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North American E&P Impairments Eclipsing 2014 With 'Significant' Pain Ahead, Says IHS

An elevated level of asset impairments in the first three months of this year and increasing charges in the second quarter, combined with a bleak commodity price outlook, has put 2015 on track to suffer the most exploration and production (E&P) asset charges in 10 years or more, IHS Inc. energy analysts calculated.

An analysis of impairments taken in 1Q2015 by 66 small, midsized and large North American E&P peer groups totaled nearly $29 billion, versus slightly more than $25 billion for full-year 2014 and the historical 10-year annual average of about $18 billion.

The IHS Herold 2015 Global Upstream Performance Review found that the dismal oil and natural gas price forecasts also signal "severe record impairments are likely to continue throughout 2015 for North American E&Ps." An asset is impaired when it's being carried on a balance sheet at a higher value than it is currently worth. To recognize the lower value of the asset, the company writes off a portion of the asset's value.

"Prolonged depressed prices for oil are hurting many of the E&Ps and will begin to limit their borrowing options," said IHS Energy's Paul O’Donnell, principal equity analyst and author of the report. "With proved reserves used as collateral for loans, E&Ps taking major writedowns 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."

Apache Corp., Devon Energy Corp. and Chesapeake Energy Corp. by themselves accounted for 62% of the combined peer group's 1Q2015 impairment charges (see Shale DailyMay 7May 6aMay 6b). The trio also recorded hefty charges in 2Q2015 (see Shale DailyAug. 6Aug. 5aAug. 5b). Onshore operator Encana Corp. recorded $1 billion-plus impairments also in the first and second quarters, high but not nearly as much as the other three big E&Ps (see Shale DailyJuly 24).

"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.

At the current futures strip price, ceiling test prices would drop by the end of this year to about $53/bbl oil and $2.80/Mcf natural gas, he noted.

The U.S. 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 prices of $94.99/bbl oil and $4.31/Mcf gas. Last year's low year-end prices were buoyed by strong prices in the first 10 months of the year.

For 1Q2015, impairments were tested using prices of $82.71/bbl oil and $3.88/Mcf gas, still elevated compared with current market prices because the quarterly calculation included seven months when prices exceeded $90 oil and $4.00 gas, the report said.

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

Another worry: E&Ps that have reduced their capital spending may take reserve revisions in addition to the price impairments.

"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," O'Donnell said.

Expected limited proved reserves growth this year because of the writedowns and revisions, he said. Those large reserve writedowns and revisions also would reduce companies' borrowing abilities, while more stringent bank lending could force operators to curtail drilling or turn to asset sales to fund spending.

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

For E&Ps that are able to weather low prices, impairments and less-than-stellar returns, a brighter future may await, he said.

"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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