Welcome to Fundamentals of International Oil & Gas Accounting Dr. Linda Nichols, CPA Texas Tech...

Welcome to Fundamentals of InternationalOil & Gas Accounting

Dr. Linda Nichols, CPA

Texas Tech University

Course Developer

Instructor for this Course

D. Larry Crumbley, Ph.D., CPA, CrFA, CFFA, FCPALouisiana State UniversityEditor, Oil, Gas & Energy Quarterly

c Linda Nicholsc Linda Nichols

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Energy is the fundamental building block for modern industrialized economies, the very lifeblood of developed economies. When it is available, we take it entirely for granted, like water flowing tamely from the tap. When availability fails, our lives are disrupted and restricted, the veneer of comfort and accommodation quickly erodes, and economic activity grinds to a halt.

C.E.H. Ross and L.E. Sloan

Class Purpose

• Overall Learning Objective:• To provide basic understanding and hands-on practice of

the accounting concepts involved in Oil & Gas Accounting on an international basis.

• To understand the accounting behind the financial statements and how your accounting entries roll into the financial statements.

• Competencies Involved:• Basic level general accounting


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Module 1 : Petroleum Operations and Introduction to Accounting

Overall Objective:

Provide a high level overview of terms and concepts relating to petroleum operations that will be discussed in the various accounting modules. Introduce successful-efforts and full-cost accounting.


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Petroleum Geology

• Organic theory

Oil is formed from organic matter of marine origin deposited with rock particles millions of years ago.


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Needed for Reservoir Formation

• Source rock (remains of land/sea life)• Conditions to cause petroleum formation (heat and

pressure)• Porosity or pore space (10% or more) and permeability

(connectability)• Trap: structural or stratigraphic


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Steps in Petroleum Production

1 Broad G&G reconnaissance work2 A lease or an option to lease may be obtained 3 Detailed G&G work is done to evaluate area of interest. 4 Data gathered in steps 1 and 3 are analyzed. If results positive, a lease is

obtained (if not already obtained).5 Further analysis of available data and possible more seismic studies done

to select drill site.6 The well is drilled.7 Based on data obtained during the drilling process (cuttings, well logs, etc),

decision made on commerciality.8a Sufficient oil and gas

Well completed & production started.8b Insufficient oil and gas Another drill site on the lease is selected, or lease abandoned


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Necessary Components of an Oil or Gas FieldNecessary Components of an Oil or Gas Field

• Source rock• Conditions to cause petroleum formation• Porosity (10% or more) and permeability• Trap: structural or stratigraphic


Hydrocarbon SystemHydrocarbon SystemSource rock: Source rock: organic-rich shale that generates oil and/or gasorganic-rich shale that generates oil and/or gasMigration: Migration: hydrocarbons escaping from the source rock and moving to a reservoirhydrocarbons escaping from the source rock and moving to a reservoirReservoir:Reservoir: sandstone or limestone rock with (generally) high porosity and permeability that can hold sandstone or limestone rock with (generally) high porosity and permeability that can hold hydrocarbon fluidshydrocarbon fluidsTrap: Trap: a structure or stratigraphic discontinuity in the reservoir rock that keeps buoyant hydrocarbons from a structure or stratigraphic discontinuity in the reservoir rock that keeps buoyant hydrocarbons from migrating all the way to the surfacemigrating all the way to the surfaceSeal:Seal: Impermeable rock above/around the reservoir that keeps hydrocarbons from leaking to surface Impermeable rock above/around the reservoir that keeps hydrocarbons from leaking to surface

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Upstream vs. Downstream Operations

Upstream: All necessary activities to find hydrocarbon reserves and bring them to the surface.

Downstream: Refining and marketing.

“Finding new resevoirs is the name of the game.”

M. Economides and R. Oligney


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Phases of Upstream Operations

• Initial prospecting• Mineral right acquisition• Exploration• Appraisal• Development [proved]• Production• Abandonment & restoration


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Types of Agreements

Concessionary

Leases

Concession Agreements

Contractual

Production Sharing Contracts (PSCs)

Risk Service Contracts


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Concessionary Agreements

• In U.S., parts of Canada, and Trinidad, individuals may own mineral rights (e.g., lease agreement).

• Some countries allow non-governmental ownership of oil/ gas after produced (concessionary contract).

Lessor (land owner) leases to the lessee (operator) the right to explore, develop, and operate the oil/ gas.

Concessionary contract: For up-front bonuses, royalties, and taxes, a government transfers ownership to the minerals to the petroleum company when the minerals are produced or sold.

Back-in or Participation: Government retains the right to participate as a WI owner (e.g., joint venture partner) after the results of initial exploration and drilling are known.

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Leases: Interests Created from Working Interest

Joint Working Interest: Two or more parties each own an undivided fraction of the WI in a single lease by 1) leasing, 2) sales or exchanges, or 3) sharing arrangements.

Overriding Royalty Interest (ORI): Similar to a royalty interest. Original lessee executes a sublease and retains an overriding royalty interest (ORI).

Production Payment Interest (PPI): A non- operating interest created out of the WI which is limited to a specific amount of money, time, or a certain quantity of oil or gas. Thus, a PPI normally ends before the reservoir is depleted.

Net Profits Interest (NPI): Non- operating interest created out of the WI by either a carve-out or retention.

Utilization: Agreement between two or more parties owning operating interests to have such interests operated on a joint basis and share the production by a stipulated percentage or fractional basis.

Pooling: Bringing together small tracts sufficient for the granting of a well permit under state spacing rules.

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Authority for

Expenditure

Contractual System

• All citizens in the country owns the minerals.

• Production sharing contract: The petroleum company is allowed to recover certain costs and receive a share of the profits.

• Risk service contract: Contractor bears all costs and risks related to exploration, development, and production. If production, contractor is allowed to recover costs as production is sold. Plus the contractor is paid a fee of its services.

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Agreement 1: Leases

Grants to oil and gas company right and obligation to operate on a property

• Bonus• Royalty• Lessee responsible for all costs• In effect indefinitely with production


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Agreement 2: Concessions

• Bonus• Royalty or in-kind payment• Contractor responsible for all costs without

reimbursement• In effect indefinitely with production• Ownership of minerals transferred to contractor


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Agreement 3: Production Sharing Contracts

• Government gets royalty (may be in-kind)

• Government retains ownership of minerals

• Contractor responsible for all exploration costs

• Government (through state oil company) has option to become WI owner in development and production

• Contractor may be required to build country infrastructure

• Bonus

• Costs are recoverable through cost oil

• Profit oil divided between government, state oil company and contractor

• Contractor has entitlement interest


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PSCs: Accounting Issues

• May have signature, development, or production bonuses

• Maximum time for production phase results in state oil company taking over 100% working interest.

• Cost recovery is capped, often 50% of gross production

• Cost recovery order is specified:OperationsUnrecovered exploration & appraisalDevelopmentImputed interest on development

Excess cost oil may be treated as profit oil or allocated to the government.


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Types of PSC Bonuses

• Signature bonus: A signing bonus; generally a lump-sum, but may be in the form of equipment.

• Production bonus: Subsequent payments are made to the government when the production reaches an agreed upon level.

• Development bonus: Subsequent payments are made to the government when development reaches an agreed upon level

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PSCs: Accounting Issues

• Overhead usually on sliding scale.

• Ownership of equipment and facilities passes to government.

• Significant production may go toward payment of taxes.

• In past, state oil company was responsible for abandonment and restoration.

• In current agreements, all parties contribute to sinking fund for abandonment and restoration. Funded amounts are computed on a units-of-production basis.

• May have domestic market obligation which may state a maximum price.

• Royalty and tax holidays may be granted.• Recoverable costs are identified in PSC.


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Agreement 4: Risk Service

• Bonus• Royalty (may be in-kind)• Government retains ownership of minerals• All costs initially paid by contractor, but recoverable

from government• Government (through state oil company) has option

to be WI owner in operations


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Risk Service: Accounting Issues

• After contract term, state oil company takes over.• Ownership of reserves by contractor is not

permitted.• Fee based on operating costs, capital costs, and a

profit factor.• Non-risk service agreements are possible, but are

rare.


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Reserve Estimation Methods

• Deterministic – results in a single best estimate of reserves. [SEC requires]

• Probabilistic – results in a range of estimates with their associated probabilities. Includes proven, probable and possible reserves.

• U.K. firms have choice.


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GAAP for Reserves Definitions

• US GAAP – only proved reserves can be reported. They are further classified as developed or undeveloped.

• UK & GAAP – Permits companies to choose reporting using either (1) proved or probable reserves (using probabilistic methodology) or (2) proved developed and undeveloped reserves (using deterministic methodology). UK SORP 2001.


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SEC’s Definition of Proved Reserves

The estimated quantities of crude oil, natural gas and natural gas liquids which geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions, i.e., prices and costs as of the date the estimate is made. Prices include consideration of changes in existing prices provided only by contractual arrangements, but not on escalations based upon future conditions. . . .

SEC Reg. 5-X, Rule 4-10(a)

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Proved Reserves Subdivided

Proved developed: those proved reserves that can be expected to be produced through existing equipment and operating methods.

Proved undeveloped: expected to be produced through new wells to be drilled on proved property or from existing wells for which significant expenditure is required for recompletion.

