Welcome to Fundamentals of International Oil & Gas Accounting

1. Welcome to Fundamentals of InternationalOil & Gas Accounting Dr. Linda Nichols, CPA Texas Tech University Course Developer

2. c Linda Nichols Instructor for this Course D. Larry Crumbley, Ph.D., CPA, CrFA, CFFA, FCPA Louisiana State University Editor, Oil, Gas & Energy Quarterly Energy is the fundamental building block for modern industrialized economies, the very lifeblood of developed economies. When it is available, we take it entirely for granted, like water flowing tamely from the tap. When availability fails, our lives are disrupted and restricted, the veneer of comfort and accommodation quickly erodes, and economic activity grinds to a halt. C.E.H. Ross and L.E. Sloan

3. c Linda Nichols Class Purpose • Overall Learning Objective: • To provide basic understanding and hands-on practice of the accounting concepts involved in Oil & Gas Accounting on an international basis. • To understand the accounting behind the financial statements and how your accounting entries roll into the financial statements. • Competencies Involved: • Basic level general accounting

4. c Linda Nichols Module 1 : Petroleum Operations and Introduction to Accounting Overall Objective: Provide a high level overview of terms and concepts relating to petroleum operations that will be discussed in the various accounting modules. Introduce successful-efforts and full-cost accounting.

5. c Linda Nichols Petroleum Geology • Organic theory Oil is formed from organic matter of marine origin deposited with rock particles millions of years ago. 5

6. c Linda Nichols Needed for Reservoir Formation • Source rock (remains of land/sea life) • Conditions to cause petroleum formation (heat and pressure) • Porosity or pore space (10% or more) and permeability (connectability) • Trap: structural or stratigraphic 6

7. c Linda Nichols Steps in Petroleum Production 1Broad G&G reconnaissance work 2 A lease or an option to lease may be obtained 3 Detailed G&G work is done to evaluate area of interest. 4 Data gathered in steps 1 and 3 are analyzed. If results positive, a lease is obtained (if not already obtained). 5 Further analysis of available data and possible more seismic studies done to select drill site. 6 The well is drilled. 7 Based on data obtained during the drilling process (cuttings, well logs, etc), decision made on commerciality. 8a Sufficient oil and gas Well completed & production started. 8b Insufficient oil and gas Another drill site on the lease is selected, or lease abandoned 7

8. c Linda Nichols Necessary Components of an Oil or Gas Field • Source rock • Conditions to cause petroleum formation • Porosity (10% or more) and permeability • Trap: structural or stratigraphic Hydrocarbon System Source rock: organic-rich shale that generates oil and/or gas Migration: hydrocarbons escaping from the source rock and moving to a reservoir Reservoir: sandstone or limestone rock with (generally) high porosity and permeability that can hold hydrocarbon fluids Trap: a structure or stratigraphic discontinuity in the reservoir rock that keeps buoyant hydrocarbons from migrating all the way to the surface Seal: Impermeable rock above/around the reservoir that keeps hydrocarbons from leaking to surface 8

9. Upstream vs. Downstream Operations Upstream: All necessary activities to find hydrocarbon reserves and bring them to the surface. Downstream: Refining and marketing. “Finding new resevoirs is the name of the game.” M. Economides and R. Oligney c Linda Nichols 9

10. c Linda Nichols Phases of Upstream Operations • Initial prospecting • Mineral right acquisition • Exploration • Appraisal • Development [proved] • Production • Abandonment & restoration 10

11. c Linda Nichols Types of Agreements Concessionary Leases Concession Agreements Contractual Production Sharing Contracts (PSCs) Risk Service Contracts 11

12. c Linda Nichols Concessionary Agreements • In U.S., parts of Canada, and Trinidad, individuals may own mineral rights (e.g., lease agreement). • Some countries allow non-governmental ownership of oil/ gas after produced (concessionary contract). Lessor (land owner) leases to the lessee (operator) the right to explore, develop, and operate the oil/ gas. Concessionary contract: For up-front bonuses, royalties, and taxes, a government transfers ownership to the minerals to the petroleum company when the minerals are produced or sold. Back-in or Participation: Government retains the right to participate as a WI owner (e.g., joint venture partner) after the results of initial exploration and drilling are known. 12

