Oil Prices are Low:
Are You Impaired?
Shishir R. Khetan, CFA – skhetan@srr.com
Naveed Yahya, CFA – nyahya@srr.com
J. Paul Getty, a renowned American industrialist, famously
half of 2014. The second half of 2014 and the beginning of
quoted “Formula for success: rise early, work hard, strike oil.”
2015 has been a completely different “story” as it relates to oil
Numerous individuals and companies have followed Mr. Getty’s
prices. Since reaching $107.62 per barrel on July 23, 2014, the
advice and have built substantial fortunes striking oil. The oil
WTI crude oil price has declined precipitously, reaching $53.27
and gas industry, particularly in the U.S., has been one of the
per barrel at year-end 2014 and $48.66 per barrel at the end of
“shining stars” as the American and global economies recovered
March 2015. Similarly, the price of Brent crude oil has declined
from the recession in late 2008. While oil prices dipped during
from $109.63 per barrel on July 1, 2014, to $58.21 per barrel at
the recession, the recovery in prices was relatively quick with
year-end 2014 and $54.36 per barrel at the end of March 2015.
the West Texas Intermediate (WTI) crude oil price averaging
The following graphs present the WTI and Brent crude oil prices
$96.45 per barrel between the start of 2011 through the first
since the beginning of 2011 through March 2015.
Chart 1 – Daily WTI Prices
Chart 2 – Daily Brent Prices
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Dollars per Barrel
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3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/
/0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0
01 03 05 07 09 11 01 03 05 07 09 11 01 03 05 07 09 11 01 03 05 07 09 11 01 03
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3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/ 3/
/0 3/0 5/0 7/0 9/0 1/0 1/0 3/0 5/0 7/0 9/0 1/0 1/0 3/0 5/0 7/0 9/0 1/0 1/0 3/0 5/0 7/0 9/0 1/0 1/0 3/0
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Source: Bloomberg
Source: Bloomberg
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©2015
Chart 3 – OSX (Oilfield Services)
The substantial decline in oil prices has resulted in
significant implications for oil and gas companies
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and businesses tied to the commodity. Several
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“bell weather” companies in the oil and gas industry
have cut capital expenditure budgets for 2015 and
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announced
Index Value
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workforce
reductions.
Schlumberger
Ltd., the world’s largest oilfield service company,
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Main Team Members
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Roles
announced on January 15, 2015 that it laid off 9,000
workers in late 2014 and took more than $1 billion in
charges in the fourth quarter of 2014. According to a
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Wall Street Journal article on Schlumberger, “profits for
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the quarter fell sharply as a glut of oil and tepid demand
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07/01/14
for fuel drove down the price of crude and demand
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Source: Bloomberg
for Schlumberger’s services.”1 ConocoPhillips, the
largest independent oil and gas company, slashed its
2015 capital expenditure budget, citing lower crude
oil prices. Mr. Ryan Lance, ConocoPhillips’ chief
executive officer, released a statement that “We are
Chart 4 – AMZ (Midstream MLPs)
responding decisively to a weak price outlook in 2015
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by exercising our capital and balance sheet flexibility.”2
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According to an interview conducted by The Energy
Report with Mr. Steven Salz, a special situations
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analyst at M Partners, falling oil prices are hurting
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oil field services companies in different measures
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depending on their specialties, but all are taking
hits. Mr. Salz thinks “the Halliburton/Baker Hughes
merger may be the first of a series of consolidations in
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the space.”3
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07/01/14
Publicly
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Source: Bloomberg
traded
oil
and
gas
companies
have
experienced a significant decline in their market
capitalizations. The S&P Oil & Gas Exploration
& Production Select Industry Index, an index of
upstream exploration and production companies,
has fallen by 40% since the second half of 2014. The
Chart 5 – XOP (E&P Companies)
PHLX Oil Sector Service Index, an index of oilfield
services companies, has dropped by 39% over the
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same timeframe. Similarly, the Alerian MLP Index, an
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index of midstream companies, has declined by 19%
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over the same time period. Graphs 3-5 present these
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precipitous declines in these indices.