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Probable and Possible Reserves

Probable reserves: Unproved reserves that are more likely than not to be recoverable. Probable reserves may become proven with additional drilling or with an enhanced recovery project. These reserves also may become recoverable if the price of oil or gas increases.

Possible reserves: Unproved reserves that are less likely to be recoverable than probable reserves.

Commercial reserves: Based on proved reserves only. May, at the company’s option, be either proven and probable or proved developed and proved undeveloped.

*Statement of Recommended Practice (SORP) 2001, Accounting for Oil and Gas Exploration, Development, Production and Decommissioning Activities, ¶ 12.

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Bias Assumptions

• There are almost as many oil/gas reserve definitions as there are countries.

• During the first week of January 2004, Royal Dutch/Shell Group slashed its estimates of oil reserves by 20% or about 3.9 billion barrels of oil.

• Stock fell 9%.• Shell, Exxon/Mobil, and Chevron/Texaco make the estimates

themselves.• By the end of 2002, a total of 4.47 billion barrels cut; another 1.4

billion barrel cut in 2003.

Source: Susan Warren and P.A. Mckay, “Methods for Citing Oil Reserves Prove Unrefined,” Wall Street Journal, January 14, 2004, p. C-4. Chip Cummins, “Shell Slashes Oil Reserves Again, News Overshadows Profit Surge,” WSJ, February 4, 2005, p. A-3

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Shell Board Kept In the Dark• One memo drafted on February 11, 2002, warned that about

one billion barrels of oil-equivalent reserves appeared not to be in compliance with SEC guidelines.

• Board learned of information only in early January 2004.• Chairman Sir Philip was ousted in early March 2004.• Most of the misstated reserves were recorded from 1997 to

2000, when Sir Philip was in change of exploration and production.

• Oil/gas reserves were increased (not by discovery) by changing its accounting.

Source: Stephen Labaton and Jeff Gerth, “At Shell, New Accounting and Rosier Oil Outlook,” New York Times, March 12, 2004, pp. A-1 and C-4.

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Types of Reserves: Proved Reserves

• Proved• Proved developed• Proved undeveloped

Before property fully developed:

Proved reserves = proved undeveloped + proved developed

After property fully developed:Proved reserves = proved developed


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Accounting Standards: GAAP

• US – FASB & SECSFAS 19 & SFAS 69

• UK – ASB & OIAC

• International – IASB

IFRS 6 & IAS 1


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FASB-IASB Project

• Improve both U.S. GAAP and IFRS while concurrently eliminating many individual differences.

• Currently focused on “short-term convergence” projects.– Addresses differences outside the scope of a major project.– Solution achievable in the short-term.

• The SEC is adopting rules to accept foreign private issuers financial statements prepared in accordance with IFRS without reconciliation to U.S. GAAP.

Vision 5 Years From Now

• U.S. public companies will be following IFRS, not U.S. GAAP.

• One standard setter (IASB) will promulgate IFRS.• Still some to-be-determined role for national

standard setters (such as FASB).

Global Standards

• A single set of high-quality, comprehensive accounting standards involves the convergence of:– Auditing standards

– Capital markets regulation

– Audit oversight

– Changes in the U.S. and legal environment


Four Types of Costs

• Acquisition Costs

• Exploration costs

• Development costs

• Production costs


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Some Acquisition Costs

• Signing bonus – upfront monies to governments*• Legal fees*• Filing/ Recording fees*• Title examination*• Options to purchase or lease*• Broker fee*• Option lapse (expense)• Shooting rights (U.S. GAAP expense; international capitalize)

* Capitalize U.S. GAAP and international.

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Some Exploration Costs

A. Costs of topographical, geological, and geophysical studies, rights of access to properties to conduct these studies, and salaries and other expenses of geologists, geophysical crews, and others conducting these studies. Collectively, geological and geophysical (G&G) costs.

B. Costs of carrying and retaining undeveloped properties such as delay rentals, ad valorem taxes on the properties, legal costs for title defense, and maintenance of land and lease records.

C. Dry hole contributions and bottom hole contributions.D. Costs of drilling and equipping exploratory wells.E. Costs of drilling exploratory-type stratigraphic test wells.

A., B., C. are non-drilling costs. U.S. GAAP, expense.

D., E., drilling costs. Possibly capitalized, U.S. GAAP.

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Drilling and Development Costs

• Development wells• Lease flow lines• Separators• Treaters• Heaters• Storage tanks• Improved recovery system• Nearby gas processing facilities

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Oil Derrickc Linda Nicholsc Linda Nichols

Types of Wells

• Exploratory Wells [unproved area]• Stratigraphic test wells (get info)*• Extension wells (test and extend known

boundaries) exploratory• Development Wells

• Service Wells [gas injection, water injection, saltwater disposal] development costs

*Exploratory and development types


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Successful Efforts vs. Full Costs

Cost SE FC

Acquisition C C

G&G E (C) C

Explor.dry hole E C

Expl.Well–good C C

Dev. Dry hole C C

Dev.Well–Good C C

Lifting costs E E

Cost Center Field Country


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Module 2: Nondrilling Exploration Costs under Successful Efforts

Overall Objective:

To gain a basic understanding of the accounting treatment of geological and geophysical (G&G) costs.


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G & G Exploration

• Surface Techniques 1. Oil Seeps 2. Aerial Photos 3. Satellite Surveys (Landsat 4) 4. Topographical Mapping 5. Geochemical surveying

• Subsurface Techniques 1. Subsurface mapping utilizing seismic surveys. 2. Structural surface maps. 3. Subsurface geophysical measurements 4. Gravity meter measurements 5. Magnetic surveys.

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Seismic Surveys[Having to do with earthquakes or earth vibrations]

1. Two-dimensional Seismic – stringing geophones in a line along the surface or the earth or behind a ship.

2. Three-Dimensional Seismic – geophones in a closely spaced grid, gives a three-dimensional view.

3. Electromagnetic recording with 3D.4. Four-dimensional surveys (time) – can monitor

water flood fronts and oil migrations within reservoirs.

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Seismic Technology

• Seismic technology continued to advance, and the next big breakthrough occurred in the early 1960s with the advent of digital technology. This enabled processing of enormous amounts of data and provided dramatically improved knowledge of subsurface geology. Now, time-lapse or four-dimensional seismic, created by multiple surveys repeated over time, monitors reservoir performance and helps improve recovery efficiency.

C.E.H Ross & L.E. Sloan


International GAAP

• US GAAP – Expense Geological & Geophysical

• UK GAAP – If the costs cannot be identified with a particular geological structure by year-end, then expense. If the costs can be identified with a particular structure, then the costs should remain capitalized at year-end.

• IASB – May capitalize if associated with particular resources (consistent with UK). Must assess for impairment.


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Geological & Geophysical Costs

• Peters Co. Pays €30,000 for G&G studies on Block A

US GAAP:

G&G Expense 30,000Cash 30,000

UK& IASB specific structure:

Intangible Assets 30,000Cash 30,000


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Peters Oil obtained shooting rights on 5,000 kilometers for €.50 per kilometer.

Shooting Rights

US:

G&G expense 2,500Cash 2,500

UK & IASB specific structure:

Intangible assets 2,500Cash 2,500


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Peters has records maintenance costs of €600 on Block C.

Records Maintenance Costs

US:

Records maintenance expense 600Cash 600

UK & IASB specific structure:

Intangible assets 600Cash 600


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UK & IASB GAAP

• If the structure becomes proved for which these intangibles have been recorded, transfer the costs to the field as tangible assets:

Tangible assets 33,100

Intangible assets 33,100


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Test Well Contributions

• Bottom-hole contribution: Contribution paid to a driller by adjoining property owners for information from drilling in a particular property regardless of the success or failure of the drilling.

• Dry-hole contribution: This concept is the same as “bottom-hole contribution” except that payment is made only if the drilling results in a dry-hole.


In order to obtain formation information, Peters enters into the following test-well contribution agreements on property close to Block C:Well 1 – bottom-hole contribution to 2,000 meters; €12,000Well 2 – bottom-hole contribution to 2,000 meters; €10,000Well 3 – Dry-hole contribution; €15,000Well 4 – Dry-hole contribution; €13,000


Well 1 was drilled to 2,000 meters and was dry.US: Test-well contribution expense 12,000

Cash 12,000

UK&IASB: Intangible assets 12,000 Cash 12,000

Well 2 was drilled to 1,500 meters and abandoned.No entry


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In order to obtain formation information, Peters enters into the following test-well contribution agreements on property close to Block C:Well 1 – bottom-hole contribution to 2,000 meters; €12,000Well 2 – bottom-hole contribution to 2,000 meters; €10,000Well 3 – Dry-hole contribution; €15,000Well 4 – Dry-hole contribution; €13,000


Well 3 was drilled to 2,500 meters and was dry.US: Test-well contribution expense 15,000

Cash 15,000

UK&IASB: Intangible assets 15,000 Cash 15,000

Well 4 was drilled to 4,000 meters and produced.No entry


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Peters has seismic equipment that was used only on Block A in 2008. Depreciation on the equipment for 2008 is €8,000 and operating costs of the equipment for the year was €10,000.

