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1 Upstream Petroleum Operations most widely accepted o&g accounting standards: SFAS 19 financial accounting and reporting by oil and gas producing companies; SFAS 69 disclosures about oil and gas producing activities in the absence of specific IFRS, IAS 1 permits companies to rely on the pronouncements of other standard setting bodies and on accepted industry practices the true value of an o&g company is the underlying value of its oil and gas reserves two categories of reserve estimation methodologies: deterministic a single best estimate of reserves is made based on known data; or probabilistic known data is used to generate a range of estimates and their associated probabilities reserves under deterministic include proved reserves (developed and undeveloped). Reserves under probabilistic include proven and probable reserves and possible reserves. US GAAP says that only PROVED reserves (reserves that are anticipated to be commercially recovered from known reservoirs) are allowed. o Proved demonstrated with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions o Proved developed expected to be recovered through existing wells with existing equipment and operating methods o Proved undeveloped expected to be recovered from new wells on undrilled acreage or from existing wells where a relatively major expenditure is required for recompletion UK GAAP allows the use of commercial reserves (includes proven and probable or proved). In some government contracts, cost sharing is dictated by the phase in which costs are incurred. Phases are also helpful in determining whether to capitalize or expense costs Divided into phases (first 5 are preproduction, last two are production): 1. pre-license prospecting geological evaluation of relatively large areas before acquisition of petroleum rights. Must obtain permission from owner of the land (usually govt outside of US) to do physical testing. a. Capitalization vs expense accounting decisions are affected by the level of certainty regarding future economic benefit. 2. Mineral interest acquisition/contracting activities related to obtaining the legal rights to explore for, develop, and produce o&g in a particular area. Company usually receives mineral interest interest in a property that gives the owner the right to share in the proceeds from oil or gas produced. a. Leases/risk agreements grants company the right to operate a property, obligates the company to pay all costs. Includes: payment of a bonus at time contract is signed, payment of a royalty equal to a percentage of value of oil produced, lessee being responsible for pmt of all the costs w/o reimbursement, the lease remaining in effect as long as minerals are produced from the property. Must also pay certain taxes ex: taxes based on volume or value of oil produced (severance/production taxes) b. Concession agreements outside of US where gvmt owns mineral rights, similar to leases. Might provide for gvmt participation in the form of a joint working interest. Same provisions as lease. c. Production sharing contracts (PSC) most commonly used arrangement. Contractor pays bonus and royalties, govt retains ownership of reserves, contractor spends a certain amt of money training local staff (recoverable) and performing certain work aimed toward developing infrastructure of host country (may not be recoverable), operating costs recoverable, profit oil split bt govt and contractor. d. Risk service contracts oil production has been achieved but need to rejuvenate production area. service is usually workovers or other ops aimed at restoring or stimulating production. e. most accountants agree that costs should be capitalized depending on whether or not

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reserves will be associated with mineral interest Exploration detailed examination of an area for which a mineral interest has been acquired, inc exploratory drilling to determine if commercial reserves exist. Usually, costs should be expensed as incurred if uncertainty is high. Evaluation and appraisal confirming and evaluating the presence and extent of reserves that have been indicated by previous testing; confirms that reserves are commercial. Expenditures should be capitalized, at least temporarily. Development move into commercial production drill additional wells, construct platforms and gas treatment plants, construct equipment and facilities needed for getting oil and gas to the surface and processing them, constructing pipelines and storage facilities. Low uncertainty = costs capitalized. Production extract o&g from reservoir and treat it to meet marketing/transportation standards. Must remove basic sediment and water (BS&W), costs expensed as incurred. Closure field must be restored to its pre-existing condition

Ch. 2 Industry Accounting Practices Major users of accounting info are: investors and creditors, tax preparers/authorities, companies involved in joint operations, government entities, and management Financial accounting includes measuring and recording the economic activities and communicating info to outside users. Why are there so many different accounting practices in o&g industry? o Risks are high and theres a low probability of discovering commercial reserves o Theres a long time lag between acquiring permits and ultimate production o No necessary correlation between expenditures and results o The underlying value of the reserves cant be valued reliably enough to be recorded on the b/s o The discovery of new reserves is a major future income-earning event o High costs and risks result in joint operations Costs incurred are accounted for by two historical cost methods: successful efforts or full cost. o Full cost capitalizes the majority of costs; cost centers range from countries to large regions o Successful efforts capitalizes only those costs that are identifiable with future economic benefits; associated with a single geological structure SFAS 69 mandates disclosure of info regarding quantity and value of proved oil and gas reserves. Must estimate and disclose the beginning and ending quantity and value of proved reserves and explain changes from one period to the next. o Reserve value disclosure is the standardized measure of the discounted future net cash flows from the production of proved reserves Successful efforts: o Relationship should exist between costs incurred and reserves discovered o Only searching costs directly related to finding reserves are to be capitalized o Pre-licensing costs dont tie to a specific asset, so expensed o All development costs are capitalized Full cost: o All costs associated with the eventual discovery of reserves are necessary to discovering reserves and represent the total cost; all should be capitalized. Ch. 3 Contracts that influence accounting decisions o&g producer must acquire the right to explore, develop, and produce minerals; must identify parties who own the rights