13. c Linda Nichols Leases: Interests Created from Working Interest Joint Working Interest: Two or more parties each own an undivided fraction of the WI in a single lease by 1) leasing, 2) sales or exchanges, or 3) sharing arrangements. Overriding Royalty Interest (ORI): Similar to a royalty interest. Original lessee executes a sublease and retains an overriding royalty interest (ORI). Production Payment Interest (PPI): A non- operating interest created out of the WI which is limited to a specific amount of money, time, or a certain quantity of oil or gas. Thus, a PPI normally ends before the reservoir is depleted. Net Profits Interest (NPI): Non- operating interest created out of the WI by either a carve-out or retention. Utilization: Agreement between two or more parties owning operating interests to have such interests operated on a joint basis and share the production by a stipulated percentage or fractional basis. Pooling: Bringing together small tracts sufficient for the granting of a well permit under state spacing rules. 13

14. c Linda Nichols Authority for Expenditure 14

15. c Linda Nichols Contractual System • All citizens in the country owns the minerals. • Production sharing contract: The petroleum company is allowed to recover certain costs and receive a share of the profits. • Risk service contract: Contractor bears all costs and risks related to exploration, development, and production. If production, contractor is allowed to recover costs as production is sold. Plus the contractor is paid a fee of its services. 15

16. c Linda Nichols Agreement 1: Leases Grants to oil and gas company right and obligation to operate on a property • Bonus • Royalty • Lessee responsible for all costs • In effect indefinitely with production 16

17. c Linda Nichols Agreement 2: Concessions • Bonus • Royalty or in-kind payment • Contractor responsible for all costs without reimbursement • In effect indefinitely with production • Ownership of minerals transferred to contractor 17

18. c Linda Nichols Agreement 3: Production Sharing Contracts • Government gets royalty (may be in-kind) • Government retains ownership of minerals • Contractor responsible for all exploration costs • Government (through state oil company) has option to become WI owner in development and production • Contractor may be required to build country infrastructure • Bonus • Costs are recoverable through cost oil • Profit oil divided between government, state oil company and contractor • Contractor has entitlement interest 18

19. c Linda Nichols PSCs: Accounting Issues • May have signature, development, or production bonuses • Maximum time for production phase results in state oil company taking over 100% working interest. • Cost recovery is capped, often 50% of gross production • Cost recovery order is specified: Operations Unrecovered exploration & appraisal Development Imputed interest on development Excess cost oil may be treated as profit oil or allocated to the government. 19

20. c Linda Nichols Types of PSC Bonuses • Signature bonus: A signing bonus; generally a lump-sum, but may be in the form of equipment. • Production bonus: Subsequent payments are made to the government when the production reaches an agreed upon level. • Development bonus: Subsequent payments are made to the government when development reaches an agreed upon level 20

21. c Linda Nichols PSCs: Accounting Issues • Overhead usually on sliding scale. • Ownership of equipment and facilities passes to government. • Significant production may go toward payment of taxes. • In past, state oil company was responsible for abandonment and restoration. • In current agreements, all parties contribute to sinking fund for abandonment and restoration. Funded amounts are computed on a units-of-production basis. • May have domestic market obligation which may state a maximum price. • Royalty and tax holidays may be granted. • Recoverable costs are identified in PSC. 21

22. c Linda Nichols Agreement 4: Risk Service • Bonus • Royalty (may be in-kind) • Government retains ownership of minerals • All costs initially paid by contractor, but recoverable from government • Government (through state oil company) has option to be WI owner in operations 22

23. c Linda Nichols Risk Service: Accounting Issues • After contract term, state oil company takes over. • Ownership of reserves by contractor is not permitted. • Fee based on operating costs, capital costs, and a profit factor. • Non-risk service agreements are possible, but are rare. 23

24. c Linda Nichols Reserve Estimation Methods • Deterministic – results in a single best estimate of reserves. [SEC requires] • Probabilistic – results in a range of estimates with their associated probabilities. Includes proven, probable and possible reserves. • U.K. firms have choice. 24