Depreciation of Support Equipment

US or UK & IASB with no specific structure:

G&G expense – depreciation 8,000 Accumulated depreciation 8,000

G&G expense – operating costs 10,000 Cash 10,000

UK & IASB with specific structure:

Intangible assets 8,000 Accumulated depreciation 8,000



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Module 3: Acquisition Costs of Unproved Property/ SE

Overall Objective:

Appreciate the various type of acquisition costs and determine when unproved properties are impaired.


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Peters acquired rights on Block A and paid a signature bonus of €5,000.

Purchase

US:

Unproved property 5,000Cash 5,000

UK & IASB:



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Development and Production Bonuses

• Development bonuses – normally capitalized as a deferred signing bonus.

• Production bonuses – normally capitalized as a deferred signing bonus.


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Bonus Example• Peters (an IASB Co.) has a PSC with the government of Haran.

Peters pays a signing bonus of €1,000,000. Peters also agrees to pay a production bonus of €1,200,000 when production reaches 1 million bbls.

• Signing bonus:Intangible assets 1,000,000

Cash 1,000,000

Commercial discovery:Tangible assets 1,000,000

Intangible assets 1,000,000

Production reaches 1 million bbls:Tangible assets 1,200,000

Cash 1,200,000


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Peters had €1,000 in overhead costs to be allocated to two properties that were investigated during June.

Internal Costs

Block A – investigated and acquired 500 kilometersBlock B – 1500 kilometers investigated; none acquired

May capitalize based on kilometers acquired:Intangible assets – Block A 1,000

Overhead control 1,000

May allocate based on kilometers investigated:Block A – 500/2000 x 1,000 = 250Block B – 1500/2000 x 1,000 = 750

Intangible assets – Block A 250Overhead expense 750

Overhead control 1,000

Note: Under US GAAP, Unproved Property would be debited instead of intangible assets.


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Peters paid €1,000 for an option to acquire 500 kilometers.

Options

Property purchase suspense 1,000Cash 1,000

Peters decided to lease 250 of the kilometers and paid an additional bonus of €5,000.

Surrendered lease expense 500Intangible assets (US: Unproved Property) 5,500

Property purchase suspense 1,000Cash 5,000


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Peters paid €1,000 for an option to purchase 300 acres and shooting rights. The value of the shooting rights alone is €400.

Option with Shooting Rights

US GAAP:

G&G expense 400Property purchase suspense 600

Cash 1,000

UK & IASB GAAP:

Intangible assets 400Property purchase suspense 600

Cash 1,000


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Impairments of Unproved Property

• US & GAAP: Significant properties are assessed individually. Insignificant properties are assessed on a group basis.

• UK & GAAP: All properties are assessed individually. Capitalized G&G is included in the assessment.

• IASB: Assess as individual cash-generating units or groups of units not to be larger than a segment.


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US & IAS: Significant vs. Insignificant

If acquisition costs are:

Significant assess individually

Not significant impair on a group or aggregate basis


* Cost of property, company size, number of unproved leases held, company’s overall portfolio of unproven property held.

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Peters paid a €50,000 bonus to obtain Block A, which is individually significant. Management has determined that Block A should be impaired 10%.

US: Impairment of Significant Property

Impairment expense 5,000Allowance for impairment – Block A 5,000


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At year-end, Peters has group properties totaling €300,000. An allowance for impairment for these properties has a balance of €40,000. Management believes the group should be 25% impaired.

US: Impairment of Insignificant Properties

.25 x €300,000 = €75,00075,000 – 40,000 = 35,000

Impairment expense 35,000Allowance for impairment – group 35,000


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UK and IAS Impairment

• Peters paid a €50,000 bonus to obtain Block A, which is individually significant. Management has determined that Block A should be impaired 10%.

• Amortization expense 5,000 Allowance for amortization and Impairment 5,000

The entry would also look like the above under IAS for grouped properties.


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Abandonment

• Treatment is similar between the U.S., U.K. and IAS.


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Abandonment of Individually Significant PropertyPeters has €50,000 in the unproved property (intangible assets) account for Block A and has an allowance for impairment for that property with a balance of €5,000. Peters abandons the Block.

Abandonment

Surrendered property expense 45,000Allowance for impairment 5,000

Unproved property (Intangible assets) 50,000

Abandonment of Individually Insignificant Properties (The UK does not have grouped properties.)Peters has a balance of €300,000 in an unproved properties-group account, and a related allowance for impairment with a balance of €75,000. Management decides to abandon one of the properties in the group. The acquisition cost of that property was €10,000.

Allowance for impairment – group 10,000Unproved property (Intang. assets) – group 10,000


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Peters has an individually significant property with a balance of €50,000 in the unproved property account and an allowance for impairment with a balance of €5,000. The property becomes proved.

Reclassification of Property

US GAAP:

Proved property 45,000Allowance for impairment 5,000

Unproved property 50,000

UK & IAS:

Tangible assets 45,000Allowance for impairment 5,000



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Assume, instead, that an insignificant unproved property is proved. The acquisition cost of the property was €10,000. The unproved property-group account has a balance of €300,000 and the related allowance for impairment for the group has a balance of €75,000.

Reclassification Of Property

US GAAP:Proved property 5,000

Unproved property – group 5,000IAS:Tangible assets 5,000


Assume, instead, that only half of the above property was proved:

US GAAP:Proved property 10,000

Unproved property – group 10,000IAS:Tangible assets 10,000



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Cost Centers

• US GAAP: May be a property or reasonable aggregation of properties with a common geological structure. The field is by far the most used.

• UK & GAAP: On a field basis.


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Module 4: Drilling and Development

Overall Objective:

Study the two types of exploration drilling costs and both drilling and nondrilling development costs.


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Drilling Contracts

• Meter rate contracts: drilling contractor is paid a specific amount per meter of hole drilled.

• Day-rate contracts: drilling contractor is paid a specified amount of each day worked on the well, regardless of the number of meters drilled (virtually all offshore work).

• Turnkey contracts: contractor performs specified services for a set price and the operator merely has to turn the key when the project is completed.

• Overriding Royalty interest to Driller.


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Some Drilling Terms

• Rigging-up: drilling rig and equipment are set up.• Spudding-in: after rigging up, the well is ready to be spudded-in.• Spud date: date the rotary drilling bit touches ground.• Tripping-in or tripping-out: pipes lowered into hole; drill pipes may have

to be removed when drill bit becomes worn or damaged or casing is set.• Blow-out prevention equipment: helps prevent an uncontrolled explosion

of oil/gas from a well.• Fishing: attempting to recover lost equipment in the hole.• Sidetracking: plugging the lower portion of a hole and drilling around an

obstruction (e.g., lost equipment)• Logging: once total depth is reached, a logging device is lowered to the

bottom. It is pulled up and measures and records properties of the formations and the fluids. Helps determine whether to complete or plug the well.


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More Drilling Terms

• Perforating: use a perforating gun to make holes in casing and cement so oil and gas can flow into the well bore.

• Fracturing: in sandstone, coarse sand or synthetic beads (called proppant) is mixed with a fluid, pumped into the formation under high pressure, causing the formation to split or fracture.

• Acidizing: in calcium carbonate material, acid is pumped into the formation to dissolve portions of the formation to create channels.

• Swabbing: if pressure is low, must swab the well to remove the fluid (mud). Small expandable packer is lowered into the well, and by swiftly pulling the packer back up, any fluid is removed.

• Directional well: drilled straight to a predetermined depth and then curved or angled to a desired location.

• Horizontal well: initially drilled straight, but gradually curved into a horizontal direction.

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Scallop Gun


Exploratory Drilling - SE

• U.S. and U.K.– Exploratory wells are capitalized if successful and are expensed if dry.

• Unsuccessful appraisal wells are charged to expense under U.S. GAAP. In the U.K., these wells may remain capitalized as long as further appraisal is planned. The IASB will likely require these wells to be expensed.

In the 1970s, engineers developed down-hole motors that could rotate the drill bit at the bottom of the well, allowing drillers to steer the bit and gradually guide the hole off vertical, eventually turning 90 degrees.

C.E.H. Ross & L.E. Sloan


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Types of Dual Purpose Platforms

1. Conventional jacket and deck--steel deck with jacket extending down to sea bottom, anchored in place by steel piles.

2. Concrete gravity platform--massive pre-cast structures that sit on the ocean floor, held in place by its own weight.

3. Guyed tower--uniform-tubular steel structure that supports a deck and anchored laterally to the ocean floor by steel cables.

4. Tension-leg floating structure held in place by vertical, tubular steel members anchored to the ocean floor by piles.

Source: IRS Litigation Guideline Memorandum, Rev. TL-91, October 14, 1993.

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Offshore Platformc Linda Nicholsc Linda Nichols

Offshore Drilling

Mobile rigs drill exploratory and evaluation wells.

Massive platforms drill the development wells (e.g., Hoover-Diana Platform)

Production facilities are constructed on the platform to handle the output.

Type of Mobile Exploratory Drilling Rigs:• Submersible Rigs - few today; shallow water.• Jack-up Rigs--350 to 400 feet--legs jacked up while moving.• Semi-submersible Rigs -- e.g.,Marine 700• Drilling Barges and Drilling Ships

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Development Drilling - SE

• All development wells are capitalized.

• In the U.S., a development well is a well drilled in a proved area to a known productive depth. In the U.K., development wells include all wells drilled after the decision to develop the field has been made. Therefore, some development wells in the U.K. might be exploratory in the U.S.

• Delineation wells are exploratory in the U.S. but are development in the U.K.


