IHS: Gloomy price outlook signals continued impairments for E&P operators

An elevated level of asset impairments in the first quarter of 2015 – coupled with a bleak commodity price outlook – is putting 2015 on track to suffer the most exploration and production (E&P) asset impairments of the past decade, according to a new report from IHS (NYSE: IHS).

First-quarter 2015 impairments for the 66 companies studied in the IHS Herold analysis of small, midsized, and large North American E&P peer groups totaled nearly $29 billion, exceeding the full-year 2014 total of slightly more than $25 billion and the historical 10-year annual average of more than $18 billion.

According to the IHS Herold 2015 Global Upstream Performance Review, a gloomy price outlook signals that severe, record impairments are likely to continue throughout 2015 for North American E&P companies. An asset impairment charge happens when an asset on a company’s balance sheet is being carried at a higher value than what it is currently worth. To recognize the lower value of the asset, the company has to write off a portion of the asset’s value.

“Prolonged depressed prices for oil is hurting many of the E&P companies and will begin to limit their borrowing options,” said Paul O’Donnell, principal equity analyst at IHS Energy and author of the report. “With proved reserves used as collateral for loans, E&P companies taking major write-downs in 2015 could have difficulty obtaining financing from their banks if prices remain depressed, and we expect significant impairments will be reported during the second-quarter earnings cycle because the prices used for ceiling tests have continued to drop. Though early in the second-quarter earnings cycle, we have already seen more than $20 billion in additional impairments reported by the group, which brings the year-to-date total to more than $49 billion and puts 2015 on track to blow the 2008 peak out of the water.”

O’Donnell said the ceiling test prices at the current futures strip price would drop to approximately $53 per barrel of oil and $2.80 per million cubic feet (MMcf) of gas at year's end.

The US Securities and Exchange Commission calculates the economics of proved reserves, using the unweighted, trailing 12-month average of the closing prices from the first day of each month. Year-end 2014 impairment tests were evaluated using a $94.99/barrel of oil prices and a $4.31 per MMcf gas price, with 2014’s low year-end prices buoyed by strong prices from the first 10 months of the year.

For the first quarter of 2015, impairments were tested using an $82.71 per barrel oil price and a $3.88 per MMcf gas price – still elevated compared with current market prices because the first-quarter calculation includes seven months during which exceeded $90 per barrel of oil and $4 per MMcf for gas.

Companies with a higher cost capital base, identified as those with high depreciation, depletion and amortization (DD&A) expense, and assets that are outside of core areas of the best plays are most at risk of significant impairment, the IHS report said.

Apache Corp., Devon Energy, and Chesapeake Energy accounted for 62% of the combined peer groups’ first-quarter impairment charges, the report said. Apache had a $7.2 billion price-related impairment charge, which was mostly tied to properties in the US, as well as assets in Canada and the North Sea. Devon and Chesapeake took price-related impairments of $5.5 billion and $5 billion, respectively, for US assets, though specific plays were not disclosed.

In addition to impairments, companies curbing spending may take reserve revisions. O’Donnell commented, “We expect operators with high debt and a large portion of proved undeveloped reserves will be among those most at risk of reserve revisions from the proved undeveloped to probable category.”

Impairments and revisions will limit proved reserve growth in 2015, the IHS report said. Additionally, large reserve write-downs and revisions will reduce the borrowing abilities of companies and a tightening of bank lending could force companies to curtail drilling or turn to asset sales to fund spending if their credit access dries up.

 “I think it is fair to say that companies that are constrained as far as borrowing is concerned, could be candidates for asset sales or corporate acquisition targets,” O’Donnell said.

But for those who can weather the discomfort of low prices, impairments and less than stellar returns, there is hope of a brighter future ahead. O’Donnell concluded, “Following the past several years of weak returns, reduction to the capital base and DD&A rates after impairment charges in 2015 could help companies achieve improved returns in the longer-term, but the sector must first endure significant pain.”

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