The COVID-19 pandemic, market uncertainty, and a potential economic downturn have impacted crude oil and natural gas prices. These trends could have an adverse and material impact to companies in the oil and gas industry.
Oil and gas companies are facing many challenges that have forced changes in business plans, including shutting in wells, pushing out drilling and completion programs, stacking rigs, idling frac fleets, laying off personnel, shutting offices, and renegotiating debt, throughput, and other agreements. Oilfield service companies are being squeezed on demand as well as prices.
Liquidity issues are common with the exception being the well-hedged upstream company. It is difficult to obtain financing for projects and operations, borrowing bases under reserve-based loans are being lowered, and M&A activity is halted in most cases. Bankruptcies are increasing and consolidations within the industry are expected.
In light of the current environment, there are many accounting and financial reporting challenges for both public and private companies. The issues discussed here are not all-inclusive. Management and governance committees should consider that many of these potential implications may require companies to make significant judgments and estimates, which can be challenging in an environment of uncertainty.
Lower crude prices may result in Proved Developed Producing (PDP) reserves becoming uneconomic. In order to qualify for inclusion as Proved Undeveloped (PUD) reserves, the company must have an approved plan to develop the reserves within 5 years. In a period of delayed drilling, difficulty accessing capital and lower prices, many companies are losing PUD reserves.
A reserve reduction impacts both successful efforts and full cost companies through higher depreciation, depletion, and amortization (DD&A) rates as well as potential impairment implications for full cost companies as discussed below.
Oil and gas property impairments
Lower prices, delayed drilling, idling of existing wells, and liquidity concerns all impact impairment considerations for proved and unproved oil and gas properties.
Successful efforts — proved properties
Successful efforts companies will have a triggering event requiring an assessment of proved properties for recoverability under ASC 360. The properties are tested at the lowest level for which there are identifiable cash flows that are largely independent of the cash flows of other groups of assets, which is generally the field level. The impairment test contains two steps: first, the undiscounted future cash flows based on management’s estimates are compared to the carrying value. If this step implies an impairment, then the fair value of the properties is determined, and if this amount is less than the carrying value, an impairment is recorded. As a reminder, hedges cannot be included in the cash flows.
Fair value assumptions used in the reserve report to determine fair value must use market-based assumptions (not company-specific). In some cases, the company-specific assumptions are consistent with those of a market participant, but this determination must be supported. As a result, the fair value reserve report may be different than the company’s internal reserve report. In addition, the fair value assumptions should be consistent with other projections such as those used in determining the fair value of acquired properties and budgeting.
Full cost — proved properties
Full cost companies are subject to the full cost ceiling test as prescribed in ASC 932 and SEC Regulation S-X, Rule 4-10. The ceiling is based on projected cash flows for proved properties using the preceding first-day-of-the-month, 12-month average price, assuming current economic conditions (LOE, capital costs) continue and a 10% discount rate. Pricing based on this formula was not significantly impacted for the first quarter; however, subsequent decreases are expected to yield a lower price for the second quarter.
As a reminder, hedges accounted for as cash flow hedges can be considered in the test; however, hedges not accounted for under cash flow hedge accounting (marked to market) cannot be included.
As discussed earlier, the current economic conditions are causing a reduction in many cases of PDP and PUD reserves. As a result, even if the pricing used in the ceiling test is not significantly impacted, the reduction in reserves may result in a ceiling write-down.
Companies are required to assess unproved properties periodically (i.e., at least annually) to determine whether they have been impaired. The assessment of these properties is based mostly on qualitative factors such as intent to drill on the lease, results from other wells drilled in the area, and the remaining term on the lease if there is no intent to renew the lease. Unproved properties should be assessed on a property-by-property basis or, if acquisition costs are not significant, by an appropriate grouping.
Successful efforts companies record an impairment expense and an allowance within unproved properties, whereas full cost companies record the impairment through a reclassification to proved properties where the costs are subject to amortization.
Equipment and other long-lived asset impairment
Companies must also determine if there are impairment indicators for long-lived assets such as frac fleets, drilling rigs, midstream assets, other equipment, buildings, or finite-lived intangible assets. Assuming there are triggers in the current environment, then, similar to successful efforts proved property assessments discussed above, the two-step assessment under ASC 360 is required. Note that if the assets meet the held-for-sale criteria, the order of impairment testing differs.