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Drilling & Development Costs/ SE

Exploratory WellDrilling costs

Dry Successful

Expensed Capitalized

Development WellDrilling costs

Capitalized


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Christmas Treec Linda Nicholsc Linda Nichols

IDC vs. Tangible Costs


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Pumperc Linda Nicholsc Linda Nichols

Exploratory Drilling Costs

Peters is drilling an exploratory well on Block A. IDC are €30,000 and L&WE costs are €200,000. The unproved property (intangible assets) account for Block A has a balance of €30,000.

Wells in progress – IDC 30,000Wells in progress – L&WE 200,000

Cash 230,000Assume the well is dry:Dry hole expense 230,000


Assume, instead that the well is successful.Wells & related E&F – IDC 30,000Wells & related E&F – L&WE 200,000


Proved property (UK & IAS: Tangible assets) 30,000Unproved property (UK& IAS: Intangible assets) 30,000


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Time Limit on Wells in Suspension

• US – One year limit unless a major capital expenditure is required and more successful wells are needed to justify the expenditure, the well would be completed if the expenditure were made, and drilling of additional wells is planned.

• UK – Three year limit in offshore or frontier environments, two years elsewhere. Circumstances may dictate costs being carried beyond these limits.


88

Workovers

• Restore or stimulate production from a particular well.

• Handled similarly in U.S., U.K., and IAS.• If the life or productivity of the well is materially

increased, then capitalize.• If the workover just maintains production, then

expense (e.g., lease operating expense).


89

Enhanced Recovery

• Enhanced recovery technology has provided impressive increases in the ultimate recovery of the total oil in place in a reservoir. For example, injecting CO2 into old oil fields has in some cases doubled recoverability up to 60% of oil in place, further extending the field’s life.

C.E.H. Ross & L.E. Sloan


Workovers

Peters paid €60,000 for a workover on well #1.

Workovers in progress 60,000Cash 60,000

If useful life is increased:Wells & related E&F – L&WE 60,000

Workovers in progress 60,000

If useful life not increased:Operating expense 60,000

Workovers in progress 60,000


91

Service Wells – Development Wells

Peters drills a gas injection well on Block A at a cost of €80,000.

Wells in progress – L&WE 80,000Cash 80,000

When completed:Wells & related E&F – L&WE 80,000

Wells in progress – L&WE 80,000


92

Capitalization of Interest

• U.S. – Interest is capitalized during the construction phase based on average accumulated expenditures.

• U.K. – Permits capitalization at the company’s option. Most do not capitalize except for very large projects.

• IASB – Expensing is common. Capitalization is permitted. If there is a specific borrowing for the project, that amount can be capitalized. If borrowing is done centrally, the amount to be capitalized is the amount expended on the asset multiplied by the average borrowing rate. (IAS 23).


93

Interest CapitalizationPeters has unproved property costs on Block A of €40,000 on January 1. During the year, Peters incurred exploratory drilling costs of €400,000. A €500,000, 8% note was outstanding during the entire year specifically for this Block. Total interest cost for the company is €800,000.

US : Avg. Expenditures:40,000 + 440,000 = 240,000

2Interest to capitalize:240,000 x .08 = 19,200Wells in progress – IDC 19,200

Interest expense 19,200

IAS: 500,000 x .08 = 40,000Wells in progress – IDC 40,000

Interest Expense 40,000


94

Module 5: Proved Property Cost Disposition under SE

Overall Objective:

To gain a basic understanding of cost disposition using SE accounting.


95

Basic Depreciation, Depletion & Amortization Formula

Production for the Year

X book value at year end

Estimated reserves at

the beginning of the year


96

Equivalent DD&A Formula

Book Value

X Production for the year

Estimated reserves at

the beginning of the year


97

Differences in Reserves

• US GAAP – proved reserves are used for leasehold; proved developed reserves are used for wells and equipment.

• UK & GAAP – for all costs, permits either proved developed and proved undeveloped or proven and probable reserves.


98

SE DD&A Example - US

• Exploration Inc. drilled the first successful well on Block A early in 2008. Data for the block as of 12/31/08 follows:

Signing bonus € 80,000Wells & related E&F 200,000Production during 2008, bbl 6,000Proved reserves, bbl 12/31/08 900,000 Proved developed reserves, bbl 12/31/08 100,000Probable reserves, bbl 12/31/08 300,000 DD&A for Leasehold: 6,000 X €80,000 = € 530 900,000 + 6,000

DD&A for Wells & Equipment: 6,000 X € 200,000 = € 11,321 100,000 + 6,000


99

SE DD&A Example - UK

• Exploration Inc. drilled the first successful well on Block A early in 2008. Data for the block as of 12/31/08 follows:

Signing bonus € 80,000Wells & related E&F 200,000Production during 2008, bbl 6,000Proved reserves, bbl 12/31/08 900,000 Proved developed reserves, 12/31/08 100,000Probable reserves, bbl 12/31/08 300,000Using total proved: 6,000 X €280,000 = € 1,854 900,000 + 6,000Using proved and probable:

6,000 x €280,000 = € 1,393 900,000 + 300,000 + 6,000


100

SE DD&A Example 2 - Calculate 2008 DD&A for lease A

The balance sheet for Roberts Oil Company as of 12/31/07 is as follows for Block A:

Property costs – proved properties € 110,000Less: Accumulated DD&A 20,000

Net property costs 90,000

Wells & related equipment 2,000,000Less: accumulated DD&A 300,000Net wells & equipment 1,700,000

Roberts’ activities during 2008 related to Lease A were:Exploratory dry hole drilled € 300,000

Development dry hole drilled 275,000Tanks & separators installed 150,000Production 100,000 bblProved reserves 12/31/08 1,020,000 bblProved developed reserves 12/31/08 900,000 bbl

Probable reserves 12/31/08 200,000 bbl


101

DD&A Answer - US

DD&A for Leasehold: 100,000 X €90,000 = € 8,0361,020,000 + 100,000

DD&A for Wells & Equipment: 100,000 X € 2,125,000* = €212,500900,000 + 100,000

* Equipment costs:

Beginning equipment (net) 1,700,000Development dry hole 275,000Tanks & separators 150,000

Total 2,125,000

102


DD&A Answer - UK

Using Total Proved:

100,000 x 2,215,000* = 197,767

1,020,000 + 100,000

* Equipment of 2,125,000 + property of 90,000

Using proved and probable:

100,000 x 2,215,000 = 167,803

1,020,000 + 200,000 + 100,000


103

Joint Production

• When both oil and gas are produced together, a conversion to equivalent energy units is required in both the U.S. and U.K. Commonly, a rate of 1 bbl = 6 mcfs is used.


104

Exclusion of Costs

• US – If significant development costs are incurred before all proved reserves are developed, exclude the portion of the development costs attributable to the undeveloped proved reserves.

• UK – All costs are included since either all proved reserves or proved and probable reserves are used for depletion.


105

Exclusion of Costs Example - US

• Production platform constructed at a cost of $4,000,000

• 15 wells drilled; total of 60 wells planned

• Exclude: 45/60 X $4,000,000 = $3,000,000

• Include $1,000,000


106

Exclusion of Reserves

• US – If proved developed reserves can be produced only after an improved recovery system is constructed, exclude the proved developed reserves associated with the costs that have not yet been incurred.

• UK - If proved developed reserves can be produced only after an improved recovery system is constructed, include an estimate of the future development costs in the depletion calculation.


107

Exclusion of Reserves Example

Gas injection project will cost €3,000,000. Proved developed reserves are 1,200,000 bbls but 500,000 of those barrels cannot be produced until after the project.

• US - Exclude 500,000 bbls PDR associated with project in computing depletion.

• UK – Include all proved (or proved and probable) reserves in depletion but include the €3,000,000 cost of the project in the calculation.


108

Module 6: Impairment and Abandonment

Overall Objective:

Upon completion of this module, you will have a basic understanding of accounting for asset retirement obligations and impairments under successful efforts.


109

Dismantlement Costs

• Handled the same in the U.S. and internationally (IAS 37).

• The present value of the future obligation is recorded as an asset and liability on the date the environment is disturbed. Annual accretion of discount on the liability is charged as a type of interest.


110

Dismantlement Costs Example

When the environment is disturbed, the present value of the future obligation at the company’s cost of capital at 6% is 1,000,0000.

Wells & related E&F 1,000,000Liability for restoration1,000,000

At the end of one year, accrete discount:1,000,000 x .06 = 60,000

Accretion expense 60,000Liability for restoration 60,000


111

Impairment of Producing Properties

US GAAP – 3 stages

1. Trigger event.2. Compare BV (include ARO) to undiscounted cash flows (exclude ARO).3. If BV > undiscounted cash flows, write down to fair value (usually discounted cash

flows excluding ARO).

IAS & UK – 2 stages

1. Trigger event.2. Compare BV (without ARO) to FV (usually discounted cash flows excluding ARO)

minus the ARO liability.


112

Impairment Example

Book value of field without ARO: €3,000,000Carrying amount of ARO liability: 521,000Undiscounted future net cash flows: 2,800,000Discounted future net cash flows before ARO: 2,100,000

• US: write-down: 3,521,000 – 2,100,000 = 1,421,000• IAS & UK: (3,000,000) – (2,100,000 – 521,000) = 1,421,000

Loss on producing properties 1,421,000Accumulated capitalized cost reduction 1,421,000

Can credit accumulated DD&A instead of Accumulated capitalized cost reduction.


