OIL PRICE VOLATILITY – 2015 RESPONSE SERIES March 2015 Asset impairment Oil price decline: the impact of impairment. Since June 2014 we have seen oil prices dramatically decreasing, with analysts and industry leaders forecasting much lower oil prices than have been enjoyed in the last four years. The days of $110 per barrel appear a distant memory and expectations, for the medium term at least, appear to be concentrated around a $60 - $70 level. These market dynamics have recently been reflected in profit warnings, spending cuts, declining share prices and decreased asset valuations. Operating company prospective The deteriorating economics are also reflected in financial reporting. In the last couple of weeks we have seen preliminary Q4 and year end announcements from various super majors and large independents in the E&P sector. Nearly all of them addressed impairment of assets in their announcements and have collectively written down their balance sheet valuations by many billions of dollars. “In any case, the significant impairments announced in the sector so far indicate that management of oil and gas companies are being significantly more conservative about oil prices, particularly in the longer term’’ Our interviewees noted that although goodwill impairment testing is relevant in assessing how well an investment has performed, its relevance to the market is in confirming rather than predicting value. Between 14 January and 3 February 2015, we noted ten FTSE 350 Oil & Gas earnings announcements reported by Capital IQ. Eight referenced specific impairment charges as a result of the oil price decline, one referenced a non-specific impairment (under review) and one made no reference of impairment at all. Source: Capital IQ Impairment describes the scenario where the recoverable amount, of the assets of the company (either non-financial assets or goodwill), is lower than the balance sheet carrying values for those assets. The general premise is that the recoverable amount is the higher of the asset’s value in use (i.e. value to the company in its current state / use) or fair value, less the cost to sell (i.e. the value which could be obtained on a sale to a hypothetical third party). Companies are required to perform this ‘recoverability analysis’ either annually or when there is an indication of impairment, such as when the market dynamics affecting underlying values have substantially declined and this decline is expected to be prolonged. Shareholders' prospective Early in 2014 KPMG interviewed a sample of stakeholders to find out their views on goodwill impairment testing – its relevance, its effectiveness, the quality of disclosure and any shortcomings that should be addressed in future. The market reaction as highlighted by the relative share price movement ranged from adverse (-4.7%) to favourable (+2.8%). Comparison of share price reaction (% gain or fall) following impairment announcement 5% 4% 3% 2% 1% 0% 10-Jan -1% 15-Jan 20-Jan 25-Jan 30-Jan 4-Feb -2% -3% -4% -5% -6% Super Majors Large Independent E&P Source: Capital IQ © 2015 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Printed in the United Kingdom. Other 9-Feb Balance Sheet Impacts From a balance sheet perspective, impairment of assets would mean that overall value of the assets recorded on the books decreases and the change is likely to be more medium to long term in nature. In particular in relation to the impairment of long-lived assets we note the following: : Type of asset Licenses Issues to consider Approach to impairment In most countries, oil companies have the right to extract hydrocarbon resources in return for paying the government taxes, royalties or sharing the production with the state. These rights cannot typically be assigned or transferred without prior governmental approval, which can be difficult to obtain. In the UK (and most emerging markets) lenders are not able to directly take security over reserves and instead seek security over contractual rights, whether under license pursuant to the Petroleum Act 1998, a production sharing agreement, or a joint operating agreement. Under current IFRS pronouncement, licenses appear on the books at their fair value only when they were acquired as a part of a transaction. The level of impairment is therefore dependent on when the asset was acquired, the prevailing oil price at that time and the gap between that and the current price outlook. It is therefore common to have different levels of impairment across a single asset portfolio. In situations where a lender has taken security over the contractual rights associated In the US it is legally possible for an oil company to with the asset, a lower oil price outlook will own the underlying reserves and so the US (with other things being equal) in general lead domestic lending market is one of the few where it Source: WoodMac to an assessment of underlying asset value is possible to get asset-level security over the diminution. Note: Ratio of Upstream Enterprise Value to WM estimate of upstream NPV. Upstream Enterprise Value = Enterprise Value x percentage of earnings in last three years underlying oil or gas field. from upstream sector. Enterprise Value = average of Market Capitalisation in November 2014 + Q3 2014 reported Net Debt (or last reporting period). Data not provided for CNPC, Petronas, Pluspetrol and Property, plant PetroVietnam, Impairment ofSinopec. property plant and equipment is and equipment usually assessed on a cash flow basis. Goodwill For those operating assets in a sliding spot market, depressed day rates for equipment such as drilling rigs or vessels could imply the presence of a deteriorating cash flow outlook. Goodwill on acquisitions is tested for impairment at least annually or when there is an indication of impairment. Where the resulting NPV on a cash flow basis is lower than the carrying amount of assets then impairment is recognised. The size and probability of impairment is likely to be more significant on the acquisitions that happened during the period of rising oil prices. Financing considerations Potential impacts of impairment Significant value in exploration and production financing is linked to the earnings and cash flow potential of the company and its underlying asset base. Reserve based lending limits are derived from the expected present value of future production from the fields in question. These take account of factors such as: Impairment of assets is a non-cash charge but will have an immediate impact on the profit and loss account. That change may impact asset based covenants or covenant headroom. Given the long-lived nature of these assets, their impairment may also have a longer term impact on EBITDA and cash flow. estimated volume of reserves capital expenditure expected oil price fiscal regime discount (risk) rate hedging and coverage operational expenditure reserve tail Lenders review the limits on a bi-annual basis taking into account reduced price decks and factors but also risks associated with the asset. The impact of oil price decrease will take effect through next month when banks start in a number of cases revising their limits based on the new price decks. Contact for Oilfield Services Euan Tait Director T: +44 (0) 1224 416 804 E: [email protected] Contact for Exploration & Production Lyuda Sokolova Director T: +44 (0)207 6944826 E: [email protected] www.kpmg.co.uk Companies and their stakeholders should be looking at their P&L and cash flow as well as their balance sheet to identify potential impairment consequences under various oil price scenarios and start discussions early to adjust operations and financing structures to the changing price environment. © 2015 KPMG LLP, a UK limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. The KPMG name, logo and "cutting through complexity" are registered trademarks or trademarks of KPMG International. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. Produced by Create Graphics | CRT035462 | March 2015
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