Many upstream companies hold inventories of drilling and lease operating supplies and equipment. These inventories are carried at the lower of cost or net realizable value. Under ASC 330, the allowance for impairment should be assessed to determine if the carrying value should be impaired considering current drilling and operating plans and dropping market values.
Goodwill and indefinite — lived asset impairment
It is not as common in the upstream sector, but goodwill may have been recorded in prior acquisitions. If so, management should assess if there are indications that it is more likely than not that goodwill or an indefinite-lived intangible asset is impaired and if so, an interim impairment test is required under ASC 350.
Equity method investments
Many companies account for investments in upstream companies using the proportional consolidation method for joint ventures and certain qualifying equity method investments. For these investments as well as investments accounted under the equity method, management should assess if there are indicators that the carrying amount of the investment might not be recoverable. If so, these investments are required to be reviewed for impairment under ASC 323.
There are many tax implications associated with the current environment. In addition, there are specific implications to companies that have received Paycheck Protection Program (PPP) loans under the CARES Act. This discussion is not all-inclusive but addresses some of the more common considerations under ASC 740.
Management should determine if the forecasted future taxable income in the carryback or carryforward period has changed, as this will impact the deferred tax valuation allowance. In addition, interim reporting requirements under ASC 740 should be carefully reviewed.
Companies with foreign earnings face additional considerations related to their indefinite reinvestment assertion and the potential impact under ASC 740 on the deferred tax accounts. Management should ensure that the company can continue to assert its intent and ability to indefinitely reinvest foreign earnings if their operations in such countries have been affected by current market conditions. In addition, there may be U.S. tax consequences related to debt forgiveness and possible Section 382 limitations.
Debt redeterminations, modifications, and loan covenants
Many companies are experiencing reduced borrowing bases upon redetermination, which can impact the classification of debt and the required write-off of a portion of any debt issuance costs as a result of the decrease in borrowing capacity in a revolving debt agreement. Also, there may be negative liquidity implications from the related inability to maintain the current drilling budget and PUD support as well as going-concern projections and assessment.
As part of the redetermination process or upon the default under covenant requirements, the credit agreement may be amended. In these situations, management should first determine whether the amendment meets the definition of a troubled debt restructuring (TDR) if the lender granted a concession and the company was experiencing financial difficulties. If the amendment is not a TDR, management should then assess the amended debt terms to determine if the amendment should be accounted for as a debt modification or extinguishment under ASC 470.
Management should also consider if there are cross-default clauses in other contractual agreements that may be triggered under a default in the credit agreement.
Companies typically enter into derivatives to protect against commodity price volatility, interest rate increase, and foreign currency fluctuations. The hedges may be accounted for under hedge accounting, typically as cash flow hedges, or nonhedge accounting (called economic hedges in practice) where the derivative is marked to market in earnings. In all cases, the derivative is recorded at fair value on the balance sheet.
There are several considerations in the current environment of falling commodity prices and interest rates. Counterparty credit risk should be assessed in the current environment both for its impact on the fair value of the instrument as well as the collectability concerns if the hedge is in an asset position to the company. Below are some other specific considerations for commodity and interest rate derivatives.
Many credit agreements require a certain level of production to be hedged, and failure to maintain the required coverage can result in a debt covenant violation. As discussed earlier, covenant violations may result in the waiver being amended in the debt agreement. In the current pricing environment, many companies and lenders may not want to force new derivatives to be submitted to meet the coverage ratio. Management should be in discussions with their lenders to ensure that this issue is considered in a timely manner.
Under the International Swaps and Derivatives Association (ISDA) agreements, there may be acceleration or cross-default provisions that can be triggered if there are defaults under other agreements. This can even be the case if the counterparty is also the lender under a debt agreement. Careful review of the ISDA provisions should be performed to ensure that the derivative will not be forced to terminate.
Companies with asset hedge positions may decide to terminate certain positions to generate liquidity and fund required debt repayments or operations. There are accounting implications for hedges accounted for under cash flow hedge accounting as unrealized amounts must remain in Other Comprehensive Income (unless it is probable that the forecasted production will not occur by the end of the originally specified time period or within an additional 2 month period thereafter, except in rare cases) and be reclassified to earnings as the underling production is sold. Also, management should consider the tax implications of realizing the gains.
Management should also consider the income statement presentation of realized and unrealized gains and losses and possible tax consequences for noncash exchanges of commodity derivatives.
Interest rate derivatives
Similar to commodity derivative requirements discussed above, many credit agreements require a certain level of interest payments to be hedged, and if not, companies may have entered into hedges to protect interest rate volatility in variable rate loans. As interest rates have fallen, companies have recorded liabilities for receive variable/pay fixed rate interest rate hedges.
In some cases, lenders as counterparties, are offering “blend and extend” restructuring amendments for swaps whereby the swap’s term is extended, and the negative fair value of the original swap is rolled into the amended swap. This strategy is intended to lower the fixed swap payments in the short term as well as provide interest rate protection for a longer period. There may be accounting implications for both swaps accounted for as cash flow hedges and economic hedges not accounted for under hedge accounting. Careful consideration of the guidance in ASC 815 is required to determine if the restructuring results in the amended swap being accounted for as (1) a debt instrument with an embedded derivative component (which then may be eligible to be accounted for under the fair value option in ASC 825) or (2) a derivative with an other than insignificant financing element requiring cash settlements to be reported as financing cash flows in the statement of cash flows. There are also additional considerations for swaps accounted for as cash flow hedges.
Restructuring and other employee-related accruals
Many companies have unfortunately had to reduce their workforce and may contemplate further reductions. There are several potential accounting implications for management to consider:
- Exit or disposal activities should be accounted for under ASC 420.
- Employee benefits changes may require accrual in interim financial statements.
- Employee terminations may result in postemployment benefit obligations being incurred and if so, these costs are accounted for under ASC 420, ASC 712, and ASC 715.
- Employee terminations may impact share-based compensation awards through the exercise of puts or calls under ASC 718.
Lease concessions are common in this environment and may result in accounting treatment as a lease modification under ASC 840 and ASC 842 if the concessions are beyond the enforceable rights and obligations in the lease contract. The Financial Accounting Standards Board (FASB) issued a recent FASB Q&A on accounting for lease concessions related to COVID-19 that provides a reasonable approach in accounting for these lease concessions.
Ability to continue as a going concern
Management is required to assess whether there is substantial doubt about the company’s ability to continue as a going concern within one year after the financial statements are issued or available to be issued (Assessment Period), considering all the facts and circumstances that exist as of the date the financial statements are issued (or available to be issued) under ASC 205-40. Substantial doubt exists when conditions and events, considered in the aggregate, indicate that it is probable (meaning it is likely to occur) that the company will be unable to meet its obligations as they become due during the Assessment Period.
Obligations should be considered in the broadest sense and include all liabilities that are or will become due and payable within the Assessment Period. This includes debt obligations that are due on demand based on their contractual terms, or that will become callable due to provisions in the debt agreement, such as a failure to meet restrictive covenants as discussed earlier, which requires management to consider debt maturities and covenant compliance for periods after the balance sheet date.
Management should also consider potential cash outflows for off-balance-sheet commitments under contractual arrangements. Examples include take-or-pay arrangements, minimum volume penalties, obligations for wells consented to but not yet drilled, delay rental payments, shut-in royalties, anticipated employee severance, conditionally puttable equity instruments currently classified as equity (or mezzanine equity). Other considerations midstream companies face when projecting cash needs is the recognition of revenues on volumes that can be applied to future periods when under delivered and any payments due on easements.
The significant uncertainty in the industry related to commodity or service pricing, production or service levels, and debt covenant compliance, creates difficulties not typically encountered when applying the going-concern guidance. The significant uncertainty about future cash flows, will often require management to prepare multiple cash flow projections that reflect different assumptions about when and how multiple possible scenarios may play out.
If management concludes there is substantial doubt, the next step is the consideration of management’s plans intended to mitigate the adverse conditions or events identified in the initial assessment. When assessing management’s plans, events should only be considered to the extent that it is both probable the plans will be effectively implemented and that they will mitigate the conditions or events that raise substantial doubt within the Assessment Period.
These are unprecedented times for the industry and will require us to make complex and challenging judgments and assessments to ensure compliant, reliable, and informative accounting and financial reporting. The industry has faced and risen to significant challenges in the past, and will remain resilient in the future. “In three words I can sum up everything I’ve learned about life. It goes on.” — Robert Frost