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Impairments n n n
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In addition to modifying operational and growth
strategies, the decline in oil prices has ramifications
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for
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07/01/14
companies’
financial
statements
and
tax
planning. An important consideration for companies
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Source: Bloomberg
is potential impairment of assets, including goodwill.
Upon the occurrence of a business combination,
goodwill is typically recorded on the balance sheet.
Goodwill represents the excess of the purchase
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2
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The Wall Street Journal, January 15, 2015.
Reuters, January 29, 2015.
The Energy Report, December 22, 2014.
©2015
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price of a business combination over the Fair Value of the net
Several factors previously outlined are particularly relevant in the
assets acquired.
For publicly traded companies and private
current environment. The deterioration in the environment in which
companies not planning to adopt guidelines recently issued
oil and gas companies are operating, the decrease in the market
by the Private Company Council, goodwill is an indefinite and
for such companies’ products and services, and the decline in
long-lived asset and is not amortized.
Rather, goodwill is
the financial performance of oil and gas companies in the fourth
tested for impairment, at least annually. Goodwill impairment
quarter of 2014 and expected reductions in 2015, may all indicate
testing standards are governed by ASC Topic 350-20-35,
potential impairment. As a result, it would be prudent for oil and
Goodwill—Subsequent Measurement, and ASC 820, Fair
gas companies and may be required by their auditors and advisors
Value Measurement.
to perform Step One of the impairment test. This test involves
It is expected that there will be more incidences of impairments
announced during 2015 than 2014. Such was the speed and
unexpectedness of the decline in oil prices that even acquisitions
made in 2014 can potentially see goodwill impairments. Given the
volatility and uncertain environment in the oil and gas industry,
there will be significant scrutiny of valuations performed during an
impairment testing, and valuation experts will have to vigorously
defend assumptions behind the projected financial performance.
In addition, the use of “Step 0” (a qualitative impairment testing
technique) is likely to reduce given the uncertainty in the current
pricing environment and the decline in valuations.
In general, the Step 0 test allows an entity to first assess qualitative
factors to determine whether it is more likely than not (i.e., more
than 50%) that the Fair Value of a reporting unit is less than its
carrying value. In order to make this evaluation, the FASB outlines
determining the Fair Value of a group of assets (the company or
reporting unit(s)) where goodwill is recorded and comparing the
estimated Fair Value to the book-carrying value of this group of
assets. If, under the Step One analysis, the Fair Value is greater
than the carrying value, then no impairment is indicated. If the
carrying value is greater than the Fair Value, then a Step Two
analysis is conducted to quantify the level of impairment which
is booked as a loss on the income statement. In addition, the
precipitous decline in equity market capitalizations may further
support the need for a detailed impairment analysis. In addition to
goodwill, ASC 360-10 requires impairment testing of other longlived assets like plant, machinery, and equipment. The oil and gas
industry is highly capital-intensive and the reductions in capital
expenditure budgets of upstream exploration and production
companies will reduce the demand and market for equipment
used in the industry.
relevant examples and circumstances to consider, including:
Other Valuation Considerations n n n
nGeneral macroeconomic conditions such as a
In addition to impairment considerations, there are other important
deterioration in general economic conditions, limitations
on accessing capital, fluctuations in foreign exchange
rates, or other developments in equity and credit markets
nIndustry and market conditions such as a deterioration in
the environment in which an entity operates, an increased
competitive environment, a decline in market-dependent
multiples or metrics (in both absolute terms and relative
to peers), a change in the market for an entity’s products
or services, or a regulatory or political development
nChanges in cost factors such as increases in raw
materials, labor, or other costs that have a negative
effect on earnings and cash flows
nOverall financial performance (for both actual and
expected performance)
nEntity and reporting unit specific events
such as changes in management, key personnel,
strategy, or customers, contemplation of bankruptcy,
litigation, or a change in the composition or carrying
amount of net assets
nIf applicable, a sustained decrease in
share price (in both absolute terms and relative to peers)
valuation implications under the Fair Value reporting standard. For
example, there have been recent instances where trading activity
has “dried up” in high yield debt issued by oil and gas companies.
