O&G - Accounting and 3-Statement Model Flashcards
Explain the differences between successful efforts and full cost accounting.
The only difference is that unsuccessful exploration is expensed for a successful efforts company but it’s capitalized and added to PP&E for a full cost company.
The successful exploration expense is always capitalized under both standards. That seems simple, but it leads to many consequences on the financial statements:
• Operating income, net income, and PP&E are usually lower for successful efforts companies and higher for full cost companies.
• However, full cost companies have higher DD&A expenses and more frequent write-downs and impairment charges because they always need to “reset” the value of their PP&E to fair market value (the so-called “ceiling test”).
Outside the US, successful efforts vs. full cost is less of a concern because IFRS limits the application of full cost – so most companies use successful efforts and you don’t have to worry about normalizing anything.
So why would a company ever want to use successful efforts accounting? It seems like full cost accounting is much better in terms of net income and therefore EPS.
This statement is not necessarily true. Yes, full cost companies often have higher operating incomes and net incomes, but high impairment charges may reduce both of those and actually make them lower.
For example, if commodity prices suddenly dropped a full cost company would have to record an impairment charge to reflect that – and so its operating income and net income might fall by quite a bit.
In general, small and startup companies prefer the full cost method and larger and more diversified companies use successful efforts because it’s easier for the larger companies to absorb the unsuccessful exploration expense.
But again, it’s a trade-off: a full cost company could easily end up with massive impairment charges that result in lower net income, EPS, and PP&E.
Let’s say a successful efforts company has a successful exploration expense of $100 and a dry hole, or unsuccessful exploration, expense of $100. Walk me through how the 3 statements change when we record these expenses.
On the income statement, operating income falls by $100 because of the unsuccessful exploration expense. Assuming a tax rate of 40%, net income is down by $60.
On the cash flow statement, net income is down by $60 so cash flow from operations is down by $60; the successful exploration expense of $100 is recorded under cash flow from investing, so that is down by $100 and the net change in cash at the bottom is down by $160.
On the balance sheet, cash is down by $160 but PP&E is up by $100 because of the $100 in additional successful exploration expense, so assets are down by $60.
On the other side, shareholders’ equity is down by $60 because of the $60 decrease in net income, so both sides balance.
Now let’s say they become a full cost company with the same expenses. Walk me through the 3 statements once again.
There are no changes to the income statement for a full cost company. On the cash flow statement, cash flow from investing falls by $200 because both the successful and unsuccessful exploration expenses are capitalized, and so cash is down by $200 at the bottom.
On the balance sheet, cash is down by $200 but PP&E is up by $200 because of the capitalized exploration expenses, so neither side of the balance sheet changes and it remains in balance.
I’m looking at a successful efforts company’s cash flow statement right now, and they’re adding back the dry hole expense in cash flow from operations and then counting it as part of their CapEx under cash flow from investing. Why are they doing that?
There is inconsistent treatment of the dry hole expense among successful efforts companies – according to the accounting rules, you should not show the expense on the cash flow statement at all.
But in real life, some companies actually add back the expense under cash flow from operations and then subtract it out again under cash flow from investing, therefore capitalizing it and adding it to their PP&E number.
Unfortunately there’s no rhyme or reason to this – it’s just an inconsistency and something you have to be aware of when analyzing the financial statements.
How do successful efforts and full cost accounting apply to mining companies?
Similar to the question above, many mining companies use a method that’s in between successful efforts and full cost.
The exact rules are company-dependent, so you have to go by what they say in the financial statements and follow whatever standard they’ve been using.
Let’s say we’re comparing 2 companies, 1 that uses successful efforts and 1 that uses full cost. How can we normalize EBITDA to make the numbers truly comparable?
Similar to the EBITDAR metric for airlines and retail companies, you can calculate EBITDAX – Earnings Before Interest, Taxes, Depreciation/Depletion, Amortization, and Exploration – by adding the Exploration expense on the income statement to EBITDA.
For full cost companies, EBITDAX is the same as EBITDA because they don’t record an Exploration expense on their income statements at all – but for successful efforts companies EBITDAX will always be higher.
If you did not do this, EBITDA would seem higher for full cost companies – but that reflects different accounting standards rather than actual cash flow.
Walk me through what happens on the 3 statements when the asset retirement accretion expense goes up by $100.
The asset retirement accretion expense relates to the asset retirement obligation, a liability on a natural resource company’s balance sheet – it reflects how much it will cost to shut down the mines or oil/gas fields of that company in the future.
If the expense goes up by $100, operating income on the income statement falls by $100 and net income falls by $60 assuming a 40% tax rate.
On the cash flow statement, net income is down by $60 but the asset retirement accretion is a non-cash expense, so you add it back and cash at the bottom is up by $40.
On the balance sheet, cash is up by $40 so total assets are up by $40; on the other side, the asset retirement obligation is up by $100 but shareholders’ equity is down by $60 due to the reduced net income, so both sides are down by $40 and the balance sheet balances.