113

Partial Abandonment

• Treatment is consistent between the U.S., U.K. and IASB. If only a portion of a cost center is abandoned (a well), the item is treated as fully amortized and is charged to accumulated DD&A.


114

Retirement of Well Example

Accumulated DD&A 100,000

Wells & related E&F 100,000


115

Module 7: Full-Cost Accounting

Overall Objective:

Upon completion of this module, you will have a basic understanding of the full-cost method of accounting.


116

Basics of FC

• All costs, except production costs, are capitalized. This includes G&G costs and all dry holes.

• US - cost center is a country.

• UK - cost center may consists of regional groups of countries.

• IASB – may eliminate FC in the future.

• Both in the U.S. and internationally, all costs must be written off over proved reserves.


117

Basic DD&A

• Peters has €2,500,000 of costs to be amortized in the Germany (book value) at December 31, 2008. Production for 2008 was 25,000 bbls and proved reserves at December 31, 2008 was 400,000 bbls. Probable reserves are 100,000 bbls.

• US and UK using proved:

25,000 x 2,500,000 = 147,059 400,000 + 25,000


118

Asset Retirement Obligations (ARO)

• Handle as with SE. When the environment is disturbed, estimate the future cost and record the present value of those costs as an asset and liability.

• The asset is included in the DD&A calculation.


119

Inclusion of Future Development Costs

• Because all proved reserves are used to compute DD&A, the future costs to develop the undeveloped reserves must be estimated and added to the capitalized costs to be amortized.


120

Exclusion of Costs

• US – Costs related to unproved properties may be excluded until commercial reserves are found or the property is impaired or abandoned. Costs related to major development projects that require significant future expenditures to determine proved reserve quantities may also be excluded.

• UK – Costs related to unproved properties may be excluded until the evaluation of the property is complete.


121

Impairment of Unproved Property

• US – As with SE, properties are considered significant or are grouped. When impaired, an asset account, impairments, is debited and the allowance is credited. If excluding U/P from DD&A, the U/P net of allowance is excludable, but the impairment asset account must be included.

• UK – Similar treatment except that all properties are considered significant.


122

Impairment Example – US Significant Property


Impairment 5,000

Allowance for impairment – Block A 5,000


123

UK and IASB Impairment


Impairment (Intangible) 5,000Allowance for amortization and Impairment 5,000

The entry also would look like the above under IASB for grouped properties.


124

Abandonment

• US & UK – abandoned costs remain capitalized and included in the amortization base.


125

Abandonment Example

Abandonment of Individually Significant Property

Peters has €50,000 in the unproved property (intangible assets) account for lease A and has an allowance for impairment for that property with a balance of €5,000. Peters decides to abandon the lease.

Abandoned costs 45,000

Allowance for impairment 5,000

Unproved property (Intangible asset) 50,000


126

Advanced DD&A

• Peters had the following costs in Germany at December 31, 2008:

Proved property € 30,000Unproved property 50,000Nondrilling exploration, P/P 60,000Nondrilling exploration, U/P 70,000Development well, P/P 500,000Wells in progress, U/P 600,000Dry holes, U/P 700,000Accumulated DD&A (500,000)Future development costs 300,000Proved reserves, 12/31/08 600,000 bblsProduction, 2008 100,000 bbls

Probable reserves, 12/31/08 200,000 bbls


127

Include All Costs

• Using proved reserves:

• €1,510,000 + 300,000 = 1,810,000

100,000 x 1,810,000 = 258,571

600,000 + 100,000


128

Exclude All Possible Costs

• Using proved reserves

• Exclude:U/P 50,000Nondrilling exploration, U/P 70,000Wells in progress, U/P 600,000

720,000

€1,810,000 - 720,000 = 1,090,000

100,000 x 1,090,000 = 155,714600,000 + 100,000


129

U.S. Ceiling Test

• Compares the book value of the cost center to a ceiling composed of:

PV of future net revenues (using current prices and costs and 10% rate for proved reserves only)

+ Costs of properties being excluded

+ The LCM of unproved properties included

- Tax difference on above


130

UK Impairment

• Follow FRS 11 as interpreted in 2001 SORP.• Perform test only if triggered.• Compute cash flow projections using expected prices and

costs. • Use commercial reserves – may include probable (or use

only proved)• Flexibility in discount rate.• Risks may be reflected by adjusting either future cash flows

or the discount rate.


131

Module 8: Production Activities

Objective:

Upon completion of this module, you will understand how to account for direct and allocable costs of production. You will also understand the basics of well economics.


132

International GAAP

• Treated similarly worldwide. Production costs are expensed.

• Costs may be direct or indirect.

• Indirect costs must be allocated to the fields covered on a reasonable basis.


133

Direct Cost Examples

• Repairs that can be traced to individual wells.• Repair of a pumping unit.• Wages for employees who work on only one property.• Wages for employees who designate hours worked on certain

properties.• Fuel for properties, invoices indicate particular properties.• Depreciation of a truck used on one property.• Workover for the purpose of restoring production.


134

Allocable (Indirect) Cost Examples

• Wages for employees who work on several properties, detailed records not kept.

• District office expenses.• Depreciation of a truck used on multiple properties

without detailed records of use.• Depreciation of district office facilities.


135

Items to Consider in Completion Decision

• Quantity of reserves• Timing of production• Future selling price• Future production costs, including production taxes• Completion costs• Cost of capital


136

Capital Decisions

• If we have drilled a well at a cost of €300,000 and it will cost an additional €150,000 to complete, should it be completed if the present value of future net revenues is expected to be €250,000?


137

The Concept of Sunk Costs

• Costs already expended (that cannot be sold and recouped) are sunk costs.

• Always look to the future. • Compare future cost to the PV of future net cash

flows.• A project may be unprofitable, but a loss might be

minimized by completing it.


138

Example

• Peters Oil estimates the following costs to drill and complete a well on Block A:Drilling costs € 300,000

Completion costs 100,000Selling price per bbl 22

Lifting costs per bbl 4 Royalty interest 20%

Is the well profitable at 20,000 or 30,000 or 40,000 bbls?


139

Solution

20,000 bbl 30,000 bbl 40,000 bblTotal revenue (22 x bbl) 440,000 660,000 880,000Less: RI's share (20%) 88,000 132,000 176,000WI's share 352,000 528,000 704,000Less: Lifting costs (4 x bbl) 80,000 120,000 160,000 272,000 408,000 544,000PV of above 188,210 276,310 360,580

The well is not profitable under any of the cases, but should be completed in each case.


140

Module 9: Accounting for Revenue

Objective:

In this module, we will gain an understanding of how revenue is allocated, recorded, and will look at issues involving unitizations and balancing.


141

Marketing Arrangements

Crude Oil Contracts

• Evergreen sales contracts

• Spot Sales Contracts

• Exchange contracts


142

Basic Crude Oil Sales Arrangements

1. Evergreen sales contract: month-to-month sales contract, called an evergreen sales contract, generally refers to a contract negotiated for an initial period of a month and renewed each month until either party cancels the agreement. In the current era of oil price volatility, most evergreen contracts reflect a negotiated price per barrel based on a fluctuating market price, an indexed price, or a fixed price plus adjustments or escalations.*

2. A spot sales contract consists of the short-term sale of a stated volume of production for a stated short-term period (such as a few days or a month or two) for the sale of crude oil based on a negotiated price between the buyer and seller. For example, the parties may agree to buy/ sell 100 barrels per day of South Texas Light crude oil from the Ralph #1, located in Hidalgo County, Texas, for each day of a specified month at $112 per barrel. Once the time period has ended or the specified sale has occurred, the contract ends.*

3. The third type of sales arrangement is the exchange (sometimes referred to as a buy/ sell arrangement), in which producers will exchange crude oil production for another stream of oil production (e.g., two companies exchange Texas crude oil for California crude).

* Evergreen and spot sale contracts allow producers to change oil purchases on short notice, but most producers rarely do so.



• Natural Gas Contracts Swing contracts

Baseload Contracts (spot sales)

Firm contracts (term contracts)

• Transportation Agreements Firm

Interruptible


144


Natural Gas Contracts

• Swing contract: Contract guaranteeing one of two parties periodic delivery of a certain amount of natural gas (the nominated amount) on certain dates in the future, within a certain delivery period, at a stipulated constant price (the strike price). Often short term.

• Baseload contract (spot sales): Similar to swing contract, but both parties agree that they will attempt to deliver or receive the specified volume on a best-effort basis, and they agree not to end the agreement due to market price movements. Little legal recourse.

• Firm contract (term contract): Both parties are legally obligated to either receive or deliver the amount of gas specified in the agreeement.


Transportation Agreements

• Firm service: Offered to customers under schedules or contracts which anticipate no interruptions.

• Interruptible: Low priority service under schedules or contracts which anticipate and permit interruption on short-notice, generally at peak-load seasons.

• Off-peak service: Only for a specified part of a year during the off-peak season.


Recording of Revenue

• US – Revenues are reported net of royalty. Reserves that will ultimately go toward royalties are excluded from reported proved reserves.