In other words, there is an absence of an “orderly market.” As a
result, to the extent that any quotes are available, these are likely
not representative of pricing in an orderly market. Therefore, such
securities may need to be valued using Level 3 inputs. Such inputs
are not observable from objective sources. The most common
Level 3 Fair Value measurement is an internally developed cash
flow model. Investment companies, such as private equity firms
and hedge funds, have invested substantial capital in high yield
debt and equity securities of oil and gas companies. These funds
are required to report their investments at Fair Value and, due to
the absence of an orderly market, would need to reevaluate their
valuation models.
During the recent oil and gas boom from 2010 through the first half
of 2014, private equity funds invested a lot of “dry powder” in oil
and gas companies. Funds backed seasoned and young oil and
gas management teams and incentivized these teams by issuing
options and other equity-linked securities. The expectation is that
these options will be cashed out upon the occurrence of an exit
event like a sale or an initial public offering. For options issued by
companies in the oil and gas industry, it is highly likely that such
options may be currently deeply out of the money because of the
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©2015
decline in valuations in the industry. To keep management teams
Shishir R. Khetan, CFA is a Managing Director in the Valuation &
motivated and incentivized, private equity funds and their portfolio
Financial Opinions Group at SRR. He has extensive experience in
companies may need to revalue their investments and issue new
corporate finance, valuations, and strategic planning. Mr. Khetan
options at such revised valuations.
serves a wide range of industries including energy, infrastructure,
If oil prices continue to decline or stay at current levels, financial
experts and industry participants are projecting an increase in the
number of oil and gas companies in financial distress, leading to
real estate, chemicals, financial services, healthcare, technology,
and general manufacturing and services. Mr. Khetan can be
reached at +1.713.221.5119 or skhetan@srr.com.
further consolidations in the industry. Cash-rich companies with
Naveed Yahya, CFA is a Vice President in the Valuation & Financial
strong balance sheets will be potential acquirers of assets and
Opinions Group at SRR. Mr. Yahya has extensive experience
distressed companies at bargain prices. As discussed earlier,
providing professional valuation advisory services in the fields
the Halliburton/Baker Hughes transaction may cause a domino
of financial reporting, taxation, and corporate transactions. He
effect in the oilfield services industry with companies looking to
has provided valuations for various SEC reporting requirements
achieve cost reductions and adapting to significantly lower capital
including purchase price allocation, goodwill impairment testing,
expenditure budgets of exploration and production companies.
setting exercise price for employee stock options, and fair value
An important financial reporting and valuation consideration in
marking for private equity investments. He also has extensive
such transactions would be the purchase price allocation exercise
experience in valuations for estate and gift tax reporting. Mr. Yahya
and the evaluation of bargain purchase considerations.
can be reached at +1.713.221.5147 or nyahya@srr.com.
Summary n n n
In summary, the precipitous decline in oil prices has resulted in
oil and gas companies slashing capital expenditure budgets and
reconfiguring their operating plans. Equity market capitalizations
of oil and gas companies have followed the lower oil prices, further
This article is intended for general information purposes only and is not intended to provide,
and should not be used in lieu of, professional advice. The publisher assumes no liability
for readers’ use of the information herein and readers are encouraged to seek professional
assistance with regard to specific matters. Any conclusions or opinions are based on the
specific facts and circumstances of a particular matter and therefore may not apply in all
instances. All opinions expressed in these articles are those of the authors and do not
necessarily reflect the views of Stout Risius Ross, Inc. or Stout Risius Ross Advisors, LLC.
creating stress on business operations and balance sheets. The
volatile and uncertain environment has enhanced the potential of
impairment of assets and other valuation considerations.
SRR has significant expertise and experience in the oil and gas
industry. Combined with its deep valuation resources, SRR has
earned the trust of oil and gas companies in assisting them with
complex valuation matters.
©2015
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