Depletion Method

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Depletion Method Overview

Depletion is the annual charge to expense for the use of natural resources, such as oil and gas, timber, and coal. It is essentially the same as depreciation, but is applied to natural resources.

In order to compute depletion, it is first necessary to establish a depletion base, which is the amount of the depletable asset.

The depletion base includes the following elements:

Acquisition costs—The cost to obtain the property rights through purchase or lease, royalty payments to the property owner,
Exploration costs—Typically, these costs are expenses as incurred; however in certain circumstances in the oil and gas industry, they may be capitalized,
Development costs—Intangible development costs such as drilling costs, tunnels, shafts, and wells,
Restoration costs—The costs of restoring the property to its natural state after extraction of the natural resources has been completed.

The amount of the depletion base, less its estimated salvage value is charged to depletion expense each period using a depletion rate per unit extracted, or unit depletion rate that is computed using the following formula:

1	×	Depletion base	×	Units extracted
Total expected recoverable units

The unit depletion rate is revised frequently due to the uncertainties surrounding the recovery of natural resources. The revision is made prospectively; the remaining undepleted cost is allocated over the remaining expected recoverable units.

Depletion Method Example

The ABC Oil Company drills a well. It expects to incur the following acquisition, development, and restoration costs associated with the well:

Land acquisition	$172,000
Land preparation (road and drill pad)	38,000
Well drilling	301,000
Trunk line construction	29,000
Estimated site restoration cost	50,000
Total	$590,000

A considerable amount of extraction equipment is also positioned at the well, but since it can be moved among well sites and is therefore not a fixed part of this well, it is depreciated separately.

The entire $590,000 is capitalized. ABC’s geologists calculate that the well has proven reserves of 250,000 barrels of crude oil. In the first year of production, the well produces 45,000 barrels of oil. The depletion charge for the first year of operation follows:

1	× $590,000 = $2.36 per barrel extracted unit depletion rate
250,000 barrels of proven reserves

$2.36 per barrel extracted × 45,000 barrels extracted = $106,200 first-year depletion charge

During the second year of the well’s operation, ABC’s engineers revise the estimated remaining proven reserves upward by 20,000 barrels from 250,000 barrels to 270,000 barrels, based on improved oil recovery techniques. Also, due to new environmental laws, the estimated site restoration cost increases by $10,000, increasing the depletion base from $590,000 to $600,000. Total production for the second year is 62,000 barrels of oil. The depletion charge for the first year is not retroactively adjusted; instead changes in cost and estimated total production are accounted for prospectively. The depletion calculation for the second year follows:

1	× $493,800 × 62,000 barrels extracted in year 2
225,000 barrels of proven reserves remaining

= $136,069, which is the depletion charge of $2.19 per barrel extracted

These depletion expenses leave $357,731 of capitalized costs yet to be amortized over remaining proven reserves of 163,000 barrels, representing a future depletion charge of $2.19 per barrel, barring any further future changes in estimates.