25. c Linda Nichols GAAP for Reserves Definitions • US GAAP – only proved reserves can be reported. They are further classified as developed or undeveloped. • UK & GAAP – Permits companies to choose reporting using either proved or probable reserves (using probabilistic methodology) or proved developed and undeveloped reserves (using deterministic methodology). 25

26. c Linda Nichols SEC’s Definition of Proved Reserves The estimated quantities of crude oil, natural gas and natural gas liquids which geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions, i.e., prices and costs as of the date the estimate is made. Prices include consideration of changes in existing prices provided only by contractual arrangements, but not on escalations based upon future conditions. . . . SEC Reg. 5-X, Rule 4-10(a) 26

27. c Linda Nichols Proved Reserves Subdivided Proved developed: those proved reserves that can be expected to be produced through existing equipment and operating methods. Proved undeveloped: expected to be produced through new wells to be drilled on proved property or from existing wells for which significant expenditure is required for recompletion. 27

28. c Linda Nichols Probable and Possible Reserves Probable reserves: Unproved reserves that are more likely than not to be recoverable. Probable reserves may become proven with additional drilling or with an enhanced recovery project. These reserves also may become recoverable if the price of oil or gas increases. Possible reserves: Unproved reserves that are less likely to be recoverable than probable reserves. Commercial reserves: Based on proved reserves only. May, at the company’s option, be either proven and probable or proved developed and proved undeveloped. *Statement of Recommended Practice (SORP) 2001, Accounting for Oil and Gas Exploration, Development, Production and Decommissioning Activities, ¶ 12. 28

29. c Linda Nichols Bias Assumptions • There are almost as many oil/gas reserve definitions as there are countries. • During the first week of January 2004, Royal Dutch/Shell Group slashed its estimates of oil reserves by 20% or about 3.9 billion barrels of oil. • Stock fell 9%. • Shell, Exxon/Mobil, and Chevron/Texaco make the estimates themselves. • By the end of 2002, a total of 4.47 billion barrels cut; another 1.4 billion barrel cut in 2003. • Source: Susan Warren and P.A. Mckay, “Methods for Citing Oil Reserves Prove Unrefined,” Wall Street Journal, January 14, 2004, p. C-4. Chip Cummins, “Shell Slashes Oil Reserves Again, News Overshadows Profit Surge,” WSJ, February 4, 2005, p. A-3 29

30. c Linda Nichols Shell Board Kept In the Dark • One memo drafted on February 11, 2002, warned that about one billion barrels of oil-equivalent reserves appeared not to be in compliance with SEC guidelines. • Board learned of information only in early January 2004. • Chairman Sir Philip was ousted in early March 2004. • Most of the misstated reserves were recorded from 1997 to 2000, when Sir Philip was in change of exploration and production. • Oil/gas reserves were increased (not by discovery) by changing its accounting. • Source: Stephen Labaton and Jeff Gerth, “At Shell, New Accounting and Rosier Oil Outlook,” New York Times, March 12, 2004, pp. A-1 and C-4. 30

31. c Linda Nichols Types of Reserves: Proved Reserves • Proved • Proved developed • Proved undeveloped Before property fully developed: Proved reserves = proved undeveloped + proved developed After property fully developed: Proved reserves = proved developed 31

32. c Linda Nichols Accounting Standards: GAAP • US – FASB & SEC SFAS 19 & SFAS 69 • UK – ASB & OIAC • International – IASB IFRS 6 & IAS 1 32

33. FASB-IASB Project • Improve both U.S. GAAP and IFRS while concurrently eliminating many individual differences. • Currently focused on “short-term convergence” projects. • Addresses differences outside the scope of a major project • Solution achievable in the short-term • The SEC is adopting rules to accept foreign private issuers financial statements prepared in accordance with IFRS without reconciliation to U.S. GAAP.

