Robert Rapier: Are Oil Companies Cooking Their Books?

Recently a friend and I were discussing the most recent quarterly results for certain oil and gas companies, and I pointed out that I was amazed that some are reporting solid free cash flow despite the plummet in commodity prices. He replied that the numbers are suspect, because in many cases companies are reporting negative income even as they report positive cash flow. He suggested that the discrepancy might be a result of “creative accounting,” so I decided to investigate. What I discovered was interesting, and worth sharing with readers.

First, let me define some terminology. Free cash flow (FCF) is a measure of the amount of cash generated by a company that is available for reinvestment or distribution to shareholders. It is one measure of a company’s overall financial health. Oil and gas companies that have been slashing capital expenditures over the past year, and have managed not to spend all of their cash flow should be among those best able to withstand several more months of low oil prices.

A company’s Standardized Measure (SM) is the present value of the future cash flows from proved oil, natural gas liquids (NGLs), and natural gas reserves, minus development costs, income taxes and existing exploration costs, discounted at 10% annually. The SM must be calculated according to specific guidelines set by the SEC. All oil and gas firms traded on a U.S. exchange must provide the SM in their annual filings with the SEC. It is a GAAP financial measure. (GAAP stands for generally accepted accounting principles, the most formal and inflexible set of rules for assessing a company’s finances.) The SM is calculated according to the average prices received over the past 12 months for oil, NGLs, and natural gas.

There are several ways to calculate FCF, but generally speaking the calculation begins with a company’s net income, adds back depreciation and amortization (because those non-cash costs relate to historical expenditures), adjusts for impairments to oil and gas properties (those non-cash impairments are applied against net income but not cash flow) and then subtracts interest paid, changes in working capital and capital expenditures:

FCF = Net income + Depreciation/Amortization + Impairments – Change in Working Capital – Capital Expenditure – Interest Costs

The reason for large discrepancies between FCF and income for some companies can often be found in the “Impairment” category. Since future cash flows are estimated on the basis of prevailing oil and gas prices, when prices are falling a company may have to take some oil and gas reserves off the books because they wouldn’t be worth extracting at prevailing prices. This results in an impairment, and it is charged against net income. However, this is merely a paper loss and it doesn’t reduce present day cash flow. Thus, in the FCF calculation, the impairment is added back to net income.

As an example, consider EOG Resources EOG -2.74% (NYSE: EOG), which is one of the largest oil and gas companies in the U.S. In Q3 2015 EOG reported net income of -$4.1 billion. However, for the same period the company reported FCF of +$1.8 billion — a discrepancy of nearly $6 billion. Is the company guilty of creative accounting? No, but let’s walk through the important financial measures to understand the reason.

At the end of 2014, EOG reported a standardized measure of $27.9 billion. But that was based on U.S. prices of $97.51/bbl for oil, $34.29 for NGLs, and $3.71/MMBtu for natural gas. The actual average price of West Texas Intermediate (WTI) in Q3 of this year was only $46.42 according to the Energy Information Administration. So EOG’s estimated future cash flows are now lower given the lower commodity price environment. As a result the company took an impairment of $6.3 billion in the quarter — nearly 23% of its previously estimated future cash flow.

EOG had net revenue in Q3 of $2.1 billion, and a cost of goods sold of $1.1 billion. But in calculating net income, the $6.3 billion impairment was applied. This was the single biggest factor in the $4.1 billion net loss EOG reported for the quarter. In calculating free cash flow for the quarter, the impairment was added back (as was depreciation). The reality is that EOG generated cash during the quarter, but the impairment means the outlook for future quarters is lower.

There are a number of other companies that similarly reported a large loss but positive FCF. There will be many more in a similar position following the release of Q4 results. In most cases, the explanation will be the impairment due to lower oil prices. It’s not an accounting trick, as these companies are generating cash in excess of what it took to operate the business. But a substantial impairment may change an investor’s appetite for a company given the potential impact on future cash flows.

Forbes