• UK – If producer is obliged to dispose of production and pay royalty in cash, then the royalties are considered like a production cost or tax. Revenue is recorded for the full sales amount and the royalty is recorded as an expense. If the royalty owner is paid in-kind, then revenue is recorded net of royalty and the reserves that will go toward royalties are excluded from reported reserves.


147

Revenue Allocation Example

• Exploration Inc owns the WI in Block A. During January, 5,000 bbl of oil were produced and sold. Assume the price for oil is €20/bbl. The royalty interest is 1/8th.

Analysis:

WI (7/8) 87,500 RI (1/8) 12,500Total 100,000


148

Solution

US:Accts Receivable 100,000

Royalty payable 12,500Oil sales 87,500

UK Royalty paid in kind:Accts receivable 87,500

Oil sales 87,500

UK royalty paid in cash:Accts Receivable 100,000

Oil sales 100,000

Royalty expense 12,500Royalty payable 12,500


149

Oil Used Off Property

€1,000 of oil from Block A was used on Block B. Royalty = 12.5%

US: Operating expense – Block B 1,000

Royalty payable 125Sales A 875

UK Royalty paid in kind:Operating expense – Block B 875

Sales A 875

UK paid in cash:Operating expense – Block B 1,000

Sales A 1,000

Royalty expense 125Royalty Payable 125


150

Gas Used Off Property for Injection

€1,000 of gas from Block A was used for injection on Block B.Royalty = 12.5%

US:Operating expense – Block B 1,000

Royalty payable 125 Gas Sales Block A 875

UK royalty paid in kind:Operating expense Block B 875

Gas sales Block A 875

UK royalty paid in cash:Operating expense – Block B 1,000

Gas Sales A 1,000

Royalty expense 125Royalty payable 125

If some gas is recovered and resold for € 600:Accounts receivable 600

Operating expense – Block B 600


151

Allocation to Wells/Leases

• Production may be measured at a central point in a field and need to be allocated back to the individual wells. Likewise, measurement may be taken at a central point for multiple fields. In this case, a two-stage allocation is needed, first back to the field and then back to the individual wells.


152

Allocation Example

• Determine the bbls of production allocated to each well, given that 3,300 bbls were measured and produced.

Well 24-hr Test Days Produced

#1 40 28

#2 50 30

#3 35 24


153

SolutionAllocation:


Well 24-hr

Test

Days

Produced

Theoretical

Production

Ratio

3300/3460

Actual

Production

1 40 28 1,120 X 0.954 = 1,068

2 50 30 1,500 X 0.954 = 1,431

3 35 24 840 X 0.954 = 801

3,460 3,300

154

Take-or-Pay Provisions c Linda Nicholsc Linda Nichols

Purchaser agreed to €1,000 in gas per month; took 0 in April.Royalty = 12.5%.

Producer records as deferred revenue.Cash 1,000

Deferred revenue 1,000

In May, the purchaser took €2,000 in gas. USCash 1,000Deferred revenue 1,000

Royalty payable 250Gas Sales 1,750

UK royalty paid in cash:Cash 1,000Deferred revenue 1,000

Gas sales 2,000


155

Revenue Recognized when Produced - US

€1,000 worth of oil is produced in April and sold in May.

Royalty = 12.5%

• April:

Crude inventory 875

Oil sales875

• May:

Accounts receivable 1,000

Royalty payable125

Crude inventory875


156

Revenue Recognized when Produced – UK Royalty Paid in Cash

• April:Crude inventory 1,000

Sales 1,000


May:Accounts receivable 1,000

Crude inventory 1,000


157

Revenue from Gas - US

• Sale of gas of €1,000Royalty = 12.5%

Pipeline charges €100 to transport to purchaser

• Delivery to pipeline:

Inventory 1,000Royalty payable 125Deferred revenue 875

• Final delivery to purchaser:

Accounts receivable 1,000Deferred revenue 875Transportation expense 100

Accounts payable – pipeline 100Inventory 1,000Gas sales 875


158

Revenue from Gas – UK Royalty Paid in Cash

• Delivery to pipeline:

Inventory 1,000Deferred revenue 1,000

Delivery to purchaser:

Accounts receivable 1,000 Deferred revenue 1,000

Transportation expense 100Accounts payable – pipeline 100Inventory 1,000Gas sales 1,000



159

Unitizations

• Both working and nonworking interests are redetermined based upon whatever sharing factors are agreed to. Typical sharing factors include square kilometers contributed, reservoir volumes attributed to each party, or recoverable bbls of oil-in-place contributed.


160

Example

• Peters discovered a new field in an area covered by an agreement with the government of Haran. The field is large and is covered also by another agreement Haran has with a different company. The government requires unitization.

• Block A WI: 100% Peters

RI: 10% to Haran Square kilometers: 50 Est. net recoverable bbls: 1,000,000

Block BWI: 60% Jasper, 40% Lacey

RI: 11% to Haran Square kilometers: 15 Est. net recoverable bbls: 1,500,000


161

Participation Factors

• Based on est. net recoverable bbls:

Working Interest:

Peters 100%(1,000,000/2,500,000) = 40% Jasper 60%(1,500,000/2,500,000) = 36% Lacey 40%(1,500,000/2,500,000) = 24%

Royalty Interest:

Haran 10%(1,000,000/2,500,000) = 4% Haran 11%(1,500,000/2,500,000) = 6.6% Total 10.6%


162

Participation Factors

• Based on square kilometers contributed:

Working interest: Peters 100%(50/65) = 76.92% Jasper 60%(15/65) = 13.85% Lacey 40%(15/65) = 9.23%

Royalty: Haran 10%(50/65) = 7.69% Haran 11%(15/65) = 2.54% Total 10.23%


163

Weighted Average Unitization

• Weighted averages of more than one participation factor may be used to determine the final participation factors.


164

Example

• Based on the previous example, assume that the number of square kilometers is assigned a weight of 70% and the number of net recoverable bbls is assigned a rate of 30%.


165

Solution

• Working interest:

Peters 70%(76.92) + 30%(40.0) = 65.84%

Jasper 70%(13.85) + 30%(36.0) = 20.50%

Lacey 70%(9.23) + 30%(24.0) = 13.66%

Royalty interest:

Haran 70%(7.69) + 30%(4.0) = 6.58%

Haran 70%(2.54) + 30%(6.6) = 3.76%

Total 10.34%


166

Equalization

The parties must agree on an acceptable approach for equalizing the value of the equipment and facilities being contributed to the unit.

1. Identify the allowable pre-unit contributions.2. Determine the value of the contributions of each pre-unit WI

owner.3. Calculate the obligation of each WI owner for pre-unit costs.4. Determine the settlement.


167

Example

• Assume that three parties each contribute property to a unit and each receive 1/3 of the WI. Assume the following costs and values:

Company Participation Value Share of Over

Factor Contributed Value (Under)

A .333 2,000,000 5,000,000 (3,000,000)

B .333 4,000,000 5,000,000 (1,000,000)

C .333 9,000,000 5,000,000 4,000,000

The companies may choose cash equalization. When paying or receiving cash, the offsetting side of the journal entry should be to wells and equipment. The companies may choose to equalize, instead, by disproportionate future spending.


168

Overlift / Underlift or Balancing

• US – the Sales or entitlement method may be used.

• UK – the entitlement method is required.


169

Example

• Assume that Golden Oil has a 49% WI in Block A in Haran. State Oil has a 51% interest. The government gets a 10% royalty paid in-kind (unaffected by imbalances).


170

Production

Jan. Feb.

Production, bbl 400,000 440,000

Royalty, 10% (40,000) (44,000)

Net to WI, bbls 360,000 396,000

Sales Price $50 $50


171

Balance Report

Jan. Feb.Entitlement:Golden (49%) 176,400 194,040State Oil (51%) 183,600 201,960Total 360,000 396,000

Deliveries Taken:Golden 300,000 96,000State 60,000 300,000

Overlift/(Underlift)Golden 123,600 (98,040)State (123,600) 98,040


172

Entries

• Sales Method – Revenue is recorded for the volume actually delivered to each party. All volumes taken are considered each party’s share of reserves in the ground.

• Entitlement Method – Revenue is recorded by each party based on what they were entitled to take. If they took more than their entitlement, a liability is recorded; if they took less than their entitlement, a receivable is recorded.


173

Entries – Sales Method

January:Golden:Accounts rec. (300,000 x 50) 15,000,000

Oil revenue 15,000,000

State:Accounts rec. (60,000 x 50) 3,000,000


February:Golden:Accounts rec. (96,000 x 50) 4,800,000


State:Accounts rec. (300,000 x 50) 15,000,000



174

Entries - EntitlementJanuaryGolden:

Accounts rec. (300,000 x 50) 15,000,000Imbalance rec./pay. (123,600 x 50) 6,180,000Oil revenue (176,400 x 50) 8,820,000

State:Imbalance rec./pay. (123,600 x 50) 6,180,000Accounts rec. (60,000 x 50) 3,000,000

Oil revenue (183,600 x 50) 9,180,000

FebruaryGolden:

Accounts rec. (96,000 x 50) 4,800,000Imbalance rec./pay. (98,040 x 50) 4,902,000

Oil revenue (194,040 x 50) 9,702,000

Golden now has a credit balance of $1,278,000 in the Imbalance rec./pay. This represents the net overdelivery for both months of 25,560 bbls. (25,560 x 50 = 1,278,000)


175

Entries - Entitlement

February

State Oil:Accounts rec. (300,000 x 50) 15,000,000

Imbalance rec./pay. (98,040 x 50) 4,902,000Oil revenue (201,960 x 50)10,098,000

State Oil now has a debit balance of $1,278,000 in the Imbalance rec./pay. This represents the net underdelivery for both months of 25,560 bbls. (25,560 x 50 = 1,278,000)


176

Module 10: Joint Operations

Overall Objective:

In this module, we will gain an understanding of joint interest operations, billings, allocations, and issues of non-consent.


177

Contracts

• Carefully examine joint operating agreements and the related accounting procedures.

• International joint operations are often governed by an operating committee. The committee has representatives of the government and each contracting party. The committee is responsible for all major decisions. The party designated as the operator must manage the property on a day-to-day basis.


178

Cash Calls

• The operator often estimates the cash requirements for the next month and may provide two or three month projections. A cash call might be made for prepayment of the next month’s estimated cash needs.


179

Accumulation of Costs in Regular Accounts

• Operator’s WI – 60%; Non-operator WI- 40%• Cost of operating the property for April: €2,000

Operating expense 2,000Cash 2,000

At month end:

Accounts receivable-nonoperator 800Operating expense 800


180

Distribution of Costs as Incurred

• Operator’s WI – 60%; Nonoperator’s WI – 40%• Cost of operating the property for April: €2,000

Operating expense 1,200

Accts rec.-nonoperator 800

Cash 2,000


181

New Material Transfer

• Invoice price including transportation is €10,000• Operator’s WI – 60%; Nonoperator’s WI – 40%

Accounts receivable-nonoperator 4,000

W/P-WE 6,000

Cash 10,000


182

Transfers to/from Warehouse

• A – new; current price + freight• B – used but sound; 75% of new price + freight• C – used and needs reconditioning; 50% of new price plus cost

of reconditioning with total not to exceed condition b (+ freight)• D – used and not good for original purpose; price commensurate

with use + freight• E – junk; prevailing junk prices + freight


183

Material Transferred from Warehouse

• Operator’s WI – 60%; Nonoperator’s WI – 40%• Condition B equipment transferred from the warehouse.• New cost: €500,000; Book value: €360,000• €375,000 allowed (€500,000 x .75)

Accounts receivable-nonoperator 150,000W/P-WE 216,000

Warehouse inventory360,000Gain on transfer 6,000


184

Transfers between Properties

• B – if originally A when moved to current property, then 75% of new cost + freight. If originally B when moved to current property, then 65% of new cost + freight.

• C,D,&E – same as before when moving from warehouse.


185

Material Transferred Between Properties

• Condition B equipment is transferred from field S to field T. The equipment was condition A when first put on field S.

• Original cost of equipment: €470,000; New cost: €500,000• Interest is S field: 70%; Interest in T field: 60%• €375,000 allowed (€500,000 x .75)

Accounts receivable-T nonoperator 150,000W/P-L&WE T field 225,000Accum DD&A – S field 66,500

Accounts receivable-S nonoperator 112,500L&WE S field 329,000


186

Overhead

• In international JOAs, overhead rates are often on a sliding scale. Various percentages are applied to amounts of identified direct charges. The rate scale may be different for exploration, development, and production. Overhead covers indirect costs including such things as district offices, home office clerical, administrative, engineering, accounting, legal, and other similar costs.


187

Overhead Example

Based on Direct Costs of Exploration Activities

Up to $6,000,000 6%

$6,000,001 to $12,000,000 5%

$12,000,001 TO $25,000,000 4%

Over $25,000,000 3%


188

Non-Consent

• One or more parties may decide not to participate in the drilling of one or more wells on the property. The remaining parties have the option of picking up that party’s share of costs to drill the well. They will then receive the nonconsent party’s share of production from that well until paid back with a penalty.


189

Non-Consent Example

• Golden Oil has a 30% WI and is the operator on Block A in Haran. Total has a 19% WI and State Oil has a 51% WI.

• Golden sends out an AFE proposing to drill an additional development well at a cost of $1,200,000. Total elects not to participate in the well.

• Golden and State agree to drill the well and each carry a proportionate share of Total’s cost.

• The JOA calls for a 300% nonconsent penalty. Total will not receive revenue (production) from this particular well until Golden and State receive their extra costs back with the penalty.


190

Division of Costs

Original Int. Proportionate Int.Golden 30% 30/81 = 37.03704%State 51% 51/81 = 62.96296%

Costs paid:Golden w/nonconsent 1,200,000 x 37.03704% = 444,444Golden normally 1,200,000 x 30% = 360,000Excess paid 444,444 – 360,000 = 84,444

State w/nonconsent 1,200,000 x 62.96296% = 755,556State normally 1,200,000 x 51% = 612,000Excess paid 755,556 – 612,000 = 143,556


191

Amount Recoverable by Golden

Proportionate share of Total’s normal cost $84,444Penalty x 300%Amount Recoverable 253,332

Assume that the well is drilled and completed, and begins production 8 months later in August 2007. Assume that net revenue (after royalty and operating costs) for the well is $600,000 in August.

Golden w/excess revenue 600,000 x 37.03704% = 222,222Golden normally 600,000 x 30% = 180,000Excess received 222,222 – 180,000 = 42,222

Amount recoverable going into September:253,332 – 42,222 = 211,110


192

Module 11: Conveyances

• Overall Objective:

To gain a basic understanding of the nature of mineral ownership and how to account for conveyances.


193

Common Mineral Agreement Provisions

• Signing bonus: Upfront monies to mineral owners or governments.

• Royalty provision: Non-operating interest bearing no portion of the costs; retained when the owner of land grants to another (e.g., lease) the right to ascertain if oil/ gas exists and if so, to develop the property. Paid to landowner (e.g., 1/8th ).

• Working interest (WI): Created by the lease and is responsible for the exploration, development, and operations.

• Primary term: Sets the time limit for the length of the lease.

• Delay rental payment: Lease normally requires a lessee to commence drilling operations by a certain date; Afterward delayed rental payment extents the lease.

• Shut-in payments: Property placed in production, but later shut-in for some reason. Lease requires additional payments (i.e., natural gas pipeline not available).


194


• Right to assign interest: Rights of both parties (e.g., lessee, lessor) may be assigned in whole or part without permission of the other (e.g., overriding royalties).

• Overriding royalty: Original lessee executes a sublease and retains an overriding royalty.

• Option payment: Payment to obtain a preleasing agreement giving the lessee a specified time to obtain a lease.

• Right to free use of resources for lease operations: Operator has the right for the free use of the oil and gas produced on the lease to carry out operations on the lease.

• Offset clause: An adjacent operator must drill an offset well within specified time to avoid the draining of a reservoir.

• Minimum royalties: Payment of minimum amount to the lessor (commonly recoverable from future royalty payments) regardless of production.


• Advanced royalties: Royalty to lessor to be paid before minerals actually extracted.

• Pooling provisions: If a working interest (WI) owner forms a pool (or unit) with other leases, the royalty interests and other non-WI owners may be forced to combine their interests with other non-WI owners.

• Production holds lease: The rights to minerals in place that is limited to time, amount, or number of units to be produced (e.g., retained, carved-out, and advances).

• Production sharing agreement: In a contractual system (govt. owns all minerals), petroleum company is allowed to recover certain costs and receive a share of the profits (e.g., payment-in-kind).

• Top lease: A new lease is executed before expiration or termination of an existing lease.



Accounting for Conveyances

• The main question is when should a gain or loss be recognized?

• The answer depends on if the property is proved or unproved and if the entire interest or only a partial interest is being sold.


197

Unproved Properties

• If selling the entire interest, the difference between proceeds and book value is a gain or loss.

• If selling a partial interest, all proceeds are considered a recovery of cost all the way to bringing the basis to zero.

• Practice is same in U.S. and internationally.


198

Accounting

• Sale of entire individually significant unproved property.

EX:U/P – Intangible assets €60,000Impairment allowance €20,000Sold for €45,000

Cash 45,000Impairment allowance 20,000

U/P – Intangible assets 60,000Gain 5,000


199

Accounting

• Sale of entire unproved property in U.S. assessed on group basis

EX:Original cost €100,000; sold for €90,000

Cash 90,000Impairment allowance 10,000

Unproved property 100,000

If sold for €110,000:Cash 110,000

Unproved property 100,000Gain 10,000


200

Accounting

• Sale of individually assessed unproved property – partial interest

EX: Cost €200,000; impairment allowance €50,000 (BV €150,000); sold 25% for

€75,000

Cash 75,000U/P – intangible asset 75,000

If selling price were €170,000 (over BV):Cash 170,000Impairment allowance 50,000

Unproved property – intangible asset 200,000Gain 20,000


201

Accounting

• Sale of unproved property in U.S. assessed on a group basis – partial interest

EX: Cost €200,000; sold 30% of the WI for €100,000

Cash 100,000U/P 100,000

If selling price were €220,000:Cash 220,000

U/P 200,000Gain 20,000


202

Proved Properties

• If entire interest is sold, the difference between proceeds received and book value is a gain or loss.

• If a partial interest is sold, the book value is allocated to the portions retained and sold based on relative fair values.

• Practice is same in U.S. and internationally.


