Last week the Wall Street Journal broke the news that the SEC plans to investigate Exxon’s valuation practices. The announcement follows on from action taken by the New York Attorney General, Eric Schneiderman, who has been investigating Exxon’s past knowledge of the impact of Climate Change since Nov 2015. Mr Schneiderman’s office recently added reserves valuation to the scope of it’s investigation as reserves are, by definition, economically producible. Both the SEC and Mr Schneiderman’s office seem to be asking two questions:
- Why hasn’t Exxon reported a reduction in reserves when prices dropped in half and the rest of the industry has collectively reported $163 billion in write downs.
- Are Exxon’s reserves overstated due to the risk of future climate change regulations that may force E&P companies to keep hydrocarbons in the ground.
The two are quite separate issues so in this post I’m going to focus the first question, how Exxon has achieved no write downs.
Reserves and the stock price
Reserves are the lifeblood of an E&P company. Changes to reserves affect both the balance sheet (the value of the company’s assets) and the income statement (the company’s earnings). Investors spend a lot of time looking at the balance sheet and income statement of companies like Exxon. They set expectations as to what the next earnings call is going to announce and those expectations drive the stock price.
Relatively small changes to reserves can lead to significant undershooting of analyst expectations, which is never good for the stock price. As the compensation packages for most executives is tied to their stock’s performance, they are typically not incentivized to let reserves be “written down”. That’s one of the reasons why the SEC exists and why it has rules for how reserves must be estimated. To protect investors.
“We don’t do write-downs”
Last year Exxon CEO and Chairman, Rex Tillerson, told Energy Intelligence that the company holds their executives accountable for the profitability of projects, ensuring that they work at lower oil prices. “We don’t do write-downs,” Mr. Tillerson told the publication. “We are not going to bail you out by writing it down. That is the message to our organization.” At first glance, this statement is a little incredulous.
I’ve been estimating reserves for projects offshore and onshore, across the globe, for the past 13 years. My work has been used to justify reserves increases and I’ve also been the bearer of bad news, calling for reserves write-downs. This is very normal as new information is constantly coming in.
Reserves are based on the information known to the estimator, at the time of estimation. The rules are pretty straight forward, however given the same data set, two different reservoir engineers will come up with two different answers. However, the two different engineers will not necessarily have the same data. The reserves estimator often has to hunt down the data then plan and execute the analysis the will underpin their reserves estimate. Two different engineers will come up with two different answers mostly because of their initiative and diligence in ensuring all stones have been uncovered; all data considered and all possible analysis conducted in order to estimate the reserves. Of course with large projects, as is the case with most of Exxon’s reserves, there is not one person estimating the reserves but a vast team of experts. That’s where management’s role becomes vital.
Within the boundaries of the rules set by the SEC, management can have a tremendous affect on a company’s reserves and hence its bottom line. By setting aggressive goals and providing the support their people need to achieve these goals, Management can challenge the current view and help the organization maintain its reserve base. That’s what I believe Mr Tillerson meant when he said, “We don’t do write downs.” He was challenging his people. Setting different boundary conditions for their thinking and motivating them to ensure that every piece of data was being considered and every possible analysis of that data conducted.
The facts of Exxon’s actual annual Reserves Filings from their past 3 10-Ks show the following:
|Classification||YE 2013||YE 2014||YE 2015|
|Total Proved Crude Oil Reserves (mmboe)||7,551||7,419||8,091|
|Total Natural Gas Proved Reserves (bcf)||71,860||69,338||60,210|
|Total Proved Reserves (mmboe):||25,216||25,269||25,269|
(Note YE = Year End)
From this data it looks as though there has been little change, specifically less than a 2% drop in Total Proved Reserves from Year End 2013 to Year End 2015. Closer investigation, however, shows that Exxon’s natural gas reserves dropped by nearly 10 trillion cubic feet from YE2014 to YE2015. This represents a write-down of 13% in one year (2,949 bcf from developed and 6,179 bcf from undeveloped).
Shell’s investigation still resonating
The statement, “We don’t do write downs.” is clearly Mr Tillerson’s way of motivating his vast staff and communicating to investors that he is doing his job. The SEC is also showing the market that they are are doing their job as they did by investigating Shell back in 2004. The result of that investigation was Shell admitting to overstating it’s reserves leading to a down grade of their credit rating and $150 million in “penalties” to the US and UK governments. This is still fresh in the minds of those of us involved in the Reserves side of the industry. No one wants to go through what Shell went through in 2004.
The drop in oil price has been difficult for the industry and that includes Exxon. They reported earlier this year that for the first time in 22 years, the company was not able to replace the reserves they produced for the world. In fact they were well under 100% replacement, coming in at 67%. As a company, they are clearly not afraid to acknowledge bad news. This is a sign of bold leadership.