Nowadays when I look at a company I ask myself:
- What would a good legitimate business look like?
- What would fraud look like?
This post attempts to answer question #2.
It does not seem to be illegal. As far as I know, nobody has gone to jail for it. The lack of consequences is a recipe for very high levels for fraud. Also, institutional investors don’t seem to catch on to the fraud that is occurring. They aren’t sophisticated enough to ask for more technical data on reserves: decline curves, well lives, the b-factor and dmin values (if Arps equations are used), etc. etc. The SEC will actually ask these sophisticated questions; they have done so in this 2011 correspondence letter with Chesapeake:
Your response to our prior comment seven also presents your projected time from first production to terminal production decline rate for the Barnett, Fayetteville and Haynesville shales. Please tell us the “b-factors” you used in determining these projected times and confirm, if true, that you used these decline parameter values in the estimation of your disclosed proved reserves in these respective shale reservoirs.
While the SEC has asked some surprisingly good questions, it does not seem serious about eliminating overly aggressive reserve estimates. It looks like the reserve estimation game will go on, though the people involved need to be careful. They need to make sure that their overly aggressive estimates are defensible and will stand up to questioning by the SEC. Shale companies are still allowed to report that some of their wells are expected to last 65 (or more) years, with a 90% chance that this estimate is on the conservative side.
For more information on how reserves can be inflated, see:
- http://www.ryderscott.com/Newsletters/911nsltr.pdf – explains issues with Arps equations in modelling shale gas reserves. A high “b-factor” and a low “dmin” value will inflate reserves.
- Study assesses shale decline rates
- Petroleum Truth Report has a very good blog post on the subject.
PDNPs – Proved developed non-producing reserves
Because shale gas wells are new, we have very little information on what their ultimate recovery will be. We don’t know if the fracturing process will last for decades. In theory, the “proppants” that hold the hydraulic fractures open may lose their effectiveness over time. We won’t know until decades from now.
We also don’t know if recovery techniques such as re-fracturing the well will improve well economics. There are a number of other secondary recovery techniques that may or may not also work.
What matters is this: the SEC seems to allow oil and gas companies to record PDNP reserves for shale gas wells. This means that an oil and gas company can simply assume that secondary recovery techniques will work. This allows reserves to be inflated even more.
Oil and gas accounting is a mess.
- It rarely helps investors understand how profitable their investments are. For example, income is rarely smooth. Many independent oil and gas companies report profits for years and then have a year or two with massive losses from impairments.
- Comparability is very poor. Aggressiveness in accounting varies widely.
- It is very complicated, which makes the preparation and auditing of financial statements more expensive.
To the sociopath, what matters is that there is a lot of room for deceptive accounting.
The effects of inflated reserves
Oil and gas companies depreciate their assets based on the units of production method. I believe that doubling the estimated reserves of an oil/gas asset will cut annual depreciation and amortization costs by half.
Asset retirement obligations will also be pushed further out into the future, lowering their net present value/liability.
The standardized measure and the SEC PV-10 value are based on estimates of the economics of the assets. These numbers will be inflated if the economic estimates are inflated.
Successful efforts accounting
This method is generally considered more conservative than full cost. However, there are ways to game the successful efforts method of accounting. If a well is a dry hole, you can simply pretend that it isn’t and that there is a chance that the well might be economic in the future. Because oil and gas is an open-ended problem, there is a very small chance that there is something that can be done to the well that would make it economic. So, you can use that as an excuse for not expensing dry holes right away. (However, eventually accounting rules will force the oil and gas company to impair the well.)
Full cost accounting and the ceiling test
With the full cost method of accounting, more costs can be capitalized than in the successful efforts method. However, there is a ceiling test rule that can force the capitalized costs to be written down. The simplified story is that the capitalized costs cannot exceed the (after-tax) net present value of the properties.
I’m not actually sure if the full cost accounting method is more aggressive than successful efforts for shale companies. With successful efforts, shale companies would avoid impairments from the ceiling test at the cost of having to impair dry holes. Because shale companies don’t drill that many dry holes, the successful efforts method might actually come out ahead.