Most countries government owns rights. US mostly individuals. Leases: Most common arrangement in US Royalty interest owned by original mineral rights owner, in return for signing lease agreement, owner receives an upfront pmt (bonus), and a royalty if any o&g is produced (specific % of the minerals produced). Royalties can be paid in either money or in-kind (portion of actual oil Royalty owner not obligated to pay any costs, but is usually responsible for its share of taxes assessed. Can also be called a non-operating or nonworking interest Working interest owned by o&g company after it enters a lease, owner responsible for all costs. Revenues = amt remaining after deducting royalty interest. o can be shared by multiple parties joint interest operation o most are undivided working interests multiple owners share in any and all reserves as well as the oil and gas JOA (joint operating agreement) governs how property is to be operated and how costs are to be shared. One owner is the operator of the property (Responsible for day to day interest) and others are non-operators In international ops, can create an overriding royalty interest (ORI) or net profits interests out of working interest. Created by being carved out or retained; classified as nonworking or non-operating. o Carved out when original interest creates an ORI by selling the interest to another party with the original party keeping its original working interest o Retained when original owner sells its working interest to another party and retains a nonworking interest o ORI owners get a share of net revenues but not responsible for any costs, share is usually a % of the hare of revenue belonging to the original working interest o Net profits interest revenue is a % of net profit from the property; usually owned by govt (in US) after it executes an offshore lease. o Production payment interest not responsible for any costs, ceases to exist after a specified amt of oil, gas, or money is paid or specifc amt of time has passed. Countries where the govt owns rights but ownership can be transferred to the contractor have concessionary systems. The most frequent types of pmts made to host govt are bonuses and royalties. Govt also paid in taxes (income, vat, duties, production, etc) o Oil companies assume full risk and cost. If o&g not discovered, contractor doesnt recover any costs. If discovered, ownership is transferred to the company, which pays a royalty to govt before production begins. o Govt is usually a royalty interest owner, can retain option to be a working interest owner. Govt will usually form a state-owned company to take over role of working interest owner. Can have up to 51% interest. PSCs govt owns all minerals. Ownership never passes to contractor; just permitted to recover costs and share in profits. o contractor pays govt a signature bonus when signing agreement. Pay a small signature bonus if also paying a development bonus due when the decision is made to develop a field within the contract area; or production bonus due when production reaches a specific level. o Might have to pay royalties even if title doesnt pass to contractor, sliding scale royalties rate is lower when production is lower and increases with production o Operating committees composed of reps from contractor and state company, permits govt and other working interest owners to be directly involved with operations. o If govt becomes a working interest owner, must pay proportionate share of future costs

Contractor must use most advanced tech and transfer knowledge to the local staff. Majority of employees must be hired locally. Training costs are recoverable. o Contractor provides all of the funding during exploration and appraisal phase. Costs incurred during development and production are shared based on working interests. o Specified length and duration of exploration and appraisal phases, each divided into various stages o Contract will specify which costs are recoverable, order of recoverability, limits, etc. Most common order of cost recovery: current year operating costs, unrecovered exploration/appraisal costs, unrecovered development costs, deemed or imputed interest on development costs, any investment credit o Profit oil production after paying royalties, production related taxes, and cost royalties. Shared between the parties. o Domestic market obligation contractor must set aside a portion of its share of production for delivery to the local market. Price is either equal to market price or contract establishes a max price that may be below market price risk service agreements: contractor pays all costs and assumes all risks. If production is attained, contractor can recoup costs as production is sold and receive a fee based on production for services. Originally used in situations where fields need rejuvenation. o Similarities with PSCs: contractor pays a signature bonus and govt receives royalty interest, use state oil company to involve govt in operations, limit term of agreement o Difference: pmt to contractor is usually a fee, not recovery of cost oil and profit oil. o