Let’s say we’re looking at an energy company that uses derivatives for hedging purposes. They record a realized gain of $60 and an unrealized gain of
$40. Walk me through the 3 financial statements.
On the income statement, you record both the realized gain and the unrealized gain, so operating income is up by $100 (normal companies may list these under pre-tax income, but for energy companies they are usually part of operating income). Net income is up by $60 assuming a 40% tax rate.
On the cash flow statement, net income is up by $60 but you subtract the unrealized gain because it’s non-cash, so cash is up by $20 at the bottom.
On the balance sheet, cash is up by $20 and the derivatives line item on the assets side is up by $40 due to the unrealized gain, so total assets are up by $60. On the other side, shareholders’ equity is up by $60 because of the net income increase, so both sides balance.
Why do energy and natural resource companies have high deferred tax expenses? How can we estimate them in a model?
They have high deferred income tax expenses because they have high PP&E balances and they depreciate PP&E differently for book and tax purposes – that difference creates deferred tax liabilities (DTLs) or deferred tax assets (DTAs).
You could attempt to estimate these differences, but it’s almost impossible unless they give you detailed numbers for everything – so you usually just assume a
percentage for current income taxes and a percentage for deferred income taxes, based on historical averages.
What are common non-recurring charges and add-backs for energy and natural resource companies?
When you’re calculating EBITDA and EBITDAX, there are the usual DD&A, Stock-Based Compensation, and Restructuring-type items to add back.
But there are also a couple of industry-specific items:
- Asset Retirement Accretion (a form of amortization)
- Non-Cash or Unrealized Derivative (Gains) / Losses (appears on the cash flow statement)
- Impairment Charges and PP&E Write-Downs (more common with full cost companies)
- (Gain) / Loss on Sale of Assets (appears on the cash flow statement)
- Environmental Remediation
You have to be really careful when adding back these charges because sometimes companies embed these items in DD&A and sometimes they list the expenses separately – read the footnotes.
How do you take into account the uncertainty of commodity prices when projecting revenue for a natural resource company?
You create scenarios for different prices – for example, you might have a low, base, and high case and assume $40 per barrel of oil in the low case, $70 in the base case, and $100 in the high case.
Generally you assume that the prices stay the same each year, i.e. that it’s $40 per barrel in years 1 through 5 of the low case. Otherwise it gets confusing to assess the impact of different prices on the model.
Why might a natural resource company use hedging, and how do you incorporate it into a 3-statement model for the company?
With hedging, a company uses derivatives to provide “insurance” against a sudden drop in commodity prices.
For example, if oil is currently at $70 per barrel the company might buy contracts that guarantee it the ability to sell oil at $50 per barrel as downside protection.
Then, if the price drops to $40, they can still sell their oil at $50 and revenue won’t drop as much.
The downside is that if oil prices jump to $100 per barrel the company won’t realize the full benefit because they paid many for those contracts that are now worthless – so their average realized price (including the cost of the contracts) might be $90 instead of $100.
You could try to use the actual numbers for derivatives, but in an operating model it’s more common to use simpler percentages and to assume a % increase over market prices in the downside case, and a % decrease below market prices in the upside case.
In addition to hedging, you also have to take into account the differential between market prices and realized prices – so the complete formula for revenue would be Annual Production * Average Market Price * Price Differential * Hedging Percentage.
Hedging seems like a good idea to smooth out a company’s revenue – why do many natural resource companies, especially large ones, choose not to use it?
Because of the downside pointed out above: that if commodity prices rise, the company would not realize the full benefits.
Large, multi-national companies like Exxon Mobil tend not to use hedging at all because they produce so much energy that hedging wouldn’t even be effective: there are not enough derivatives available to cover all their production.
How do you determine which expenses on the 3 statements are linked to Production and which are not?
Usually companies point this out explicitly in their filings by saying that certain expenses “trend with production.” If they don’t list that, just think through which expenses would depend on energy/mineral production:
- Production Expense
- Sales Taxes
- Transportation
- Depreciation, Depletion & Amortization (DD&A)
- Accretion of Asset Retirement Obligation
The first 3 are dependent on how much is extracted, transported, and sold, so they are linked to production; DD&A is also linked to production because each unit produced depletes the company’s reserves. Each unit produced also makes it more expensive to shut down the operation in the future, which explains the asset retirement accretion.
G&A, Capital Expenditures, and the Exploration expense could go either way but generally they will be linked to Production as well: the more a company produces, the more employees it needs and the more it needs to spend to replace its depleted reserves.
Stock-Based Compensation, the Derivative Fair Value Gain or Loss, Impairment and Restructuring Charges, and Interest Expenses should not be linked to production because they are not directly correlated. They will be linked to revenue, based on historical averages, set to 0, or dependent on other schedules (interest and debt).