34. Vision 5 Years From Now • U.S. public companies will be following IFRS, not U.S. GAAP • One standard setter (IASB) will promulgate IFRS • Still some to-be-determined role for national standard setters (such as FASB)

35. c Linda Nichols Global Standards • A single set of high-quality, comprehensive accounting standards involves the convergence of: • Auditing standards • Capital markets regulation • Audit oversight • Changes in the U.S. and legal environment

36. c Linda Nichols Four Types of Costs • Acquisition Costs • Exploration costs • Development costs • Production costs 36

37. c Linda Nichols Some Acquisition Costs • Signing bonus – upfront monies to governments* • Legal fees* • Filing/ Recording fees* • Title examination* • Options to purchase or lease* • Broker fee* • Option lapse (expense) • Shooting rights (U.S. GAAP expense; international capitalize) * Capitalize U.S. GAAP and international. 37

38. c Linda Nichols Some Exploration Costs • Costs of topographical, geological, and geophysical studies, rights of access to properties to conduct these studies, and salaries and other expenses of geologists, geophysical crews, and others conducting these studies. Collectively, geological and geophysical (G&G) costs. • Costs of carrying and retaining undeveloped properties such as delay rentals, ad valorem taxes on the properties, legal costs for title defense, and maintenance of land and lease records. • Dry hole contributions and bottom hole contributions. • Costs of drilling and equipping exploratory wells. • Costs of drilling exploratory-type stratigraphic test wells. A., B., C. are non-drilling costs. U.S. GAAP, expense. D., E., drilling costs. Possibly capitalized, U.S. GAAP. 38

39. c Linda Nichols Drilling and Development Costs • Development wells • Lease flow lines • Separators • Treaters • Heaters • Storage tanks • Improved recovery system • Nearby gas processing facilities 39

40. c Linda Nichols Oil Derrick

41. c Linda Nichols Types of Wells • Exploratory Wells [unproved area] • Stratigraphic test wells (get info)* • Extension wells (test and extend known boundaries) exploratory • Development Wells • Service Wells [gas injection, water injection, saltwater disposal] development costs *Exploratory and development types 41

42. c Linda Nichols Successful Efforts vs. Full Costs 42

43. c Linda Nichols Module 2: Nondrilling Exploration Costs under Successful Efforts Overall Objective: To gain a basic understanding of the accounting treatment of geological and geophysical (G&G) costs. 43

44. c Linda Nichols G & G Exploration • Surface Techniques 1. Oil Seeps 2. Aerial Photos 3. Satellite Surveys (Landsat 4) 4. Topographical Mapping 5. Geochemical surveying • Subsurface Techniques 1. Subsurface mapping utilizing seismic surveys. 2. Structural surface maps. 3. Subsurface geophysical measurements 4. Gravity meter measurements 5. Magnetic surveys. 44

45. c Linda Nichols Seismic Surveys[Having to do with earthquakes or earth vibrations] • Two-dimensional Seismic – stringing geophones in a line along the surface or the earth or behind a ship. • Three-Dimensional Seismic – geophones in a closely spaced grid, gives a three-dimensional view. • Electromagnetic recording with 3D. • Four-dimensional surveys (time) – can monitor water flood fronts and oil migrations within reservoirs. 45

46. c Linda Nichols Seismic Technology • Seismic technology continued to advance, and the next big breakthrough occurred in the early 1960s with the advent of digital technology. This enabled processing of enormous amounts of data and provided dramatically improved knowledge of subsurface geology. Now, time-lapse or four-dimensional seismic, created by multiple surveys repeated over time, monitors reservoir performance and helps improve recovery efficiency. C.E.H Ross & L.E. Sloan

47. c Linda Nichols International GAAP • US GAAP – Expense Geological & Geophysical • UK GAAP – If the costs cannot be identified with a particular geological structure by year-end, then expense. If the costs can be identified with a particular structure, then the costs should remain capitalized at year-end. • IASB – May capitalize if associated with particular resources (consistent with UK). Must assess for impairment. 47

48. c Linda Nichols Geological & Geophysical Costs • Peters Co. Pays €30,000 for G&G studies on Block A US GAAP: G&G Expense 30,000 Cash 30,000 UK& IASB specific structure: Intangible Assets 30,000 Cash 30,000 48

49. c Linda Nichols Shooting Rights Peters Oil obtained shooting rights on 5,000 kilometers for €.50 per kilometer. US: G&G expense 2,500 Cash 2,500 UK & IASB specific structure: Intangible assets 2,500 Cash 2,500 49

50. c Linda Nichols Records Maintenance Costs Peters has records maintenance costs of €600 on Block C. US: Records maintenance expense 600 Cash 600 UK & IASB specific structure: Intangible assets 600 Cash 600 50