Oil and Gas Company Balance Sheets

Part of a massive industry with a dominant global presence due to humans' daily energy.

Author: Osman Ahmed
Osman Ahmed
Osman Ahmed
Investment Banking | Private Equity

Osman started his career as an investment banking analyst at Thomas Weisel Partners where he spent just over two years before moving into a growth equity investing role at Scale Venture Partners, focused on technology. He's currently a VP at KCK Group, the private equity arm of a middle eastern family office. Osman has a generalist industry focus on lower middle market growth equity and buyout transactions.

Osman holds a Bachelor of Science in Computer Science from the University of Southern California and a Master of Business Administration with concentrations in Finance, Entrepreneurship, and Economics from the University of Chicago Booth School of Business.

Reviewed By: Christopher Haynes
Christopher Haynes
Christopher Haynes
Asset Management | Investment Banking

Chris currently works as an investment associate with Ascension Ventures, a strategic healthcare venture fund that invests on behalf of thirteen of the nation's leading health systems with $88 billion in combined operating revenue. Previously, Chris served as an investment analyst with New Holland Capital, a hedge fund-of-funds asset management firm with $20 billion under management, and as an investment banking analyst in SunTrust Robinson Humphrey's Financial Sponsor Group.

Chris graduated Magna Cum Laude from the University of Florida with a Bachelor of Arts in Economics and earned a Master of Finance (MSF) from the Olin School of Business at Washington University in St. Louis.

Last Updated:November 29, 2023

How are Oil and Gas Company Balance Sheets Different?

Oil and gas companies are part of a massive industry with a dominant global presence due to humans' daily energy. As a result, there are several unique aspects of the balance sheets for companies in this industry. 

One of the most significant factors impacting oil and gas company balance sheets is the price of crude oil.

Like any other commodity, the price of crude oil cannot be controlled, as it fluctuates based on the supply and demand of the product. In addition, prices are also affected by transportation costs, geopolitical problems, and even adverse weather. 

Fluctuating prices of crude oil result in revenue that changes throughout the year.

Proved, Probable, and Possible Reserves

An asset that shows up on oil and gas balance sheets is oil reserves. Oil reserves estimate the amount of crude oil a company believes exists and can be extracted in a particular location. These estimations fall under three categories:

1. Proved Reserves

These estimations have over a 90 percent chance of being extracted. Proved reserves can be further broken down into developed reserves or undeveloped reserves. 

Developed reserves are the oil currently in pipelines and expected to be extracted from existing wells. As the name suggests, undeveloped reserves are oil expected from new wells and expanding existing wells. 

2. Probable Reserves

These estimations have a 50 percent and 90 percent chance of being extracted. 

3. Possible Reserves

These estimations have less than a 50 percent chance of being extracted.

This does not necessarily mean the company is incapable of recovering the oil in probable and possible reserves. Instead, it may be unprofitable for the company to recover this oil.

A widely used term for Proved Reserves is 1p

1p + Probable Reserves = 2p

2p + Possible Reserves = 3p

Oil companies usually value their reserves by taking their Present Net Value (NPV) and subtracting the costs of discovery and extraction. However, two different accounting methods can be used to come up with this cost.

Successful Efforts vs. Full Cost

When a cost is capitalized, it is not expensed in the period it was incurred. Instead, it is spread out over time through depreciation. This allows companies to earn revenue and realize the expense over time instead of learning the total cost simultaneously. 

Under the successful efforts accounting method, the costs of drilling an oil well are capitalized if the well is successful. Conversely, if a well is drilled and unsuccessful, the price is considered an expense in that period.

The full-cost accounting method allows a company to capitalize on all its costs for searching and drilling new wells. Whether or not the well is successful, the price is realized similarly. 

More prominent companies use the successful efforts method because their revenues are usually significant enough to realize the entire expense at once.

On the other hand, smaller companies prefer to use the full-cost method because their revenues may not be as significant, and they will be able to boost their earnings by realizing the exploration expenses over time. 

Likewise, while most companies usually see their assets increase as the firm grows, oil and gas companies tend to see their assets decline as they produce more revenue because their assets are being depleted to gain that revenue. 

Derivative Fair Value

A derivative is a contract between two parties that derives its value from the performance of an asset, index, or interest rate. Products fall under two categories: lock and option. 

In the oil and gas industry, a lock derivative, such as futures, would bind the company to buy crude oil at a predetermined price and on a future date set in the contract.

For example, suppose a company purchased a derivative that allows them to buy oil at $60 a barrel in a year. If the price of oil rises to $100 a barrel, the oil company will get to buy at $60 a barrel and protect themselves from the price increase.

However, there is a risk that the price of oil could fall to $40 a barrel, and the oil company would have to buy at $60 a barrel, hurting the company instead and allowing the supplier to profit. 

On the other hand, an option derivative, such as stock options, would allow the holder of the contract to buy or sell an asset at a predetermined price, on a future date, for a fee known as the premium.

For example, suppose a company bought stock options that allow them to purchase 100 shares of their stock at $30 per share in a year. The stock option cost the company a premium of $500.

If the stock price rises to $50 a share, the company could execute the contract and purchase 100 shares at $30 a share in a year. This will result in a $1500 profit if you subtract the $500 cost of buying the contract from the $2000 total profit. 

However, if the stock price falls to $10 a share, the company could choose not to execute the contract and simply take the $500 loss for the cost of purchasing the contract rather than the $2000 loss which would occur if the agreement was executed.

Oil and gas companies frequently use derivatives to protect themselves from fluctuations in the price of commodities. These derivatives appear on the balance sheet anywhere from current and long-term assets to current and long-term liabilities. 

Asset Retirement Obligations

Another item that frequently shows up on the balance sheet of oil and gas companies is asset retirement costs. 

