bp and Shell are taking multibillion dollar impairments – what does that mean?

A tour through the headline-grabbing world of energy impairments

Both bp and Shell recently announced that they each expect to take huge impairments when they report their second quarter earnings results.

Coincidentally, each expects to take an impairment up to $2 billion. 

These are huge numbers. And they often grab headlines.

But what are impairments? How do they happen? And once they happen, what do they mean for the future performance of energy businesses?

Assets – how energy companies make money

An energy company uses its assets to create value in a way that generates ongoing profits for the company.

But what are an energy company’s assets?

On the upstream oil & gas side, the largest asset is all the oil and gas that the company has access to under the ground. If the company places a well in the right spot, and installs the right technology and performs the right services in and around that well, it will “produce” the oil and gas, i.e. bring the oil and gas to the surface. Sell the oil and gas, and you have your profits.

On the midstream oil & gas side, the largest asset is the network of gathering, processing, and transportation equipment, e.g. pipelines, that these companies use to move hydrocarbons from one place to another. Either these companies can buy and sell hydrocarbons pre and post transport, or they can charge tolls for hydrocarbon owners to use their networks.

On the downstream oil & gas side, the largest asset is the collection of processing equipment that turns crude oil into finished petroleum products like gasoline, diesel, and jet fuel. The business model here is the classic case of selling the finished products for more than you bought the crude oil for.

On the electric utility side, the largest assets are the power plants and the transmission and distribution infrastructure, including the substations. Commercial models vary across this space, but all involve monetizing the creation and conveyance of electricity to a point where customers can use it.

All these assets have assigned monetary values that appear on each company’s balance sheet.

That’s what the balance sheet does. It shows all the assets and their corresponding values on one side. On the other side, it shows all the company’s liabilities and their values, along with the owners’ equity.

The fundamental equation of accounting is

Assets = Liabilities + Equity

We can see, then, that equity is the extent to which assets exceed liabilities. Equity tells us how much value is assigned to the owners of the business, since liabilities are owed to entities outside the business.

One “asset” that does not appear on a balance sheet?

People.

While companies very much rely on people to generate profits, the company of course doesn’t own the people. And they don’t even have long-term leases on people, like they would on some of their actual assets. 

The people are free to leave the business at any time. It’s one reason why we don’t see people, and the value of people, on the balance sheet, even though people are critical to the performance of every enterprise.

The point here is that assets have a value, and that value appears on the balance sheet.

How are these assets valued? 

For the large equipment-type assets we talked about before, they first appear on the balance sheet at their purchase price.

Say a refiner buys a large piece of crude processing equipment for $10 million. And say this piece of equipment has a 10 year useful life.

This asset would show up on the balance sheet with a value of $10 million as soon as it’s purchased and put in operation. 

Then after one year, we’d have a $1 million depreciation charge against this asset, reducing its balance sheet value to $9 million.

We’d keep that same pattern all the way to the end of year 10, when the equipment is fully depreciated and no longer has any balance sheet value, i.e. book value.

We just talked about one way the value of an asset declines over time on the balance sheet – through depreciation. 

Impairments are another way we reduce asset values.

Impairments – when assets are no longer worth what we thought they were

All physical assets have finite useful lives. 

For accounting purposes, we define the duration of the asset’s useful life in advance, so we know how to manage the bookkeeping for that asset’s book value.

That’s one way an asset becomes less valuable over time – we simply wear the asset out during the course of normal use.

But an asset can become less valuable in other important ways.