Accounting for Oil and Gas (#251)
/In this podcast episode, we discuss the accounting for oil and gas operations. Key points made are noted below.
Reporting of Reserves
In this industry, the real value generated by a business is underground, which means that the main focus of attention is on the amount of reported reserves. In general, reserves are considered to be the amount of commercially recoverable oil and gas. Within that general concept are two subdivisions, which are proved reserves and unproved reserves. The main focus of attention from an accounting perspective is proved reserves, which are those oil and gas reserves that can be reasonably estimated to be commercially recoverable from known reservoirs. In other words, you know it’s there, and it’s cost-effective to extract it at current market prices.
The reported level of reserves keeps changing. It’s not that the amount in the ground keeps changing. When a reservoir is first discovered, there’s a certain amount of oil and gas in there, but not all of it is recoverable. The situation differs by reservoir, but let’s say that it’s only feasible to extract half of what’s in a reservoir at the current market price. But then if prices go up, it becomes cost-effective to use more expensive techniques, like injecting steam into the ground. So as the price goes up, a larger proportion of the reservoir becomes available – maybe that brings you to 60% that can be extracted. Or, someone invents a new technique for extracting oil, such as fracking. Whenever something like this happens, even more of a reservoir becomes accessible – maybe the accessible portion goes up to 70%. So what all of this means is that reported reserve levels can fluctuate – a lot.
Depreciation, Depletion, and Amortization
Another unique thing about oil and gas is the concept of DD&A – which stands for depreciation, depletion, and amortization. In this industry, there are lots of tangible assets, like wells, and pumps, and storage tanks – but there are also intangible assets, like the cost to lease mineral rights from a property owner. So, someone figured out years ago that they’d lump all of these assets together and use a standard depletion calculation to charge everything to expense. And therefore, we get the term DD&A, since it combines elements of depreciation, depletion, and amortization.
The way it works is called the unit of production method, where you divide the capitalized cost by the total estimated amount of the reserve – there’s that reserve concept again – and multiply by the number of units produced. So basically, the amount amortized in each period is directly related to the amount produced, so if the production level increases, so does the amortization expense.
But of course, it’s not that simple. There are two schools of thought regarding which expenses to capitalize. Under the successful efforts method, if you drill a dry hole – which means you didn’t find any oil or gas – then the costs associated with that well are charged to expense right away. That’s nice and conservative, since expenses are more likely to be recognized up front.
The other approach is the full cost method, which takes the position that you can’t drill successful wells without also drilling some dry holes. And based on that logic, you pretty much capitalize everything, even if you’re suffering through a string of dry holes. So as you might expect, a business using the full cost method will have more assets on its books than another firm that’s using the successful efforts method.
Asset Impairment
Which brings up the issue of whether these assets can ever be impaired. The main concern is with companies using the full cost method, since they tend to overload their balance sheets with assets. The solution is called the ceiling test, which starts with the present value of future cash flows from the firm’s producing properties, and then subtracts out the cost or fair value of those properties, along with income tax effects. The result is then compared to the net book value of the assets being tested, to see if a write down is needed. So it’s a bit different from the impairment testing system used in other industries.
Impairment is a very big deal in the oil and gas industry, because projected cash flows can vary all over the place. For example, cash flows can drop catastrophically along with the usual gyrations in the prices of oil and gas. Or, the government that controls the drilling production process decides to alter tax rates, or it alters the requirements to restore well sites after production is done. What this means is that an oil and gas firm could appear to have perfectly reasonable asset levels in one year, and finds itself writing off a good chunk of those assets in the next year.
Severance Taxes
And then we have the interesting issue of severance taxes. These are taxes on production that’s levied by the government. So, you produce a $1,000 of gas, you have to pay a portion of that to the government. The main problem is that a producing property usually has more than one party that gets paid for the revenue from a producing well, so the government could be faced with the collection of severance taxes from a bunch of entities.
For example, the Smith family owns the mineral rights underneath a property, and they lease out those rights to an oil and gas firm in exchange for a royalty. And on top of that, the oil and gas firm needs to raise money to pay for drilling wells, so it sells half of its interest in the lease to someone else, in exchange for cash. That means there are now three parties that owe severance tax to the government.
There are two ways to make this more efficient. One is that the buyer of the oil or gas pays the government, so it’s essentially acting like an agent, withholding the amount of the tax from what it would otherwise have paid to the interest owners. The second option is that the operator of the property is paid the entire amount by the purchaser of the oil or gas, and then the operator pays the tax to the government on behalf of the other interest owners. In a way, these arrangements are somewhat similar to how sales taxes are handled in other industries.
Revenue Recognition
And there are lots of issues related to revenue. For example, what if a well site extracts oil or gas and then turns around and uses some of it to power the machinery at the well site? How do you account for that? Turns out, you don’t – the government doesn’t tax it, and the interest owners don’t receive a royalty, on the grounds that you otherwise would have had to bring in the fuel from somewhere else, which counterbalances the lost revenue.
But then things get more complicated. What if you then shift that oil or gas to a nearby property and use it to power the equipment over there? That other property may have different ownership percentages, and perhaps some of the interest owners over there aren’t even the same folks as the ones involved with the first property. So now, you have to record the oil and gas coming out of the source well as revenue, and pay royalties and taxes on it, and then charge it to expense at the receiving site. It’s issues like this that keep accountants employed.
Another revenue issue is take-or-pay arrangements. This is where a pipeline owner commits to taking a minimum amount of gas from a well site each month. But it may not take the gas during the warmer months, when gas demand goes way down. In that case, as the name of the arrangement implies, the pipeline has to pay the producer anyways. The accounting treatment for these payments is that they’re recorded as a deferred credit, which is used to reduce the amount of payments made in other months when the pipeline takes more gas from the well site. Once again, full employment for accountants.
Interest Capitalization
And a parting thought. On top of what I’ve mentioned here, oil and gas companies also capitalize their interest on drilling projects, and they can potentially have massive liabilities for asset retirement obligations, like restoring drilling sites to their original condition. All of these issues mean that oil and gas accountants have to deal with the full range of accounting issues, practically on a daily basis. In short, this is one of the more technically challenging accounting areas in the world.