Asset retirement obligations are daily in commodity industries or companies that create physical infrastructure. In addition, there are legal obligations to return a long-lived asset to its original condition once the company is done using it. 

Once the asset is restored to its original condition, and the clean-up or removal is complete, it is considered to be retired. 

In the oil and gas industry, just as there are costs to drilling and setting up an oil well, companies have to pay to shut them down. This is a liability to be paid in the future that accumulates over time as the company drills new oil and gas fields. 

This cost is usually estimated and adjusted as time passes, depending on factors such as management's need for the asset, economic factors like inflation, and laws or regulations that impact the time and costs of the asset retirement. 

Certified Public Accountants (CPAs) should be consulted when coming up with the fair cost of asset retirement to ensure that the company complies with the Financial Accounting Standards Board (FASB). 

How to Analyze Oil and Gas company Balance Sheets

There are some specific items to look for on an oil and gas company balance sheet to get insight into the health and value of the company. 

A significant indicator of a company's financial health is its debt. When oil companies take on debt to fund their business operations, it is usually secured by their assets, such as their oil and gas fields.

Debt comes with many rules the company must follow, known as debt covenants. If any of these covenants are broken, the company has defaulted on its debt and must pay the debt back or negotiate with the loaners. 

Companies that take on massive amounts of debt to grow are hazardous because of the fluctuating nature of oil prices. 

During times of high oil prices, oil companies can take on a lot of debt because the cash flow will also be increased. However, when oil prices come crashing down, the company is still left with the burden of debt and a lesser cash flow to keep up with it.

When debt covenants are broken during low oil prices, the debt holders are hesitant to take over the company's assets. Instead, they choose to negotiate and extend the debt but, sometimes, this pushes the problem into the future.

Two critical ratios to examine these firms are debt-to-EBITDAX and debt-to-equity.

Debt-to-EBITDAX And Debt-to-Equity

The following ratios are commonly used to analyze oil and gas companies. 

1. Debt-to-EBITDAX

This ratio calculates a company's total debt by its earnings before interest, taxes, depreciation, amortization, and exploration expenses. It can measure the company's ability to pay off the debt it has acquired.

Usually, a low ratio means that the company can pay its debts faster with a smaller chance of default. While a higher percentage usually means it may be more challenging for the company to pay back its debt. 

2. Debt-to-Equity

This ratio is commonly used to evaluate a company's financial leverage. It is calculated by dividing the total liabilities by shareholder's equity. It provides insight into the company's proportion of debt or equity to finance its operations. 

Other ratios

Another item on the balance sheet to examine is the oil and gas reserves, usually the company's primary assets. 

The natural gas-to-oil reserve ratio shows the company's reserves' diversity. It can provide information on whether a company's earnings would be affected more by fluctuations in natural gas prices relative to changes in crude oil prices. 

Another key indicator is the ratio of proved undeveloped reserves to the total proved reserves. This shows how much of the reserve base is producing revenue and how much is left for the company to use. 

An alternative would be the company's enterprise value divided by the proven and probable reserves (2P), which is a ratio showing how well the company's resources can support its business operations.

A relatively low ratio usually suggests that the company is undervalued, while a higher percentage may mean the company is overvalued or trading at a premium.

It is also possible to estimate the company's value by calculating its reserves and other net assets. 

Engineers often prepare reserve reports for energy companies that estimate the quantities of resources expected to be extracted. 

The reports also estimate the future prices of crude oil and natural gas along with expenses and capital expenditures the company might undertake. 

All this information is discounted to determine the present value of these cash flows, aiding in the company's valuation

How Does the Oil and Gas Industry Work?

Companies in the oil and gas industry can be broken down into five segments:

1. Upstream Companies

The upstream segment is also called Exploration and Production (E&P). These businesses focus on searching for and identifying new resources of crude oil and natural gas by drilling exploratory wells underground and underwater. 

They also operate wells that extract these natural resources from the ground to the surface through drilling and hydraulic fracking. An example of an upstream company would be Devon Energy. 

2. Midstream Companies

Companies in the midstream segment focus on storing and transporting crude oil and gas from wells to the companies that will sell it.

This is accomplished mainly through extensive pipeline systems that may transport resources anywhere from a few miles to thousands of miles. Some examples of midstream companies are the TransCanada Corporation and Enable Midstream Partners LP.

3. Downstream Companies

The downstream segment is where companies refine crude oil and sell natural gas and oil products. In addition, various products, such as gasoline, asphalt, diesel, etc., can be distributed. These businesses are also known as refining and marketing (R&M) companies. 

Downstream companies rely heavily on profit margins because they try to sell refined products for more than the cost of acquiring natural resources. Some well-known examples are Valero Energy and Sunoco Inc.

4. Oilfield Services

These companies are not directly involved in finding, transporting, or selling oil and gas. Instead, they provide services to companies that do, usually through contracts. 

Some services include drilling, maintenance, and repairs on oil fields, chemical treating, and perforating. A few examples of such companies are Halliburton Company and Schlumberger Limited.

5. Integrated Majors

These companies are involved in several segments of the oil and gas industry simultaneously. Most commonly, they own oil fields and drilling operations and use a third party for transportation. Then, they use their refineries and distribute the oil to consumers. 

Integrated majors are some of the biggest oil and gas companies by market cap. Some examples include Exxon Mobil and Chevron. 

There are also National Oil Companies (NOC) which are private, government-owned oil and gas firms. NOCs are usually essential to the economy of the country they operate in. They allow countries with vast reserves of oil to profit immensely from exports. 

The biggest oil company in the world, Saudi Aramco, is just one example of a NOC.

Researched and authored by Alan Majo | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources: