Fair Value: The Q2 Profit Vulture

Mark-to-market adjustments have cut into energy companies' second-quarter results.

Fair-value accounting took unusually large chunks out of energy companies’ second-quarter earnings.

In the past two weeks, several companies have reported sharply lower profits due to the effect that high oil and gas prices had on their valuations of derivatives, which they measured at fair value on June 30. The financial instruments are used to hedge commodity price risk.

Finance executives who recalculated the fair-value assessments a month later, after oil prices declined, had a more positive story to tell — and now predict that their third-quarter results will reflect that change. Indeed, fluctuating energy prices show the volatility that mark-to-market accounting can bring to companies’ financial statements.

Roger Manny, CFO of oil and gas company Range Resources, lamented that fact during a recent conference call with investors. He revealed that the company’s $164 million noncash accounting charge — taken when it applied fair value to its open commodity derivatives — would have been “completely eliminated” had the company made its calculations on July 23.

However, for the sake of Range Resources’ Q2 results, the new calculations don’t matter. The mark-to-market losses contributed to the company’s $35 million net loss. “Oil and gas companies that hedge their production to protect cash flow had a tough second quarter in ’08, and Range was no exception,” said Manny.

Plains All American Pipeline, for example, took an $87 million writedown, which cut its second-quarter profits more than in half, compared to the same period last year. In 2007, the oil transporter reported $105 million in net income for the quarter ending June 30, compared to its 2008 Q2 profit of only $41 million.

The company said that the “larger than usual mark-to-market adjustment [resulted] from the unprecedented increase in crude oil prices and volatility during the period.” However, while on an investor conference call, its senior vice president of finance, Al Swanson, said that he expects the valuations to “reverse” and be higher in future quarters.

During Dynegy’s most recent investor call, CFO Holli Nichols had a similar sentiment after reporting the company’s mark-to-market losses totaling $481 million. She said that a “significant portion” of the losses “reversed” in mid-July. And South Jersey Industries, an energy services holding company, said its $20.9 million mark-to-market losses on derivatives used to hedge its commodity asset management and marketing businesses had been “virtually eliminated” by the end of July when natural gas prices decreased.

The back-and-forth of positive and negative assessments for judging the values of assets and liabilities against current market demand have emboldened critics of fair-value accounting in recent months. They claim recent valuations during the down market have created unfair, negative pictures of the value of their assets — particularly those owned by financial institutions that reported huge write-downs after the credit markets began tanking. To be sure, advocates of fair value believe the accounting method results in truer, more up-to-date financial results.

However, one-time noncash charges don’t necessarily interest investors. “We pretty much ignore it,” said John Edwards, a vice president at investment firm Morgan Keegan who covers Plains All American and MarkWest Energy Energy Partners. The latter company attributed its $177.8 million net loss partly to the $253 million charges it took after marking its derivatives to market.

Rather than focusing on an accounting number that changes from quarter to quarter, analysts are more concerned with these companies’ abilities to distribute cash. “We don’t focus all that much with respect to the minutiae of FAS 133,” Edwards said. FAS 133 governs hedge accounting and requires companies to record the changes in fair value of derivatives and their underlying commodities in earnings.

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