Bleak oil price outlook signals severe impairment charges likely to continue throughout 2015 for North American E&Ps

Earnings outlook for the North American oil and gas sector further diminished by impairment charges

Lower oil, natural gas, and natural gas liquids prices are resulting in greatly reduced cash flow generation from North American E&P companies but depressed oil and gas prices are also resulting in significant impairment charges that are causing a widespread number of companies to report quarterly losses instead of profits. An elevated level of asset impairment charges (a write down in the value of an asset) in the first quarter of 2015 coupled with a bleak commodity price outlook for the rest of the year puts the sector on track to suffer the most asset impairments since 2008 when the gas-weighted producers took material charges following the collapse in natural gas prices. The large impairment charges taken by the sector will aid the critics who chastise the industry from failing to generate strong returns.

First-quarter 2015 impairment charges for the 66 companies in our IHS Herold Small, Midsized, and Large North American E&P peer groups exceeded the full-year 2014 total and the historical 10-year annual average for those groups. So far in the second quarter earnings cycle, the group has continued to report sizable impairments ($6.2 billion and counting) and we expect further significant impairments will be reported during the remainder of 2015 as the determining oil and gas prices used for the impairment ceiling tests continue to drop further.

The United States Securities and Exchange Commission (SEC) 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 undertaken using approximate prices of $95/bbl oil and $4.30/Mcf gas, as 2014's low year-end prices were buoyed by strong prices from the first 10 months of the year. First quarter of 2015 impairments were tested around $83/bbl oil and $3.90/Mcf gas and the determining prices for the second quarter fell to approximately $71/bbl oil price and $3.35/Mcf gas price.

Futures prices through year-end 2015 paint a bleak outlook and the expectation that we will continue to see major asset impairments through year-end. Using a combination of actual and futures prices, we project third-quarter 2015 prices will be approximately $60/bbl and $3.00/Mcf and year-end 2015 determining oil and gas prices as low as $53/bbl and $2.85/Mcf, 44% and 34% lower than year-end 2014, respectively. At this level, even with this year's cost reductions, the best areas of the best North American unconventional plays will be under stress.

In addition to commodity prices, factors such as future development costs and production levels are also taken into consideration. Recently reported cost reductions, which operators have generally guided to be approximately 15-30%, will offset some of the commodity price declines.

First-quarter 2015 impairments

The aggregate first quarter impairment expense for the group totaled $28.6 billion. To assess the impact of impairments, we adjusted for company size by calculating the impairments as a percentage of year-end 2014 net cumulative capitalized costs for proved and unproved properties. By this method, One mid-sized E&P took the most significant impairment charge, equal to 24% of its year-end 2014 capitalized cost. Four others in the group all took first quarter impairments equal to 20% or more of their year-end capitalized costs. One E&P of the four in its second-quarter 2015 earnings release reported an additional $245 million asset impairment, increasing its first-half 2015 impairments to $1,043 million, equal to 30% of its year-end 2014 capitalized costs while another E&P in the group took a second quarter impairment raising its total to 39% of capitalized costs.

Reserves also at risk of revisions

In addition to economic impairments, we expect to see negative reserve revisions with the most likely coming from proved undeveloped (PUD) reserves being downgraded to the probable reserves category at year-end 2015. We expect high-debt companies with a large portion of PUD reserves will be most at risk of proved reserve revisions, as the companies struggle to secure the financing for PUD development and are forced to curtail drilling. The SEC requires that companies with reserves booked as PUDs must plan to develop these reserves within a five-year period.

We plotted debt-to-total book capital as a measure of leverage against the percentage of year-end 2014 proved reserves that are undeveloped. Those companies in the top right quadrant, within the red bubble, possess higher debt and have a higher percentage of undeveloped reserves suggesting they are at risk for negative reserve revisions.

Negative reserve revisions will limit proved reserve growth for the group in 2015 and therefore likely result in poor reserve replacement cost performance. Proved reserves often are used as collateral for securing debt and obtaining bank loans. Reserve revisions and impairments will likely make it more difficult for companies to access additional debt and maintain current credit limits. With the likely tightening of bank lending, sustained low prices may result in E&Ps being forced to sell off assets to reduce debt and fund capital spending.

Returns have been weak

Despite strong oil prices in recent years, increased costs have squeezed margins and resulted in poor return-on assets-employed for the group. Asset impairment charges in 2015 will reduce net income for this year meaning that 2015 will be another year of disappointing returns. The group will likely enter 2016 with a smaller capital base and lower DD&A rate, which should lead to better returns in the longer term, but significant pain will need to be endured before this.

4 August 2015 by Paul O'Donnell, Principal Analyst

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This article was published by S&P Global Commodity Insights and not by S&P Global Ratings, which is a separately managed division of S&P Global.