay a few hundred dollars for a lease, drill a handful of wells and proclaim that the field is “proved up” and flip it for $25,000 an acre.

But there is another word associated with magic…it is “poof".

What do you think? Leave a comment below.

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