Natural gas: Shale firms' balance sheets raise 'red flags'

Natural gas shale companies' financial statements don't add up, says Dallas Fed advisory member. Companies have high leverage, little cash, and very low estimates for natural gas extraction, she says.

By , Producer, CNBC.com

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    In this May 15, 2011 photo, hundreds of drilling pipes are stacked at a rail center in Gardendale, Texas. Energy companies have leased hundreds of thousands of acres in South Texas and are drilling oil and gas wells on the Eagle Ford shale formation. But a Dallas Fed advisory member and a New York Times report question whether drilling companies have the natural gas reserves and the solid financial footing that they claim they do.
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The numbers on major shale companies financial statements do not add up, said Deborah Rogers, advisory council member for the Federal Reserve Bank of Dallas.

"I have to say that after all the work I've done I think there is some sleight of hand in the balance sheets," said Rodgers in a CNBC interview.

Rogers, a former stock broker for Merrill Lynch, started questioning shale companies' financial statements after listening to a speech in 2009 by Aubrey McClendon, CEO of Chesapeake Energy, one of the largest shale gas companies.

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"He (McClendon) was throwing out some numbers and I thought these numbers aren't adding up. So I went home and started doing some research and what I found that was there were a number of anomalies within the balance sheets, the financial statements of these companies that raised a lot of red flags for me," said Rodgers.

Rodgers said she began researching predominantly the shale companies in the Barnett region and North Texas, regions known in the industry for having large reserves of natural gas. But she said as she began to crunch the numbers she saw a suspicious trend.

"I was seeing basically the same picture across the board, virtually no cash on the balance sheets, very highly leveraged," said Rodgers.

Rodgers comments come on the back of an investigation by the New York Times that reported that shale gas companies may not be able to deliver inline with their expectations.

The Times reports that since the S.E.C. implemented a rule change in 2008 that affects how companies report their gas reserves, major shale companies have seen a dramatic increase in their reserves in their federal filings.

The Times reports:

Among 19 of the largest shale companies reviewed by The New York Times, at least seven increased — some by more than 200 percent — the amount of undeveloped reserves they reported in their federal filings immediately after the rule took effect, according to their S.E.C. filings. Investors cheered the rule change as it was adopted, and in the following months they sharply bid up the stocks of five of the seven companies.

Before the S.E.C. rule change, companies were limited to reporting gas only from "areas close to their active wells as part of their "proved" reserves, the amount of gas that a company estimates to investors it will tap," according to the Times. But once the rule was implemented companies then could include gas that was farther from producing wells in their reserves estimates.

This may seem fine and well, but the modeling methods companies are using to measure the gas farther away from the "proved" reserves does not have to be disclosed and third-party audits are not required. And this raises some eyebrows.

According to the Times:

However, in internal e-mails and documents, many industry executives and federal officials have questioned whether some companies are overstating, perhaps intentionally, the amount of gas they can economically produce in a given period. This practice, known as overbooking, is illegal because it misleads investors trying to assess a company’s strength and banks that use reserves as collateral for loans.

Chespeake's McClendon responded to the Times report in a press release and said he stands by all of the companies financial statemens to shareholders. He also stated that Chesapeake and "other shale gas producers are 'routinely beating natural gas production forecasts."

Rodgers reached out to geologists in Houston and expressed her concerns regarding the estimates shale companies were giving and she heard for herself from industry insiders that the math doesn't add up.

"They basically corroborated and said that when you count in and factor in all the costs, the lease costs, everything, that shale gas, they can't really pull it out of the ground at $3.50. It's really about $7.50 to $8.00 mcf and that's a substantial difference," said Rodgers.

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