Capitalization of interest and internal costs
Capitalizing expenses increases reported earnings and book value in the short run. (In the long run, the profits and inflated book value will be slowly reversed over the life of the producing assets. This is a very long period of time.) Obviously a sociopath would capitalize as many expenses as possible.
If an oil and gas company is involved in different plays, it is normal for some basins to be uneconomic. To figure out if a play is economic or not, an oil and gas company will usually ultimately end up drilling exploratory wells. If the results are good, these properties should be transferred over to proved/evaluated properties. If the exploration results are bad, the corresponding properties should be impaired. But there is a third option that goes against the spirit of the accounting rules. You can simply leave these assets in limbo, capitalize the cost of exploration wells, and have the properties remain “unevaluated”. Oil and gas is subjective. Management could prepare some excuse as to why the property might become economic in the future pending further investigation or some nonsense like that. Putting off these impairments will avoid losses in the short term, effectively increasing reported profits.
Some oil and gas companies have very high exploration costs capitalized into their unevaluated properties. The high cost suggests that exploration wells have been drilled and that the company has a pretty good idea that the play is not economic. If the exploration costs were lower, erhaps the company has only spent money on seismic and other initial stage exploration costs. Therefore it does not have a good idea of the play’s economics and the practice of keeping its properties classified as unevaluated would be legitimate.
The idea is to sell midstream assets at inflated prices and simultaneously enter into a contract for midstream services at inflated prices. This is basically an asset sale combined with a loan. For accounting purposes, you pretend that the whole transaction is an asset sale and that the midstream contract is fair. Because the whole transaction is an asset sale, you get to realize fake profits from erroneously classifying the loan as part of the asset sale.
General accounting tricks
There are some accounting tricks that would work for any company. For example, you could depreciate software over 25 years instead of a more reasonable timeframe. (The idea that a piece of software will last 25 years is pretty ridiculous.)
My post on mining has some other examples of general accounting tricks.
This game is all about cherry picking metrics that make the company look good:
- Production costs per mcfe. If you are aggressively capitalizing interest and G&A/internal costs, this metric will be inflated.
- $/acre of acreage sold. If you sell only your best land, then this figure will look great.
- Production growth, ignoring increases in share count and/or increases in debt.
- Initial well production rates from selected wells. These often have little to do with the overall economics of a play.
- Market cap/units of resources in the ground (e.g. Market cap / mcfe). If reserves are being inflated, then obviously this metric will also be inflated.
There are ways in which management teams can enrich themselves without having to disclose it in regulatory filings. Usually insiders (including their families and the board of directors) can enjoy private aircraft, expensive restaurants, sports games, and fancy hotels as part of a corporation’s “travel and entertainment” expenditures. Not all of these expenses have to disclosed in the DEF 14A filings and other regulatory filings.
Investors should pay attention to the level of G&A expenses relative to legitimate business expenses. Sometimes the excessive G&A is due to corporate waste. Sometimes it is due to paid stock promotion (these show up in the 10-Ks as “investor relations” expenses). Sometimes it is a combination of both.
Wheeling and dealing
There are opportunities in selling overpriced equity in oil & gas companies, royalty trusts, and midstream companies.
There’s probably a reason why short sellers are paying very expensive borrows to short some of the royalty trusts IPOed in the past few years.
One idea is to sell flawed properties to investors who don’t understand the flaws. As far as I can tell, there aren’t too many flawed properties in the oil and gas world compared to mining. Oil and gas assets in Egypt, Argentina, etc. are flawed due to the political risk. Other reserves are stranded in areas without the right infrastructure to properly process or transport/export the hydrocarbons.
Another idea is to take on oil and gas projects which won’t have cash flow until years later. Deepwater E&P has lengthy timelines and resembles mining in some ways. The projects have high risk and can take several years before they come into production. A stock promoter can sell inflated promises about the future. It will take years before investors realize that these projections about the future were overly optimistic.
