Hedge Accounting is Distorting the Reality of Oil and Gas Production Earnings

Yes, it has been some time since I have posted anything. What can I say? Life is busy!

OK, I was trained as an undergraduate accounting major, so I understand as well as anyone the desire to match liabilities with the period in which they are incurred. However, the accounting methods for hedging under SFAS 133 (“Accounting for Derivative Instruments and Hedging Activities”) often seem to do more damage than good. Let me explain why this may be a great time to look again at some compelling small-cap exploration and production company stocks. I am writing this entry for the benefit of some of my friends who aren’t experts in oil and gas accounting (neither am I), so pardon the rudimentary lesson, but it is important for investors in this sector to understand.

What some investors see in the most recent quarter (Q1 2011) for small and mid-cap oil and gas producers are large negative net income numbers. Casual observers then ask: “How come these companies aren’t making tons of money in this high oil price environment”. Or: “If they can’t make money at $105 per barrel oil, when can they”? Some of these companies were punished in the stock market after their most recent quarterly results (which unfortunately also came at a point when NYMEX oil prices have been dropping from their highs). So, I will make two very basic statements to start off here:

1) Most of these companies did NOT lose money this quarter, and

2) You have not yet seen $100 per barrel oil hit the income statements of most of these companies

What actually happened is that commodity hedging, and the accounting thereof, has made it harder to see the true earnings of oil and gas producers. Rather than smoothing out earnings, hedge accounting can make earnings significantly more volatile, and moreover, completely misrepresents how an oil and gas company thinks about hedging its risk and managing its budget. Contrary to what we want, in a very volatile oil price market, companies that have locked in fixed prices actually appear MORE volatile than their unhedged comparables.

I will start with the basics, creating an example with my fictitious “Dave’s Oil Company” (DOC). DOC produces 200 barrels of oil a day, and has confidence that production will remain for the next couple of years. So in the latter half of 2010, as oil prices were rising to over $90 per barrel on the NYMEX futures “strip”, DOC decided to hedge some risk by entering into an oil swap with a large derivatives dealer, covering half its production, or 100 barrels per day. A swap basically is a contract that says DOC will pay the other party if oil is above that level and the other party will pay DOC if oil is below that level. That swap allowed DOC to guarantee that it would receive $90 per barrel for 2011 and 2012, regardless of whether oil prices went up or down. If oil goes to $80, the other party pays DOC $10, DOC sells the oil for the market price of $80 and they have received $90 all-in. If oil goes to $100, DOC pays the other party $10, sells its oil for the market rate of $100, and in the end has netted $90 per barrel.

So, DOC has done something great for its investors, its budgeting process, and its lenders and other partners. It has established a future price for a portion of its production and reduced a certain amount of price risk. Since they only hedged half of their production (100 barrels per day of their 200 barrels per day production), they still have some exposure to the upside and the downside, but their volatility is cut in half. If oil drops to $40 per barrel, they will get an average of $65 per barrel (100 barrels at $40 and 100 barrels at $90), and if oil goes to $130, they will receive an average of $110 per barrel (100 barrels at $130 and 100 barrels at $90). In a world where oil might range from $40 to $130, they will only range from $65 to $110.

Now Q1 of 2011 rolls around, and let’s say oil goes to about $110 per barrel by end of quarter. DOC is selling its oil on the open market for $110 and paying the other party in the swap $20. They are netting that expected $90 per barrel for half of their production, and happy to be getting the other half at high market price of $110. Their average realized price after hedging is $100. Total revenue for the quarter would be:

Revenue = 91 days in the quarter X 200 barrels per day X $100 per barrel = $1,820,000

And let’s assume for the moment that they have something like a 20% pre-tax margin.

Pretax Income = Revenue of $1,820,000 X 20% = $364,000

Less a 40% tax rate would give us Net Income of $218,400

With 100,000 shares outstanding, EPS is $2.18

As a shareholder, you’d be happy about your beloved DOC selling oil at $100. Although they gave up some upside with the hedge, everyone sleeps better at night and they can better manage their business.

