Editor’s Note: Starting this week, we will publish The Energy Letter on Mondays rather than Wednesdays.

This past week brought a wave of weak earnings reports and write-downs by companies in the energy sector due to low natural gas prices and falling oil prices. Many companies missed estimates on earnings, revenues, or both — and there were a number of write-downs as a result of declining reserves.

The bad news hit many companies: Chevron Corp (NYSE: CVX), Total SA (NYSE: TOT), ExxonMobil (NYSE: XOM), Royal Dutch Shell (NYSE: RDS.A), Buckeye Partners (NYSE: BPL), Apache Corp (NYSE: APA), Enbridge Energy Partners (NYSE: EEP) and Tesoro Corp (NYSE: TSO) all recently reported lower than expected earnings or falling revenues for the third quarter.

One of the hardest hit companies was Chesapeake Energy (NYSE: CHK), which reported a $2 billion loss. The reason for Chesapeake’s loss is worth an examination, because its recent woes are emblematic of the troubles facing most natural gas producers.

Because of low natural gas prices, Chesapeake wrote down 4.9 trillion cubic feet of natural gas reserves, taking a charge of $2 billion during the quarter as a result. It is important to understand what it means to write down a reserve, so let’s review some definitions.

A natural gas or oil resource refers to the total amount in place, only a fraction of which can be recovered. The fraction that is recovered is called the recovery factor. The reserve is a subset of the resource, and refers to how much oil or natural gas is technically and economically recoverable at prevailing prices.

To illustrate, the Bakken formation that stretches underneath northwestern North Dakota, northeastern Montana, southern Saskatchewan, and southwestern Manitoba may contain as many as 500 billion barrels of oil. However, the amount that is technically recoverable with current technology is only a small fraction of the total. In 2008 the U.S. Geological Survey put the number of technically recoverable barrels at 3 billion to 4.3 billion barrels.

This, however, still does not represent the proven reserve (generally shortened to simply “the reserve”). Depending on the complexity of extracting and processing the oil in a particular location, the cost of producing oil or natural gas can vary greatly. If a company owns a lease and the cost to produce the oil is presently $50/bbl, those barrels represent oil reserves for that company because the current price of oil is well above that level.

If, on the other hand, the total cost to produce those barrels is $100/bbl — and the market price for that oil falls below $100/bbl — then the oil is no longer economically recoverable. In this case, what was formerly an oil reserve at $100/bbl must be written down, as long as prices remain below $100/bbl.

The oil is still there, and the company still has access to it as long as their lease is active, but the value of that oil (or natural gas) must be removed from their books. When prices maintain levels above $100/bbl, or technology improves enough to lower the cost of production to below the current market price, then the value of those barrels will be put back on the company’s books.

This is what happened with Chesapeake, and the same write-downs are impacting the financials of other companies in the sector. Note that this was not Chesapeake’s only problematic issue, but it was responsible for the $2 billion charge for the quarter.

Lower natural gas prices had a negative impact on Chesapeake’s quarter beyond the write-downs. Even though average daily production increased 24 percent year over year and average daily liquids production increased 51 percent year over year, revenues were down 25 percent versus the third quarter of 2011.

Excluding the write-down, Chesapeake earned 10 cents a share, beating estimates by a penny a share. Revenues, despite being lower than a year ago, also came in higher than expected.

Chevron issued an earnings warning several weeks ago. This past week they announced earnings of $2.69 per share for the third quarter versus $3.92 per share in the third quarter of 2011. Revenue fell to $55.66 billion from $61.26 billion. Chevron was hurt by lower oil and gas prices, lower production, and the continued outage at their Richmond, California refinery. Chevron announced that the refinery would be back online in the first quarter of 2013, so the outage will also impact their fourth quarter earnings.

Chevron’s loss is Valero Energy’s (NYSE: VLO) gain, as Valero beat earnings estimates due to strong refining margins. ExxonMobil also beat estimates based on better than expected results from their refining business, but consistent with the sector ExxonMobil’s income was down 7 percent year over year.

Tesoro (NYSE: TSX) didn’t fare as well as Valero, coming in short on revenues and earnings. The company attributed this to lower margins in the California region, typically one of their strongest markets. The company attributed off-spec crude oil delivered to their Martinez refinery which caused them to lose 10,000 barrels/day of capacity for September.

Shell reported lackluster earnings, but like ExxonMobil the refining sector performed well. Shell also wrote down $354 million in natural gas assets.

What should investors make of the weak quarterly earnings?

First, investors must be extremely picky about companies whose primary mission is natural gas production. This sector is not likely to fare well in the foreseeable future, but select companies with exposure to natural gas production should still be OK. An example is Linn Energy LLC (NSDQ: LINE) because they have hedged natural-gas production through 2017 and oil through 2016. Thus they are less impacted by low natural gas prices.

As for oil, prices remain historically high, but they’ve been falling. In the past two months West Texas Intermediate (WTI) is down 10 percent and Brent crude is down 5 percent. This will probably cut into quarterly earnings for upstream producers, but refiners typically enjoy better margins in such a market. This is evidenced by Valero’s strong quarterly performance, as well as the downstream performance of ExxonMobil and Shell.

Around the Portfolios

Despite the weak quarter, Chevron’s fundamentals still look good. The company is currently trading just above our Buy target of $105, but the recent weakness may offer an entry point for investors interested in adding Chevron to their portfolio. Buy Chevron below 105.

I still expect Valero and Tesoro to outperform in the short term, as I expect oil prices to remain weak, barring extraordinary geopolitical events. Both companies are recommended Buys.

Aggressive Portfolio holding Afren (LSE: AFR) announced last week that it has started production in the Okoro Field extension off the coast of Nigeria, increasing its overall production by about 5,000 barrels of oil equivalent per day (bopd). UK-based Afren’s Okoro output now exceeds 21,000 bopd. Buy Afren below GBp 175.