The majority of the promotions in the independent oil and gas sector don’t have promotion-friendly properties. Many of them are involved in the hype surrounding shale gas and shale oil. Because shale wells can be built quickly, a promoter can’t make too many outrageous promises about them. The wells should come online within a few years and demonstrate cash flow (or a lack of it). One way around this problem is to constantly be growing. When a company is rapidly expanding, it is difficult for investors to figure out the cash flows and economics of the old assets. As well, problems with aggressive accounting are pushed further out into the future.
What to do when the proverbial excrement hits the fan
Not all oil and gas promotions end badly. Some of them have good management teams that actually create value. Some of them manage to gracefully exit their promotions by selling the whole company to an idiot buyer. Foreigners may wrongly assume that the reserve estimates of American and Canadian companies can be trusted. After all, the rule of law in first-world countries tends to be much stronger than those in China and other emerging economies. When the company gets too big and it is too hard to keep the pyramid scheme portion of the company going, smart management teams will try to sell their companies to people who don’t know any better.
But not all managers are born with skill. Some management teams will run their company into the ground. One common pattern in the independent oil and gas sector is that a company will take on debt to fuel its growth. Unfortunately, debt is dangerous. Some of these companies will become increasingly distressed and will need to find new sources of capital. Selling shares is almost always ideal but is not always an option. Here are some alternative sources of capital:
- Issue convertible debt. Whereas normal debt pays interest in the form of cash, convertible debt pays some or all of the interest in the form of call options on the company’s shares. The call options can be seen as a very cheap way of performing a secondary offering without all of the underwriting fees and the discount on the shares in the secondary offering. If the call option isn’t exercised, then the E&P effectively has debt with a very low interest rate.
Historically, promotional Wall Street darlings tend to continually issue stock. When they can’t issue stock any more, they start to issue convertible debt. If the convertible debt falls a lot in price, the company is now really in trouble and can’t sell any more convertible debt or normal debt. It may enter bankruptcy soon.
- Volumetric Production Payments (VPP). I actually think that VPPs might actually make a lot of sense for the buyers. The buyers receive a yield on the investment as they can get paid to take on counterparty risk. The buyers are also exposed to fluctuations in commodity prices. This may be very desirable for investors who would otherwise buy commodity futures or exchange-traded products such as UNG and GLD (products that don’t have yield). In practice however, it seems that most buyers of VPPs try to hedge the commodity price risk. If we erroneously assume that the hedges are perfect, then the buyers are effectively buying debt in a company. For a distressed E&P company, VPPs can be attractive because it allows the company to issue very expensive debt. Investors may not figure out that the debt is expensive and that the effective cost of capital is very high.
- Give overriding royalty interests to your suppliers. This is one of the things that ATPG did before it went bankrupt.
What investors should do to avoid being scammed
Investors should pay attention to red flags. Investors should probably stay away from companies that continually sell stock. They should be extremely wary of any company that is effectively paying more than 10% to borrow money. A high cost of capital is a sign of a very distressed company. Companies borrowing at 10% or more likely will not generate returns that beat their cost of capital. They are candidates for a death spiral.
On the reserve estimation side, investors should look for red flags:
- Does the company try to help investors understand the assumptions behind the reserve estimates? This almost never happens. Companies rarely state projected cash flows, decline curves, etc. etc.
- Does management have integrity? Do the reserve engineers have integrity? The answer is usually (or almost always?) no.
- What is the expected well life?
- Do the PDNPs make sense?
- What are joint venture partners saying about the economics of the JV assets? Independent E&P companies tend to be more promotional than their partners.
- What are other companies saying about similar assets?
- Does management have a history of overpromising and underdelivering?
- Does the company present at conferences held by Roth Capital, Rodman and Renshaw, or SeeThruEquity? Crappy promotional companies tend to be overrepresented at these conferences.
Furthermore, investors could look at state records for well production and build their own decline curves.
The big picture is that investors should stay away from this sector. Investors have virtually no defense against fraud. There needs to be more integrity in the sector if shareholders are to make money. Investors should demand more transparency so that they can actually perform due diligence on their holdings.