But WAIT… hedge accounting changes what you see on that income statement. DOC has made a commitment to pay the swap counterparty through 2012. According to the accounting rules, DOC has to recognize this liability. Hedge accounting says DOC must calculate the total value of all those barrels that will be sold at $90. If oil prices on the futures exchange now say that oil will be $110 for the next two years, DOC has to show what that number is. With 365 days in 2012 and 274 days remaining in 2011, it would look like this:

100 barrels per day X 639 days X $20 per barrel = $1,278,000

DOC records a hedge liability on its books (either as a liability or as a change in other comprehensive income in the equity section) and the offsetting entry goes on the income statement. OUCH! They record a “Loss on Derivative Instruments”) above the tax line for $1.278,000. WOW. That wipes out all their net income for the quarter. Heck, it’s almost as big as their revenue line! Now you see this income statement instead:

Revenue: $1,820,000

Pre-Tax LOSS = <$914,000> (that’s the $364,000 “normal” income less the $1,278,000 loss)

After a 40% Tax benefit: Net Income (Loss) of <$548,400>

With 100,000 shares outstanding, EPS is negative <$5.48>

That is the headline number: “Dave’s Oil Company Losses $5.48 per share in First Quarter”

Oh, sure, the company press release then says “adjusting for non-cash hedge accounting losses, the company made $2.18 per share. But the damage is done at the headline level.

More importantly, did the company actually LOSE that $1.2 million? I contend they did not. They have lost the OPPORTUNITY to sell at that higher price in the future, but they made that decision for good reason.

Here’s the next step: When second quarter rolls around, DOC will sell its oil on the open market at the going rate, let’s say it is still high at $110 per barrel. At that point, they record revenue at the market price of $110, and reverse the portion of the liability associated with the current quarter, offset that with a charge against income in the income statement, and the net of it makes it look like they sold the hedged oil at $90 per barrel. That is a good thing…trying to make the income statement look like the reality. However, DOC could just as easily NEVER recorded the liability and would STILL be recording the $90 per barrel currently on an after-hedge basis in Q2. I contend we should use some sort of contingent liability recording in the footnotes of the statements, but that what was done in the old days, and post-Enron, nobody likes this treatment.

But here’s what makes the current method really bad and volatile: If oil prices DROP in Q2 (like they have in 2011), DOC will reverse a large portion of that liability. Let’s say oil goes to $100 across the futures strip, so now DOC will reverse roughly half of what they recorded previously (except that portion associated with the now-past Q2 2011). For simplicity’s sake, let’s say that is roughly $600,000. The Q2 income statement would look like this:

Revenue: $1,820,000

Pre-Tax GAIN = $914,000 (that’s the $364,000 “normal” income plus the $600,000 gain)

After a 40% Tax: Net Income of $548,400

With 100,000 shares outstanding, EPS is $5.48

So, now you see the volatility I spoke of: Instead of recording two consecutive quarters of $2.18 in earnings per share, the company has recorded a $5.48 per share loss followed by a $5.48 per share profit. It still looks, to the unaided eye, that the company has made ZERO profit for the first two quarters combined. And importantly: contrary to what we want, in a very volatile oil price market, companies that have locked in fixed prices for longer periods actually appear MORE volatile than their unhedged comparables. The price volatility “around” the hedge gets recorded every quarter and whipsaws a small company’s recorded profits (but not their cash flow…and that is why you should look at cash flow instead of earnings).

You may also see why I contend many E&P companies did not lose money in Q1 (and please note the vast difference between oil-focused companies and those that produce mainly natural gas). You should also see why I said you haven’t yet seen the impact of $100 oil on many companies. Many of them are living with older hedges that have kept them averaging more like $75 to $80 in Q1. As the older hedges come to fruition and are replaced by higher-priced barrels, you will ultimately see higher average oil prices on income statements. Maybe I will post a separate blog on that subject…

In any case, if oil prices stay just under $100 through Q2, you will see large reversals of those liabilities and losses from Q1, resulting in non-cash gains to be recorded in Q2. The headline numbers will look much more positive in Q2 (July and August reporting dates). There may be some good deals to be had right now in oil-focused small cap E&Ps with large, attractive, hedge positions.

But don’t be fooled: hedge accounting is making it hard to look at headlines and bottom lines. As always, value and truth is found in between the lines.