Forecasting Changes in Profitability in the Oil and Gas Industry Using Ratios and Data Envelopment Analysis

Fairfield and Yohn (2001) show that disaggregating change in return on assets into change in asset turnover and change in profit margin helps in predicting future profitability. For oil and gas firms, we disaggregate return on assets in the same manner and also use data envelopment analysis (DEA) to develop an efficiency measure. DEA is a linear programming based technique that allows us to measure the efficiency of oil and gas firms’ exploration and development efforts using net property, plant and equipment as an input and oil and gas footnote disclosures as outputs. For oil and gas firms that use the full cost method, we show that change in asset turnover does not help predict future profitability whereas our efficiency measure based on DEA is useful in forecasting future profitability. On the other hand, for firms that use the successful efforts method, we document that both change in asset turnover and our DEA-based efficiency measure are useful in predicting future profitability. Furthermore, the amount of oil reserves reported in the financial statement footnotes is useful in predicting future profitability for successful efforts firms but not for full cost firms. Prior researchers have argued that full cost accounting results in relatively low quality accounting numbers (Bandyopadhyay, 1994; Ramakrishnan and Thomas, 1992). Our results support this argument by showing that the usefulness of financial ratio analysis in forecasting full cost firms’ profitability is limited. Additionally, we show that for oil and gas firms, a DEA efficiency measure can provide information in forecasting change in future profitability that is incrementally useful to that provided by traditional ratios.