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Low prices of crude oil and natural gas (even with West Texas Intermediate near $50 per barrel) have placed a choke hold on exploration and production activities in the United States, causing a rapid decline in rig count and oilfield operations. As this decline has occurred, oilfield services (OFS) companies have experienced increasing economic hardship, forcing some to reorganize their capital structure and others to liquidate assets in order to raise cash. The situation has produced a sharp decline in the value of oilfield equipment and is adversely affecting the accounting treatment of oilfield equipment on company financial statements. However, it’s also possible that a few cost-saving measures may be leveraged from low equipment pricing, such as reduced ad valorem property taxes and property insurance premiums.
Valuation Director, Opportune
Unprecedented Declines in Oilfield Equipment Prices
The magnitude of the recent decline in the price of used oilfield equipment is unprecedented in recent times. It wasn’t too long ago that equipment manufacturers supplying OFS companies had a huge backlog and that used equipment in working condition was largely unavailable. Today, there is a surplus of used equipment available at a fraction of the price commanded just a few years ago. For instance, in mid-February, three equipment spreads used in hydraulic fracturing sold at an auction in Midland, Texas for an average price of $5.5 million, compared to their new cost (in 2010-2012) of $25 million to $30 million for each spread. Most recently, two 2015-model fracture pumps sold for $300,000 each at an auction in Fort Worth, Texas, and four more 2015 models sold in Odessa, Texas for $400,000 each— compared to a new cost of about $1 million each. All types of equipment used in well services operations, including coiled tubing, acidizing, cementing, wireline, hydraulic fracturing, and workover and drilling rigs, as well as support equipment such as generators, compressors, frac tanks, light towers, tractors, trailers, and tools, are being sold at auction in record quantities and exiguous prices.
These historically low equipment prices have and will continue to have an impact on elements of accounting and finance that rely on the value of property, plant and equipment (PP&E) as an integral component, most notably oil and gas services companies who follow U.S. Generally Accepted Accounting Principles to measure the impairment of their long-lived assets under Accounting Standards Codification (ASC) 360-10 “Impairment and Disposal of Long-Lived Assets.”
Potential Impairments of Long-Lived Assets
ASC 360 is a two-step test where the first step is a comparison of an asset group’s carrying value to the sum of its undiscounted cash flows to test for recoverability, and the second step is a discounted cash flow analysis to estimate the fair value of the asset group. ASC 360 recognizes that an asset group may not generate adequate cash flows to support its carrying value (often referred to as “book value” or “net book value”) and allows the owner to write-down the asset to a recoverable level consistent with its fair value. The fair value is generally regarded as the greater of the asset group’s (1) present value of future cash flows or (2) net realizable value, which is the price the seller would expect to receive if the asset were sold less associated selling costs. In a strong market, the value of the former normally exceeds the latter by a significant gap, but in a weak market where ASC 360 would more likely be applied, the gap narrows and net realizable value is sometimes higher than the present value of future cash flows. In other words, the asset could be sold for a higher price than its profit-generating capability. When a company adjusts for impairment loss, the asset group’s carrying value cannot be written-down below this net realizable value “floor,” making the estimate of net realizable value very important and likely to be reviewed closely by auditors and regulators.
In a slow market, auction sales similar to those mentioned previously or negotiated sales are generally accepted as a reasonable proxy for net realizable value, but it can be challenging to document a confirmed sale because results of oilfield equipment sales at auction and terms of negotiated sales between buyer and seller are seldom made public—which makes notable the Keane Group acquisition of the U.S. assets of Calgary-based pressure pumper Trican Well Service Ltd. in March 2016. The $247 million transaction involved mostly pressure pumping and support equipment, with 650,000 horsepower according to the press release. The nearly pure-play character of the assets included in the transaction allows for comparison between the transacted price per horsepower of $380 (a common metric used in the pressure pumping business) and the cost for new equipment of around $900 per horsepower. A review of Trican’s financial statements suggests that the age of the equipment was likely to be similar to those at auction sales. Based on auction results and the Trican negotiated sale, it appears that used pressure pumping equipment sells for 20% to 40% of the cost of new equipment.
Goodwill Impairment Testing
For OFS companies thinking the downturn will cause a write-down of goodwill from their balance sheets, the low prices for oilfield equipment may prevent just that. After testing long-lived assets, goodwill is tested for impairment under ASC 350 “Intangibles – Goodwill and Other”. ASC 350 is a two-step test where the first step (called step 1) is comparing the fair value of a reporting unit to the carrying value of the reporting unit. If the fair value of the reporting unit is less than the carrying value of the reporting unit, the reporting unit is deemed to have failed step 1, and is required to go to step 2, which is estimating the fair value of goodwill to see if a write-down is required. If the carrying value of PP&E were significantly written-down as part of ASC 360, it is possible that the reporting unit’s fair value could be greater than the “adjusted” carrying value of the reporting unit, causing it to pass step 1 of ASC 350 indicating no impairment of goodwill. Assuming the market bottom occurred in the first half of 2016, revenue projections used for the income approach in the ASC 350 fair value analysis for the remainder of 2016 and beyond are likely to yield a higher step 1 value and exceed the carrying value of the reporting unit, allowing goodwill to settle in and stop looking over its shoulder.
Possible Cost-Saving Measures
There are a few cost-saving measures that can be leveraged from low equipment pricing. A significant ad valorem property tax reduction opportunity is available to companies with the appetite to fight for it. There is no question that used oil and gas equipment has seen a drop in value. But it’s unknown how receptive property tax assessors will be to using auction results or the Trican negotiated sale as a demonstration of the fair market value of oilfield equipment. It is reasonable to expect that tax assessors will concede to a lessened value based on the undeniable state of the industry, especially if the taxpayer prepares a plausible, well-documented position for a lower value.
Low equipment prices may also be an opportunity for cost savings on property insurance premiums. The “actual cash value” used by underwriters to develop premiums should reflect the abounding availability of low-priced equipment available in the market as a suitable replacement. Low replacement cost equals a reduced payout by the carrier in the case of an insured loss, and the savings get pushed through by a reduction in premiums.
In the future, look for used OFS equipment prices to move lower as more idle equipment is rationalized and sent to an already oversupplied used market. Bargains will be available to those willing to wait. The best equipment has not yet been sold as OFS companies hold on to their best-performing assets and sell their second-tier and older equipment. In the meantime, companies can use low used equipment prices to save some much-needed cash, even if they are required to write-down the value of some assets.
Will Carroll is a Director at Opportune LLP. Will has over 17 years of valuation and engineering experience managing and performing valuation and fixed asset related projects that generate critical information and analysis that enhance the ability to make and execute upon key financial and strategic decisions. Will has an BS in Civil Engineering from Texas A&M University.
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