Accounting Inconsistencies In Big Oil Could Affect Your Portfolio

With the price of West Texas Intermediate crude falling to its lowest levels since June 2012, you might be tempted to think that things couldn’t get any worse for the energy sector.

After all, the U.S. energy revolution has just begun and oil production is forecast to increase until 2020 before topping out at 9.6 million barrels per day (bpd), an increase of 48% in daily production from 2012.

How bad could things get if the increase in U.S. oil production accounts for 197% of the total increase in global production? According to the BP Statistical Review of World Energy 2014, the United States booked a production increase of 1.1 million bpd last year. The rest of the world saw production fall by 554,000 bpd, for a net global gain of 557,000 bpd.

#-ad_banner-#​But all the good news in energy is assuming that the United States can keep production increasing. Cracks in the shale story are leading some investors to doubt that assumption, making falling oil prices the least of your worries.

The Premature Demise Of America’s Energy Revolution
In September, my colleague Tim Begany highlighted the fact that unconventional wells deplete at a much faster rate than other resources. It seems that while the shale play has made the United States the top producer of natural gas and one of the largest oil producers in the world, the good times may not last as long as you may have thought.

Production from conventional oil wells tends to decline about 5% a year. As you compare that with an average annual production decline of 50%-to-75% from shale gas wells and up to 78% from shale oil wells, the problem becomes more apparent. Worse still, newly drilled wells, at a cost upward of $12 million, may not produce as much as the initial wells in a shale formation, since prime areas are generally drilled first.

But that is only part of the problem. Bloomberg recently reported a little-known accounting discrepancy that shows many shale drillers may be trying to pull one over on investors.

Accounting Shenanigans & Two Sets Of Books
Bloomberg was the first to report that 62 of the 73 U.S. shale drillers reported one estimate of reserves in Securities and Exchange Commission filings and another, much higher estimate in public presentations and documents to investors.

The SEC requires that company executives sign off on estimates of proved reserves, making them legally accountable. Companies are not, however, held to the same accountability in their public presentations to investors and often report ‘resource potential’ instead of proved reserves.

This sets the stage for a dangerous practice across the industry. Estimates in presentations may include acreage that will not be drilled for decades, projects with a low likelihood of success and wells that are likely never to be drilled because they would lose money. The average estimate of resource potential for the industry was 6.6 times higher than the estimate of proved reserves reported to the SEC, according to the Bloomberg article.

Besides litigation risk, explorers are setting themselves up for a big disappointment if production fails to meet lofty expectations.

Pioneer Natural Resources Co. (NYSE: PXD) reported an estimated annual production of 11 billion barrels of oil equivalent, or boe, to investors in 2013, but just 845 million boe in SEC filings — a difference of about 13-times, according to Bloomberg.

The estimate that the company presented to investors has increased more than 50% over the last year, from just seven billion barrels reported in 2012. Pioneer produced 58.9 million boe and spent $2.88 billion in capital expenditures in 2013.

Rice Energy, Inc. (NYSE: RICE) reported 2.7 billion BOE to investors and just 100 million BOE to the SEC — a difference of 27 times, according to Bloomberg.

The company’s operations are concentrated in the Appalachia region with acreage in Pennsylvania and Ohio. While the Marcellus and Utica formations have seen strong production growth, the company’s exposure leaves it at risk when well production starts to decline. Rice Energy produced 7.9 million boe and spent $465 million in capital expenditures in 2013.

I, like many of you, am not ready to write off the revolutionary change in our country’s energy production just yet. The surge in production has almost completely eliminated imports and helped the U.S. to economic growth well above other developed nations. Manufacturing is getting a second-life on cheaper energy costs and many companies that had offshored production are returning factories to domestic soil.

But you may want to be more selective to the companies in which you trust your hard-earned investment dollars.

Chesapeake Energy Corp. (NYSE: CHK) reports 13.4 billion barrels of oil equivalent to investors and 2.7 billion BOE to the SEC, a relatively lower spread of five times, according to Bloomberg.

While the spread is still disturbing, the company spent $7.6 billion in capital expenditures last year to develop its reserves and find more resources. At that level of investment, I am much more confident that Chesapeake Energy can overcome the difference in its reported reserves.

Risks to Consider: Estimates aside, the U.S. energy revolution is a material fact and investors need exposure to this huge theme. Do not avoid the E&P sector completely, but be cautious of company estimates. Look to guidance from experts like StreetAuthority’s Dave Forest who has more than a decade of experience as a geologist and analyst.

Action To Take –> Watch the difference between SEC filings and investor presentations for reserves at E&P companies. Those with large differences may find it harder to meet expectations as wells mature or may have to spend more on capital expenditures.

As I mentioned above, Dave Forest, StreetAuthority’s natural resource and commodities expert is the best source for industry insights. For more information about how to gain access to analysis of the latest changes in these precious resources, click here.