Ch. 4 Accounting for pre-license prospecting, nondrilling exploration, and license acquisition costs successful efforts first phase of evaluation is pre-license prospecting, which involves geological evaluation. Occurs before a mineral interest has been acquired. Costs are sizeable and could lead to discovery of new reserves, but are incurred at a time when uncertainty is high. Reconnaissance survey G&G (geological and geophysical) study over a large physical area, purpose is to identify smaller areas that may contain oil and gas. If results are promising, conduct a detailed study. o US SFAS 19 under successful efforts method, G&G costs must be expensed as incurred; overhead related costs should be expensed as well as either overhead costs or G&G costs o UK: initially capitalize all G&G costs no matter when they were incurred. Costs that cant be specifically identified with a particular geological structure are written off in period incurred, allocate overhead costs so specific G&G activities Important to see if contract discusses recoverability of pre-license prospecting and exploration costs, including G&G costs incurred before and after license acquisition. o Lease/concession agreement prob no provisions permitting cost recovery o PSCs /risk service contractor might be able to recover G&G costs incurred after acquisition, maybe even before acquisition Cost of acquiring support equipment should be capitalized If a company gathers seismic data and it is not used for a project, costs should be written off. If the company decides to reevaluate and pursues the project, then: o If reprocessing relates to the search for oil and gas, it should be accounted for the same way as prospecting and nondrilling exploration costs (expense for US) o If relates to how to best develop reserves, should be capitalized as development costs Cost of acquiring a mineral license should be capitalized when incurred, rarely recoverable under PSCs or risk service agreements At what point should development and production bonuses be accrued? Development as soon as it becomes apparent that operations will proceed to development phase ( after

discovery of commercial reserves). Production when it becomes more likely than not that production levels will reach the requisite levels as agreed in contract. Internal costs related to acquisition, such as salaries of employees, should be capitalized. Costs of holding a nonproducing property are expensed as incurred, include: delay rentals paid on leased mineral properties, property taxes, accounting costs, legal costs o Still have costs even though you havent drilled Successful efforts requires that unproved properties be assessed annually to determine if properties have been impaired. Impairment occurs if there is some indication that the capitalized cost is greater than the future economic benefits. US GAAP assumes that property interest of a property is equal to the price paid. If impaired, recognize a permanent loss. Accounting for abandonment of an unproved property depends on if it was originally classified as being individually significant. If so, net capitalized acquisition costs should be charged to surrender and abandonment expense. Can surrender part of property, esp outside of US where contracts cover large areas. Accounting depends on status of the portion that is retained. o If the value of the retained acreage > cost of entire acreage, then costs that are capitalized should be treated as the cost of the retained acreage. o IF value reflects a diminishment in companys assessment of future economic benefit, entire property should be assessed for additional impairment Unproved property should be reclassified to a proved property status when commercial reserves are discovered on property. When entire interest in an unproved property is sold, accounting depends on whether the property was individually significant and impaired on an individual or group basis. o IF individually significant, recognize gain or loss o If individually insignificant, only recognize gain if selling price > original cost, no loss. Debit allowance account instead.

Ch. 5 Accounting for exploratory drilling & appraisal costs successful efforts after a license has been obtained and prelim exploration work finished, then drill exploratory well PSCs usually define exploratory phases as 3-5 years; specific number of wells must be drilled Cost of developing new infrastructure for wells is very high, so even if there are reserves it will not be commercial yet. Appraisal activities determine extent and commerciality of reserves. General nondrilling exploratory costs are expensed Exploratory drilling type costs are capitalized pending determination of whether the well has found commercial reserves. If so, capitalized costs become part of enterprises well and related equipment and facilities. Exploratory well drilled in an unproved area to find a new reservoir in a field previously found to be productive or extend a known reservoir Stratigraphic test well drill to obtain info pertaining to a specific geologic condition. Are i. exploratory if not drilled in a proved area ii. Development if drilled in a proved area US doesnt define or address appraisal wells, prob because appraisal is not very different from exploration Should separate intangible drilling costs (IDC) from equipment costs. Distinction is significant in tax law. o All or a portion of IDC incurred is deductible more rapidly than cost of equipment o IDC expenditures for drilling that dont have a salvage value/are incident to and necessary for drilling of wells. Include up to cost of installing production flow valves.

