Successful Efforts Method (SEM) and Full Cost Method (FCM) of Accounting for Oil and Gas Producing Activities

Functions/Segments of Oil and Gas Industry Exploration and Production (E&P) Transportation Refining and Gas Processing Marketing and Distribution An independent oil company is one involved primarily in only E & P activities An integrated oil company is one involved in E & P activities as well as at least one of the other functions.

E&P Activities Acquisition activities Exploration Activities Development Activities Production Activities

Acquisition activities Involve activities carried out for acquisition of rights to explore, develop and produce oil and gas

Exploration activities Prospecting activities conducted in the search for oil and gas Ariel, geological, geophysical, geochemical, topographical and seismic surveys analysis, studies and their interpretation Investigations relating to subsurface geology Structural test drilling Drilling of exploratory and appraisal wells

Development activities Purchase, shipment or storage of equipment and materials used in developing oil and gas accumulations, completion of successful exploration wells Drilling, completion and testing of development wells Drilling, completion and recompletion of service wells Laying of gathering lines Construction of offshore platforms and installations Installations of separators, tankages, pumps, artificial lifts and other producing and injection facilities required to produce, process and transport oil or gas

Production activities pre-wellhead activities (lifting the oil and gas to the surface, operation and maintenance of wells, extraction rights, etc.) Post-wellhead activities (gathering, treating, field transportation, field processing, etc., up to the outlet valve on the lease or field production storage tank, etc.)

Costs Associated with E&P Activities Acquisition Costs Exploration Costs Development Costs Production Costs

Acquisition Costs Costs incurred in acquiring property, i.e. costs incurred in acquiring the rights to explore, drill and produce oil and natural gas Lease bonus, brokers’ fees, legal costs, cost of temporary occupation of land, crop compensation paid to farmers Costs of obtaining Petroleum Exploration License (PEL) and Mining Lease (ML) For onshore E & P activities PEL and ML are issued by State Government on recommendations of Central Government For offshore E & P activities, PEL and ML are issued by Central Government

Exploration Costs Costs incurred in exploring property Costs of surveys and studies (like aerial, geological, geophysical, geochemical, and seismic surveys) Costs of environment clearance, defense clearance, etc. Salaries and other expenses of geologists, etc. Costs of carrying and retaining undeveloped properties, such as delay rental, maintenance of land, annual license fees in respect of PEL

Development Costs Costs incurred in preparing proved reserves for production, i.e. costs incurred to obtain access to proved reserves and to provide facilities for extracting, treating, gathering, and storing oil and gas Costs of clearing ground, draining, road building, gas lines and power lines to the extent necessary in developing the proved oil and gas reserves Costs to drill and equip development wells and service wells including costs of platforms and well equipments such as casing, tubing, pumping equipment, etc.

Development Costs Costs to acquire, construct and install production facilities such as lease flow lines, separators, treaters, heaters, manifolds, measuring devices and production storage tanks, natural gas cycling and processing plants and utility and waste disposal systems Depreciation and applicable operating cost of related support equipment and facilities in connection with development activities, and annual license fees in respect of ML

Production Costs Costs incurred in lifting oil and gas to the surface and in gathering, treating, and storing oil and gas Pre-wellhead costs: Costs of labour, repairs and maintenance, materials, supplies, fuel and power, property taxes, insurance, royalty, etc., in respect of lifting the oil and gas to the surface, operation and maintenance including servicing and work-over of wells Post-wellhead costs: Costs of labour, repairs and maintenance, materials, supplies, fuel and power, property taxes, insurance, etc., in respect of gathering, treating, field transportation, field processing, including cess up to the outlet valve on the lease or field production storage tank, etc.

