A Closer Look at GEOI Costs Are Costs Spiraling out of Control?
The first step in determining the GEOI cost structure is to figure out how much it costs to produce the oil. More specifically we need to look at the costs as they occur out in the oil fields. As the oil fields are usually leased by the oil producers these field expenses are commonly referred to as lease operating expenses. Lease operating expenses are usually abbreviated with the letters LOE. LOE comprise such mundane items as contract labor, supplies and tools, groceries and food, surface repairs and maintenance, road maintenance, gathering, meals and entertainment, etc. It would be correct to say that LOE is a good measure of production costs out in the oil fields. This measure (LOE) also includes production taxes because part of the cost to get the oil and gas out of the ground includes production taxes.
Lifting CostsThe sum of production costs and production taxes essentially equals LOE. LOE is an excellent measure of the cost to lift the oil out of the ground. Therefore,we can use LOE as our lifting costs. This line item is often times found in the income statement as 'LOE.' Some companies list LOE as 'production costs.' This figure is also found in the Notes to Consolidated Financial Statements, " Results of Operations from Oil and Gas Producing Activities."
GEOI's income statement lists 'Oil and gas production' under "OPERATING COSTS AND EXPENSES" on the income statement. The 2004 10K has the income statement on page 37. Now turn to page 56 and reference note N, "Oil and Gas Producing Activities." Here you will see that production costs match the amount listed on the income statement. It can also be determined that production taxes are part of these costs as there is no separate line item in these notes.
Keep in mind that depletion, depreciation, and amortization (DD&A) is not part of
lifting costs. We are only looking at the cost to get the oil out of the ground.
In summary, lifting costs will give us a good idea of how expensive it is to produce oil. More specifically we are looking at lifting cost per BOE (barrel of equivalent) produced. We want to know how much it costs for GEOI to lift each BOE produced in any given year or any given quarter. Once these results are known the first step is looking at the trends and seeing if the costs are increasing or decreasing.
The chart below chronicles the trends in lifting costs at GEOI.
(Click on image to enlarge.)
Clearly the trends in the lifting costs are not very good. In fact they are terrible. It is especially disturbing that the costs have risen dramatically in the latest quarter, Q3 2005.
Total CostsThe next step in looking at cost structure is to add in D&D (depreciation & depletion) along with G & A (general & administrative.) DD&A is the portion of capitalized costs that are expensed on the income statement and consequently decrease earnings. Capitalized costs are those costs used in acquisitions, development and exploration. Capitalized costs are NOT expensed on the income statement. Since costs used in production are NOT capitalized they ARE expensed and consequently subtracted against earnings on the income statement. The above statements are only true if a company is using the full cost (F.C.) method of accounting. If an oil and gas company used the alternative accounting method of successful efforts (S.E.) then the above statements would not be true. Since GEOI uses the F.C. method of accounting we will only focus on this method as described.
The chart below essentially adds DD&A and G&A to the above lifting costs to get the Total Costs. Total costs give us the big picture of the company's overall cost structure. Like lifting costs we also must determine what the total cost is per BOE produced. These per BOE costs are absolutely essential in determining what an oil and gas company is worth.
Why?
The higher the cost structure the lower the profit margins. The lower the profit margins the lower the valuation that must be placed on those associated oil reserves. Alternatively, the lower the cost structure the higher the net profit margins. The higher the net profit margins the higher the valuation that must be placed on those oil reserves.
While it is true that company "A" could have a higher cost structure than company "B" and still have a higher net profit margin we must refrain from passing judgment on company "A" until we determine how much it earned per BOE produced. Company "A" could have a higher grade of oil than company "B" and consequently it could earn more per BOE produced and a higher profit margin.
For now lets stay focused on total costs per BOE produced. The chart below depicts GEOI total costs per BOE produced the last 6 years. The latest quarterly results are also presented. It is obvious that costs are spiking and this will lead to problems for not only GEOI but also the shareholders of GEOI due to pressure on valuation of proved reserves.
(Click on image to enlarge.)
Higher costs equals lower valuation on proved reserves all things being equal. As valuation of oil reserves declines so does the value of the company and consequently the shares of GEOI stock. This is a primary reason why
GEOI shares have fallen by over 50% in the last 6 months. So even though the price of crude may rise, the valuation of GEOI proved reserves may be flat or even lower over time.
Why Cost Structure is so ImportantCost structure is
very important in
any company no matter if it is an airline, a restaurant, or an oil and gas company. Companies with higher cost structures than their peers nearly always suffer from lower profit margins, less net income, and less earnings per share. Companies with higher cost structures and lower profit margins also have less margin for error when it comes to conducting business. In other words, companies with the higher cost structure are less insulated from falling prices.
In the case of GEOI falling prices could come as a result of declining oil prices. This could be a result of any number of reasons. Therefore if oil prices would ever go lower GEOI and companies like GEOI with extremely high cost structures will be the first to suffer. The suffering will come in the form of a net loss for the quarter. While I feel oil prices will remain steady to higher over the longterm
GEOI provides the investor less margin of safety.
The Causes of GEOI High Cost StructureThe primary drivers behind GEOI high cost structure is the steadily increasing LOE (Lease Operating Expenses) and the declining production from the associated oil fields.
The chart below is worth a thousand words when discussing production and why production costs per BOE have continued to rise steadily over the same time period.
(Click on image to enlarge.)
GEOI management has admitted that they are incapable of actually increasing production. In the latest quarterly report CEO Jeff Vickers stated, "...With the two additional wells we plan to drill before year-end we are seeking to stabilize our production..." You know it is a red warning flag when the company plans to drill 2 new wells but those wells are only able to slow the decline in production (NOT INCREASE PRODUCTION.)
After analyzing lifting costs, total costs, and production we have taken a very important first step in understanding why GEOI is not a good company to invest in. Given the facts and the statement by CEO Jeff Vickers it is evident that the trends in rising cost structure, decreasing production over the long term, increasing cost per BOE produced and pressure on the valuation of GEOI's proved reserves will continue.
In my next post we will compare GEOI with other companies. One of the companies will be
Arena Resources: Ticker symbol ARD. Investors will see what cost structure and production charts look like at a quality oil and gas company. This will further serve as a warning to those who remain invested in GEOI shares. It will also further serve as an opportunity for those investors who are not afraid to go short on GEOI shares.
Data for Charts taken from SEC Filings that include:
2001 10K ,
2004 10K and
2005 3Q 10Q.
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