Equipment costs include all tangible or salvageable costs of drilling the well and the cost of both intangible and tangible costs past the production flow valves. o Distinction doesnt matter in financial accounting costs of drilling wells are charged to non-depreciating asset accounts, drilling in progress accounts (WIP). If commercial reserves are discovered, drilling in progress account transferred to another asset account that can be depreciated. If well is unsuccessful, must be plugged and abandoned, costs charged to dry hole expense, net of any equipment salvaged from the well. Capitalize G&G costs using 3D and 4D methods to the well/field, other G&G costs expensed. All working interest owners must have opportunity to approve project and expenditures. Process of obtaining approval is authorization for expenditure (AFE). o In joint operations governed by JOA, partner approval obtained through process of executing a AFE. o In joint ops not governed by JOA, approval rests with the contractually defined operating committee. No standard form of AFE, each company designs their own. Should at least include detail to enable non-operators to assess reasonableness of costs. Should include estimates for IDC and equipment costs, completions costs, and abandonment costs. o Most agreements require operator to obtain reapproval from other working interest owners if actual costs exceed budgeted costs. o AFEs also used to get approval from non-operators for projects where estimated costs exceed the single expenditure limits specified in JOA. o

Ch. 6 Accounting for the costs of development successful efforts - Development activities are required to gain access to and produce reserves. Typical activities: building roads, locating well sites, drilling development and service wells, installing equipment to lift oil and gas to surface and move it to storage. o Equipment like flow lines, separators, heaters, storage tanks, meters - Occur before production but may also occur after production begins - Costs that have been capitalized to this point should be transferred from drilling in progress accounts into the appropriate well and equipment accounts for the field/ - All of the costs incurred in developing reserves should be capitalized as a cost of the asset - Development well drilled within the proved area of a reservoir to the depth of a stratigraphic horizon known to be productive - Service well drilled for the purpose of supporting production in an existing field - These wells and other development activities are to be capitalized, successful or not - G&G activities associated with a well should be capitalized to the well, G&G activities associated with development activities should be capitalized to the field - General administrative overhead is an expense and not allocable. Overhead related to the direct support of development operations can be capitalized. - If costs associated with operating equipment are material, should allocate costs (inc depreciation) to the operations being served, then capitalized or expensed depending on nature of operation. - Generally, all reasonable and necessary costs incurred to acquire an asset and ready it for use are capitalized. - Interest costs are capitalized if incurred during construction phase of a self-constructed asset. o Only for qualifying assets constructed for an enterprises own use or intended for sale or lease that are constructed as discrete projects o Amt of interest capitalized = portion of interest costs incurred when asset was being

constructed that could have been avoided if the spending on the asset had not been made o Capitalization period begins when: expenditures for the asset have been made, activities necessary to get the asset ready are in progress, interest cost is being incurred Sole risk situations (carried interests) result from situations where one or more working interest owners agree to bear the costs of another owner in hopes of recovering the cost from future production o Most common: non-consent operation where one party is unwilling/unable to pay its proportionate share. The owners go elect to go forward carry the others share of costs. If the well is dry, carrying party cannot get reimbursement from carried party. If successful, carrying party can usually keep share of production that would have gone to carried party to recoup the cost. In order to compensate carrying party for addl risk, theyre also entitled to an additional share of the carried partys production as a penalty ORIs and net profits interests are nonworking interests bc owner does not have any role in operation and is not responsible for any costs. Farm-in/farm-out: owner of a working interest (farmor) transfers all or part to another party (farmee) in return for farmees performance of an action (drill well, develop property, etc).

Ch. 7 Depreciation, Depletion, and Amortization successful efforts - If expense and revenue matching is not possible, must match based on rational allocation. o Tangible assets (PPE) depreciation o Intangible assets (patents, trademarks) amortization o Systematic write off of natural resources depletion - Only capitalized costs that are completed and placed into service are subject to DD&A. - Cost center determines how costs will be grouped to compute DD&A, usually by field a single reservoir or multiple reservoirs grouped on or related to the same geological structures. - Portion of total reserves used in computing DD&A should be determined based on: o How reserves are related to royalties recording revenue net of royalty OR recording revenue gross (inc royalties to be paid). Usually do option 1. o Reserves owned or entitled to include only the portion of total reserves that the reporting entity owns - Unit-of-production method must be used in amortizing the capitalized costs of acquiring contractual mineral interests and the costs associated with wells and related equipment - Formula: book value at end of period x production for period Estimated reserves at beg of period - the book value that is subject to DD&A is the balance of net capitalized costs at end of period - in order to use reserves as of the beginning of the period, use the most current estimate, add back production - since most reservoirs contain oil and gas, must use one single equivalent unit of measure. Use average Mcf of gas to barrel of oil conversion of 5.81 Mcf to 1 barrel. o Mcf = thousand cubic feet - Companies must recognize future costs associated with dismantlement/environmental restoration when the assets are placed into service or when obligation to dismantle occurs. - Reserve estimates must be reviewed at least annually bc prices change every year. o Any change in reserve estimates -> change in DD&A rates Ch. 8 Full Cost Accounting in international Operations - all costs incurred in prospecting, acquiring mineral interests, exploration, appraisal, and development are capitalized, even though some costs are from unsuccessful efforts

only production costs and general corporate overhead are expensed as incurred Believes that all costs incurred successful or not are necessary for finding oil and gas. In the long run, results in a superior reflection of firm earnings. If successful efforts is used, write-offs result in wide fluctuations in net income. Against full cost: by applying the method, many capitalized costs do not meet the definition of an asset. Unsuccessful efforts are worthless, makes it difficult to assess how efficiently a company is finding and developing reserves. Costs that are capitalized are to be accumulated on a country by country basis. Cost center used for accumulating costs, computing DD&A, and application of the full cost ceiling test. o Not allowed to group operations governed by different governments G&G exploration and exploratory dry holes are capitalized until expensed through DD&A Internal costs directly related to property acquisition, exploration, and development are capitalized Use unit-of-production method in computing DD&A: Formula: book value at end of period x production for period Estimated proved reserves at beg of period Under unit-of-revenue method, amortization should be based on current gross revenue from production. Use when the selling price of oil and selling price of gas are so disproportionate that unit-of-production would result in an incorrect matching of revenues and costs. x production during year valued at actual selling prices Formula: book value at year end Estimate proved reserves at beg of year valued at year end prices two costs can be excluded from the full cost amortization pool: o unevaluated property costs excluded until evaluation of the property is complete (until commercial reserves are found or property is impaired/abandoned) o significant development costs costs related to major development projects that are expected to require significant future expenditures to determine proved reserve quantities costs NOT excluded from DD&A pool are impaired through a ceiling test. o Involves comparison of the value of the proved reserves in each cost center to the net book value for cost center o Ceiling value is the max net book value allowed, if exceeded, must record impairment Unevaluated properties costs should be assessed annually. Individually significant properties must be assessed individually, individually insignificant ones can be grouped.

Ch. 9 Accounting for Production Costs and Company Evaluation - Production costs include the cost of producing or lifting oil and gas to the surface, field treatment and transportation, gathering, and storage - Expensed as incurred under successful efforts and full cost accounting - Production costs include: labor costs (inc employee benefits), normal repair and maintenance of wells and related equipment, recompletions, cost of materials and supplies, overhead costs - Some costs are directly attributable to a particular property, others require allocation to the property or well level o Almost every contract requires that costs either be directly identified or allocated to the well/property for cost sharing purposes. Allocation method must be consistent with generally accepted international cost allocation methods. Usually responsibility of the operator to choose most appropriate allocation method. - Allocation of oil sales from tanks can be by: o FIFO first oil sold is from the beginning inventory o Available for sale beg inventory and allocated production for each well are summed to equal the quantity available for sale, the total is used to compute a ratio of oil available

for sale per well. Gas sales are either long-term contract or short-term sales. o Long-term is usually between a producer and pipeline company, prices are usually fixed and adjusted only to reflect changes in inflation. o Short-term are either spot market sales (usually involve short term sales to pipelines or other common carriers and are responsive to changes in natural gas prices and changes in short term demand) or direct sales (gas sold directly to an end user or distribution comp) Gas is sold from a central point, so its necessary to track costs and production o determine costs and sales at the individual level. o Most common method is metered gas allocations metered using an orifice meter near the wellhead. Initial metered volumes may be used to allocate the sales gas back to well. o Can also allocate based on well tests wells are tested every month to determine gas flow rates and volume of condensate production o Allocate based on dry gas production if gas is wet gas, a portion that is initially metered will be removed as condensate during processing, so volume of gas exiting the facility will shrink. Test data is used to estimate shrinkage, which will be used to adjust the wet gas volumes to dry gas volumes o Allocating flash gas o Allocations based on GOR (umber of cubic feet of as produced with a barrel of oil) Most widely used ratio for evaluating operating performance is Lifting costs per BOW = total annual lifting costs/annual production in BOE; o evaluates how effectively a company is controlling operating costs and how efficient the company is at getting oil and gas out of the ground. DD&A per BOE = total annual DD&A/annual production in BOE Average daily production per well = annual production/365 days Average daily production per well = annual production/365/net wells Average production per employee = annual production/number of full time employees