203

Accounting

• Sale of entire proved propertyEX: Currently have on the books for this proved property:P/P – tangible assets € 50,000Wells & rel. E&F 220,000Accum. DD&A 30,000

Sold for €200,000Cash 200,000Accum. DD&A 30,000Loss on sale 40,000

P/P – tangible assets 50,000Wells & rel. E&F 220,000


204

Accounting

• Sale of partial interest in proved property

EX: The 100% WI owner carved out some WI (30%) and sold it for €300,000.

70% of the WI was retained, 30% was sold. Current BV: property €100,000; Wells & rel. E&F €600,000; total BV

€700,000Allocation:FV sold/Total FV x BV = BV sold

300,000/1,000,000 x 700,000 = 210,000 sold(received 300,000 so gain is 90,000)

Cash 300,000P/P - Tangible assets (.30) 30,000Wells & rel. E&F (.30) 180,000Gain on sale 90,000


205

Accounting

• Sale of WI in proved property with retention of non-WIEX: BV property €100,000; Wells & rel. E&F €600,000; total BV €700,000

The WI is sold for €750,000 but an ORI is retained.750,000/1,000,000 x 700,000 = 525,000 soldGain is 225,000 (750,000 - 525,000)

Cash 750,000Investment in ORI 175,000

P/P – tangible assets 100,000Wells & rel. E&F 600,000Gain 225,000


206

Module 12: International

Overall Objective:

In this module we will examine issues of international operations, and foreign currency transactions.


207

Types of Agreements

• Leases• Concessions• Risk service• Production sharing contracts


208

Foreign Currency Transactions

• In the U.S. and in most of the world, a two-transaction approach is required wherein the underlying asset is carried at historical cost with monetary gains or losses taken directly to income in the period in which they occur.


209

Foreign Currency Transactions: Export Example

• On June 1, Assume that Peters, a U.S. company, sells crude to a German customer at a price of 1 million Eurodollars (EUD) when the spot exchange rate is $1.26 per EUD. Peters allows the German customer 30 days to pay. At the end of 30 days, the EUD has depreciated to $1.25.

June 1Accounts receivable EUD 1,260,000

Sales 1,260,000To record sale at spot rateJuly 1Foreign exchange loss 10,000

Accounts receivable EUD 10,000

Adjust to new spot rateCash 1,250,000

Accounts receivable EUD 1,250,000Record payment and conversion

If the balance sheet date comes before the payment date, the receivable should be revalued at that time.


210

Foreign Currency Transactions: Import Example

Peters makes a purchase of equipment on December 1 from a German company for 1 million EUD when the spot rate is $1.26. Peters has 60 days to pay. The spot rate is $1.255 on 12/31 and $1.25 when paid on February 1.

December 1 (Record purchase at spot rate)Equipment 1,260,000

Accounts Payable 1,260,000

December 31 (Adjust value of payable)Accounts payable 5,000

Foreign exchange gain 5,000February 1 (Adjust value of payable)Accounts payable 5,000

Foreign exchange gain 5,000(Record payment)Accounts payable 1,250,000

Cash 1,250,000


211

Production Allocation Example

• Assume that Zapco is involved in petroleum operations in China, Zapco has 49% WI while Local has 51% WI. Annual gross production is to be divided as follows:

• VAT 5% of gross production• Royalty 12.5% of gross production• Cost oil 62% of gross production. Order: Operating expense, exploration costs

(paid by Zapco), development costs.• Remaining is profit oil: 10% to government, remainder split between Zapco

and Local based on WI.• Assume: Recoverable operating costs are €10,000,000

Unrecovered explorations costs are €50,000,000 Unreceovered development costs are €100,000,000 Annual gross production is 7,000,000 bbls

Price is €20 per bbl

Adopted from Gallum et. Al, Fundamentals of Oil & Gas Accounting, 4th, Penn Well, 2001.


212

• Barrels •Chinese •Govern-• ment•(in bbl)

•Local Oil Company• 51%•(in bbl)

•Zapco Oil Company• 49%•(in bbl)

•Annual Gross Production •7,000,000

•VAT (5%) • 350,000 • 350,000

•Royalty (12.5%) • 875,000 • 875,000

•Cost Oil (62% x 7,000,000) •4,340,000

• Operating costs:•10,000,000/20 = • 500,000 bbl

• 500,000 • 255,000 • 245,000

• Exploration costs:•50,000,000/20 = • 2,500,000 bbl

•2,500,000 •2,500,000

• Development costs:• 100,000,000/20 = • 5,000,000; 1,340,000 • is max allowed

•1,340,000 • 683,400 • 656,600

•Remainder • 0

•Profit oil: 7,000,000•x [1-(5%+12.5%+62%)/100%]

•1,435,000

• To Government:• 1,435,000 x 10%

• 143,500 • 143,500

• Allocable Profit Oil:• (1,435,000 x 90%)

•1,291,500

• 1,291,500 x 51% • 658,665

• 1,291,500 x 49% • 632,835

•TOTAL •7,000,000 •1,368,500 •1,597,065 •4,034,435


213

Module 13: Disclosures

Overall Objective:

In this module we will gain a basic understanding of the disclosures required by SFAS No. 69 in the US as well as international disclosures.


214

The Six Required US Disclosures

1. Proved reserves information2. Capitalized costs related to oil and gas producing activities3. Incurred acquisition, exploration & development costs4. Results of operations for E&P forward-looking disclosures

5. Standardized measure of discounted future cash flows6. Change in the standardized measure of discounted future

cash flows


215

Historical disclosures

Forward-looking disclosures

International Standards

• The UK does require reserve value disclosures (#1,2,3,4).

• UK does not require 5 and 6.• The IASB is in favor of 1,2,3,4, but undecided

about 5 and 6.


216

Module 14: Financial Statement Analysis

Overall Objective:

In this module, we will gain a basic understanding of statement analysis utilizing ratios, concentrating on industry-specific ratios.


217

Liquidity

• Current ratio

Current assets

Current liabilities

• Quick Ratio

Cash + Securities + Receivables

Current liabilities


218

Financial Strength

• Debt to S/E: Total debt S/E

Return on S/E: Net income S/E

Return on assets: Net income Total assets


219

Specialized Industry Ratios

• Reserves Replacement:

Extensions and discoveries + improved recoveryProduction

Average reserves per well:

Proved reserves at beginning of year Net wells

Average daily production per well:

Annual production/365Net wells


220


• Finding Cost Ratio:

G&G costs + all exploratory drilling costsReserve extensions and discoveries (excluding revisions)

Lifting Costs per BOE:

Total annual lifting costsAnnual production in BOE

DD&A per BOE:

Total annual DD&AAnnual production in BOE


221


• Reserve Life Ratio:

Total proved reserves at beginning of year

Production


222

Example

• ABC provides the following information at December 31, 2006:Proved reserves of oil (in thousands of barrels)Beginning of year 180Revisions of previous estimates 10Improved recovery 20Extensions & discoveries 60Production (25)End of year 245

Number of net wells producing 6G&G costs € 40,000Exploratory drilling costs 700,000Lifting costs 125,000


223

Example Ratios

• Reserves Replacement:

60 + 20 = 3.2 25

Reserve Life:

180 = 7.2 25

Average Reserves per Well:

180,000 = 30,000 bbls 6


224

Example Ratios

• Average Daily Production per Well:

25,000/365 = 11.42 bbls per day 6

Finding Cost Ratio:

€40,000 + €700,000 = €12.33/bbl60,000

Lifting Cost per BOE:

€125,000 = €5/bbl 25,000


225


Abbreviations

AFE Authority for Expenditure

ARO Asset Retirement Obligation

bbl Barrels

BHP Bottom Hole Pressure

BOE Barrels of Oil Equivalent

BTU British Thermal Unit

C Capitalize

CNG Compressed Natural Gas

CV Carrying Value

DD&A Depreciation, Depletion, and Amortization

DR&A Dismantlement, Restoration & Abandonment Costs

E&F Equipment & Facilities

E&P Exploration & Production

FC Full Cost

FMV Fair Market Value

GAAP Generally Accepted Accounting Principles

G&G Geological & Geophysical

GTL Gas to Liquid

IASA International Accounting Standards Board

IDC Intangible Drilling & Development Costs

JI Joint Interest

JOA Joint Operating Interest

LCM Lower of Cost or Market

LNG Liquefied Natural Gas

LOE Lease Operating Expense

LPG Liquefied Petroleum Gas

226


L&WE Lease & Well Equip.

LWD Logging while Drilling

Mcf 1000 cubic feet of Natural Gas

MMcf One million cubic feet of Natural Gas

MWD Measuring while Drilling

NGL Natural Gas Liquids

NPI Net Profit Interest

NWI Non- Working Interest

ORI Overriding Royalty Interest

P&A Plugging & Abandonment Costs

PDR Proved Developed Reserves

P/P Proved Property

PR Proved Reserves

PSA Production Sharing Agreement

Psia Pressure per square inch Absolute

PV Present Value

RI Royalty Interest

SE Successful Efforts

SEC Securities & Exchange Commission

TD Total Depth of Well

UK United Kingdom

U/P Unproved Property

WI Working Interest

W/P Wells in Progress

Abbreviations

227

Thank You !!

[email protected]

[email protected]


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Welcome to Fundamentals of International Oil & Gas Accounting Dr. Linda Nichols, CPA Texas Tech...

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