Key Takeaways of Oil and Gas Sector

CA Garima Mittal

In this article, author attempts to brief oil & gas sector related cost & its accounting. For any queries or suggestions, author can be reached at garimamittal@live.in.

The oil & gas industry is usually divided into three main sectors: upstream (also known as exploration and production (‘E&P’)), midstream & downstream. The upstream part of the industry involves the first phase of finding and drilling oil, the midstream phase involves shipping and storing the oil and the downstream phase involves refining and distributing the processed oil-based products. Midstream sector provides an integral link between the upstream and downstream sectors. Midstream operations are often included in the downstream category and considered to be a part of the downstream sector.

The oil & gas upstream sector cost can be classified as:

1. Cost of Acquisition Activities: Includes cost incurred to obtain the exploration rights for development and production of oil & gas. It includes leases or purchase of properties, legal costs, broker’s fees, and portion of costs applicable to mineral when land and mineral rights are purchased in fees and other costs incurred in obtaining mineral rights.
2. Cost of Exploration Activities: Cost incurred in identifying areas, drilling and exploratory wells and exploratory-type stratigraphic test wells etc.
3. Cost of Development Activities: It involves the preparation of discovered reserves for production.
4. Cost of Production Activities: It includes cost of operate and maintain wells etc. Production costs are wages for workers and electricity for operating well pumps.

There are two generally accepted accounting methods to account for cost of upstream activities:

1. Full Cost Method (FC)
2. Successful Effort Method (SE)

Under US GAAP, the companies follow either of the two method of accounting for exploration and production activities. The SE method is governed by FAS 19 financial accounting and reporting by Oil & Gas producing companies and FC method is governed by SEC regulations S-X Rule 4-10 financial accounting and reporting for oil & gas producing activities pursuant to the federal securities laws and the energy policy and conservation Act of 1975 and various SEC staff views. Therefore, E&P companies that use SE method should apply the guidance of ASC 932-360-35 & ASC 360-10-35 to account for impairment of their oil & gas asset whereas E&P companies that use FC method should apply the guidance in Regulation S-X, Rule 4-10, SAB Topic 12.D & FRC Section 406.01.c

The main difference between FC & SE methods is the cost treatment of unsuccessful activities: should be capitalised or expensed. FC method capitalises both successful & unsuccessful activities whereas SE method capitalises only the cost of successful activities, whereas the cost of unsuccessful activities are expensed under this method. A drilling effort is classified as successful if it results in the extraction of economically recoverable oil & gas and classified as unsuccessful if it results in a dry hole.

Exploration costs capitalised under either method are recorded on statement of financial position as part of Non- current assets. This is because oil & gas reserves are considered productive assets for an oil & gas firm.

Impairment under FC & SE accounting method

Under FC method, SEC regulation requires a test of over capitalization. The test is made by putting a ceiling to ensure that net capitalized costs do not exceed the value of the company. The ceiling test is performed quarterly and is made by comparing the net capitalised cost to a cost ceiling value. If capitalized cost is more than the ceiling, then it is permanently written down.

Under SE method, the three step impairment process undergoes. First, an event or circumstance that indicates the occurrence of impairment must exist. The second task is making the comparison between the undiscounted future net cash flow with the book value of the property. If the comparison shows that the undiscounted future net cash flows is less than book value, determination of the impairment amount will be made. In determining the impairment amount, comparison between the book value and fair value of the property is made as third step.

In reference to matching cost and transparency viewpoint, SE method is much more favourable than FC method, the reason being it matches the expenses of a period against revenues of the same period and does not mix the successful & unsuccessful activities. However, FC method is favourable practically as it will enable reporting the financial statements which gives favourable view of their income and help companies to look for more investors.