Accounting Methods for Oil and Gas Producing Activities Technical and theoretical problems Characteristics: - high risk - high investment - lack of correlation between the expenditure incurred and the value of resulting reserves - long time span between the points when costs are first incurred until benefits are received

Accounting Methods for Oil and Gas Producing Activities All production costs are charged as an expense of the period All development costs are capitalized Treatment of acquisition costs and exploration costs Successful Efforts Method/Full Cost Method Different results on earnings, return on investment and book value Fundamental accounting issue: Whether to capitalize or expense acquisition and exploration costs

Successful Efforts Method (SEM) Rationale: expenditures providing no future economic benefits should be expensed Only those costs lead directly to discovery of oil and gas are capitalized Direct relationship is required between costs incurred and reserves discovered Costs that do not result in discovery of reserves (dry hole costs) are charged as expenses of the period Treatment is similar to Research and Development Costs

Successful Efforts Method (SEM) acquisition costs, (2) drilling exploration costs and (3) development costs should be treated as capital work-in-progress when incurred All costs other than these should be charged as expense of the period When the well is ready to commence commercial production, the costs referred to (2) and (3) corresponding to proved developed oil and gas reserves should be capitalized as ‘producing properties’ from capital work-in-progress to the gross block of assets All acquisition costs should be capitalized from capital work-in-progress to the gross block of assets

Successful Efforts Method (SEM) acquisition costs, (2) drilling exploration costs and (3) development costs should be treated as capital work-in-progress when incurred All costs other than these should be charged as expense of the period When the well is ready to commence commercial production, the costs referred to (2) and (3) corresponding to proved developed oil and gas reserves should be capitalized as ‘producing properties’ from capital work-in-progress to the gross block of assets All acquisition costs should be capitalized from capital work-in-progress to the gross block of assets

Successful Efforts Method (SEM) If the cost of drilling exploratory well relates to a well that is determined to have no proved reserves, then such costs net of any salvage value are transferred from capital work-in-progress and charged as expense of the period

Full Cost Method (FCM) First corporation to use FCM was Belco Petroleum in 1957 The philosophy behind FCM is that costs of acquisition, exploration and development are necessary for the production of oil and gas. Because there is no known way to avoid unsuccessful costs in searching oil and gas, FCM considers both successful as well as unsuccessful costs incurred in the search for reserves as a necessary part of costs of finding oil and gas Dry-holes are an inevitable part of exploration effort Both, successful and unsuccessful costs are capitalized, even though unsuccessful costs have no future benefits

O & G Ltd. began its operation on April 1, 2009, with the acquisition of a lease in KG Basin. During the first year the following revenue was earned and costs were incurred: Revenue Rs.2,45,000 Acquisition costs related with dry-holes Rs.4,00,000 Acquisition costs related with successful wells Rs.1,00,000 Exploratory dry-hole costs Rs.18,00,000 Exploratory successful wells Rs.5,00,000 Development costs- resulted in dry-holes Rs.25,000 Development costs- resulted in development wellsRs.75,000 Production costs Rs.75,000 Depreciation and depletion under SEM Rs.70,000 Depreciation and depletion under FCM Rs.2,90,000

Profit and Loss A/c Expenses SEM Rs. FCM Revenues Acquisition costs Exploratory dry-hole costs Production Costs D & D 4,00,000 18,00,000 75,000 70,000 - 2,90,000 Revenue Net loss 2,45,000 21,00,000 1,20,000 23,45,000 3,65,000

Partial Balance Sheet Liabilities Assets SEM Rs. FCM Acquisition costs Exploratory dry-hole costs Development costs Exploratory successful wells D & D 1,00,000 - 5,00,000 7,00,000 70,000 6,30,000 18,00,000 29,00,000 2,90,000 26,10,000

Industry Practices Companies following SEM: Oil and Natural Gas Corporation Ltd. Oil India Ltd. BG Energy Holdings Ltd. Cairn Energy Plc. Hindustan Oil Exploration Co. Ltd. Chevron Oil Ltd. BP Plc.

Industry Practices Companies following FCM: Reliance Industries Ltd. Essar Oil Ltd. Gujarat State Petroleum Corporation Ltd. Niko Reources Ltd. Joshi Technologies