Summary
- An impairment is really not that easy for an outside observer to determine.
- Some impaired assets will earn a decent return in the future which will cause some managements to not impair the assets.
- Conservative depreciation can overcome an excess purchase price as can conservative reserve assumptions and other variables.
- Integration may be the source of usually large profitability not seen by smaller pure upstream competitors.
- Debt is low enough that a lot more debt is not a concern.
- This idea was discussed in more depth with members of my private investing community, Oil & Gas Value Research. Get started today »
Several authors and analysts have determined that Exxon Mobil (XOM) needs a write-off or impairment of unconventional assets. In order to get to that conclusion one has to first be aware of the assumptions made by the accounting system for those assets. A Wall Street Journal article was the latest of many claiming that Exxon Mobil had less than adequate accounting procedures to resist revaluing the unconventional assets downward (as in a large downward adjustment) that would result in a loss due to asset impairment.
The problem is that many things go into a decision to incur an impairment charge. From an investment standpoint, the investor needs to decide if that current book value will earn an adequate return in the next upcycle. The assets in question are in the range of $30 billion (in reviewing several of these articles). That is around seven to eight percent of the total book value reported in the first quarter. Therefore, the argument is likely over a figure that is insignificant to a company the size of Exxon Mobil. Somewhere around 5% is generally a relevant figure when considering a necessary impairment charge.
Exxon Mobil has long been a "successful efforts" accounting company. Though any accounting can be abused by management if management is determined enough, the "successful efforts" accounting has long been regarded as the more conservative accounting method in the industry. Because it is regarded as conservative, there is not a requirement to mark the assets to value through the typical "lower of cost or market" calculation done with typically smaller firms using another accounting system (full cost).
But the analysis does not end there. Managements can choose to depreciate overproduction using a conservative well reserve figure or a very aggressive figure. The choice to capitalize or expense ongoing activities is made based upon whether management determines the items in question are significantly worth it (tax code definition) or will last long enough that capitalization is needed. Therefore, even though a company may use the same overall system, other choices may result in more depreciation of what was an overvalued asset. There are many potential areas where one management may capitalize an item while another would expense it because the benefits "are just not worth it."
Therefore, an overpayment of an acquisition can be overcome over time with conservative accounting assumptions regarding depreciation and expense classification going forward.
Another area to look at is that Exxon Mobil is integrated. One subsidiary may have signed contracts with another subsidiary that are long term to justify the book valuation. A smaller company subject to current market conditions may not be able to escape a lower asset valuation in this fashion because they sell "to the market."
The last and probably most important view is whether or not the assets will recover in the future to deliver much better profits and cash flow. This is a very subjective part of the evaluation process. But usually the views of management prevail.
Those who are demanding impairments appear to overlook the financial strength rating of the company and the long history of delivering profits. The last few years have not been pleasant for the industry in general. But that does not make management automatically incorrect about predicting a better and more profitable future.
