One of the main tools investors use to evaluate an oil and natural gas producer is the company’s net asset value (“NAV”). To calculate this, most investors use the discounted cash flow (“DCF”) method. The DCF on the asset side is fairly straightforward. Under National Instrument 51-101 (“NI 51-101”), reporting issuers are required to disclose their reserves’ engineering information in their Annual Information Form. Investors can take the reserves data, use their own commodity assumptions, and perhaps add the contingency resources and risked exploration upside in order to derive the asset valuation.

Evaluating the liability side is trickier than it seems. On top of the reported debts on the balance sheet, investors can find an item called the Asset Retirement Obligation (“ARO”), also known as decommissioning liabilities. These liabilities are related to abandonment and reclamation in the oil industry. At the end of the life of an oil well, the company is required to do “downhole” operations to treat the producing hydrocarbon formation properly. This minimizes the risk of future contamination, particularly to the ground water. Reclamation involves restoring the surface to proper environmental standards. Provincial governments in Canada have specific guidelines and requirements for these activities. The asset retirement obligation raises three main issues for investors that they ought to be aware of:

1. Reserves engineers do not evaluate the entire amount of the ARO. Reserves engineers such as GLJ Petroleum Consultants Ltd. and McDaniel & Associates Consultants Ltd. evaluate only the subsurface obligations, i.e., abandonment. Their evaluations do not include reclamation. In addition, the reserves report only includes wells that have assigned reserves. An oil company might have an inventory of inactive or suspended wells that might need to be abandoned in the near future. In the meantime, the company is still paying fixed costs such as property tax, but these wells are not included in the reserves report. In Alberta alone there are close to 80,000 inactive wells. On average, it takes $50,000 or more to abandon and reclaim a well, and this translates to at least $4 billion of liabilities for the industry. Therefore, ARO is a significant item to consider when calculating the NAV of the company.
2. A wide array of assumptions is used in the industry. Because the ARO might not be independently verified, the reported ARO in the balance sheet is heavily dependent on management’s assumptions. A survey of 70 listed issuers shows quite a bit of variance for the reported 2013 year- end results. The discount rate assumption ranges from 2.4 percent to 8.5 percent, and the ARO time frame ranges from 15 years to 60 years or more. While the time frame varies due to the nature of the assets, companies with similar assets can have quite different assumptions. The discount rate varies significantly because under International Financial Reporting Standards, a company is allowed to use either a credit-adjusted discount rate specific to the company or the government risk-free rate.
3. New regulations are coming. Provincial securities regulators are on top of this. In December 2014, the Canadian Securities Administrators published amendments to NI 51-101 that provide a more precise definition of ARO and increase the responsibility of the companies to disclose any significant amount of ARO. These amendments will come into effect on July 1, 2015. As such, investors will be able to see these changes when companies announce their 2015 year-end reserves in early 2016.

What it means for investors

What are the implications? As investors, we do not have the luxury of the full set of engineering reports to accurately calculate our own ARO for each company. However, some adjustments can be made, and the following is an example:

Taking Bonterra Energy Corp. as an example, the reported decommissioning liabilities in its 2013 balance sheet are $37 million. Note 14 of the financial statements says that the un-discounted decommissioning liabilities are $134 million, extended up to 50 years, yet Bonterra has a reserve life index of 17 years. Assuming that the existing assets will last twice as long, and that the abandonments are evenly spread out, a simple DCF model can be built. With these assumptions, the estimated decommissioning liabilities become $81 million, over 110 percent more than the reported number.

“Different assumptions used in evaluating asset retirement obligations make investors compare apples to oranges, without further analysis.”

In a more extreme example, Penn West Petroleum Ltd. reported decommissioning liabilities of $603 million in its revised 2013 balance sheet. The company is using a dis- count rate of 6.5 percent. Yet the industry norm is the government risk-free rate of around 3.2 percent for year-end 2013. After adjusting the discount rate, the decommissioning liabilities escalated to over $2 billion.

In summary, as noted above, investors do not have all the detailed information regarding the timing of the ARO spending. But all disclosures require companies to include the total un-discounted ARO, and the discounted rate as well as the time frame used. The oil and gas industry is aware of the issue, and it will be interesting to see whether the reporting issuers make any changes when the 2014 results are out. Plunging oil prices—from over US$100 per barrel to below US$50, and natural gas prices below US$3 per thousand cubic feet—will accelerate this problem further. Not only will the companies have less cash flow to spend on abandonments, but oil well production will drop below the economic threshold sooner because the netback is being compressed. With that, and before the new requirements come into place for 2015 year-end disclosures, an astute investor can adjust the 2014 numbers and be ahead of the crowd.