MODULE 5 ACCOUNTING FOR EXPLORATION, DRILLING AND DEVELOPMENT COSTS

MODULE 5 ACCOUNTING FOR EXPLORATION, DRILLING AND DEVELOPMENT COSTS

OUTLINES Preparation for Development and Drilling Accounting for Development Costs Controversial Issues in Accounting for Exploration and Development Costs

Preparation for Development and Drilling Nigeria Oil and Gas Companies may be involved in four different types of functions or segments namely; Exploration, and Production (E &P), Storage and Transportation, Refining and Hydro Processing, Distribution and Marketing. A company may decide to operate I any of the four segments or a combination thereof. For the purpose of this module, we will limit our self within the content of the topic. Exploration is the search for Oil with a view to discovering oil-in-place, while production is the removal of oil from the ground and surface treatment. In this segment, companies explore from underground reservoirs of oil and gas and produce the discovered oil and gas using drilling wells, through which the reservoir oil, gas and water are brought to the surface and separated. Companies that are involved in E & p are only to explore and produce the discovered oil and gas and sell it depending on the nature and conditions of the contract, i.e. concession, joint venture or production sharing contracts. This segment is referred to as an upstream activity.

Preparation for Development and Drilling.Cont. Oil and gas drilling is highly capital intensive, requiring a huge number of technocrats with fantastic remuneration, this necessitating pre-drilling operations, before actual drilling. Drilling operations basically comprise of; i. Staking (locating oil well site) after due consideration of a number of nature surface attributes-terrain, body of water, marshy environment, etc. ii. Compliance with regulatory requirements on spacing of oil wells iii. Providing access road to the drilling location, leveling of drilling site for placement of working equipments and erection of field offices, and increasing permeability through fracturing, acidizing and thermal processes. Two methods of drilling have been used in the oil and gas industry namely; rotary-rig drilling and cable-tool drilling. The cable-tool method is one of the oldest mechanical means known for drilling into the earth s surface cable-tool rigs have long been used for drilling wells and salt brine well.

Preparation for Development and Drilling.Cont. In the cable-tool method of drilling, a heavy piece of forged steel is lowered into the hole. The bit, which weighs several hundred pounds, is raised and then dropped in the hole, literally pounding a hole in the earth. Ware is pumped into the hole to float the cuttings of rock away from the bottom of the hole. Rotary drilling is by far the most widely used method of drilling for oil and gas today. In rotary operations, the hole is drilled by rotating a drill bit downward through the formation. The used oil and gas drilling practice entails the engagement of an independent drilling contractor, who can do the drilling more effectively, efficiently and economically because of experience. Drilling contract may take the form of; 1. Footage rate contract (requiring installation payment per foot of hole drilled until the required depth is reached) 2. Day rate contract (requiring daily payment of specified amount in respect of the number of feet drilled).

Preparation for Development and Drilling.Cont. 3. Turnkey contract (where the contractor is paid only after satisfactory drilling of well to the required depth and other conditions specified in the contract). Presently, footage rate contracts are the most popular although day rate contracts are also common, while turnkey contracts are less common. Some of the problems encountered in oil and gas drilling may include the following; 1. The excess of formation pressure which may lead to blow-out which is dangerous to the ecosystem. 2. Twisting off of part of drill string which may lead to the abandonment of oil well and the drilling of another well 3. Collapse of part of the drilled hole may be experienced, leaving the pipe trapped in the depths 4. The formation may exclude hydrogen sulphide which is a gas with a very foul odour, thereby necessitating abandonment of well.

Accounting for Development Costs Development costs as defined in the financial accounting standard of USA are costs incurred to obtain access to proved reserves and to provide or gain access to and prepare well locations for drilling, including surveying well locations for the purpose of determined specific development drilling sites, clearing ground, draining, road building and relocating public dwellers, gas lines and power lines to the extent necessary in developing the proved reserves. All development costs are capitalized whether reserves are successful or not. The development cost incurred, that is, cost of drilling and development well are usually kept in the Authority for expenditure (AFE) or well-in-progress account until the drilling is completed before it is re-classified to wells and related facilities Equipment Account. This is ranked for amortization. The accounting for development cost is the same under Successful Effort and Full Cost Methods.

Controversial Issues in Accounting for Exploration and Development Costs The nature, complexity and importance of the petroleum E&P industry have caused the creation of an un-usual and complex set of rules and practices for petroleum accounting and financial presentation. The nature of petroleum exploration and production raises numerous accounting problems. Below are some of it; 1. Should the cost of preliminary exploration be recorded as an asset or an expense when no right or lease might be obtained? 2. Given the low success rates for exploring wells, should the well costs be treated as assets or as expenses? Should the cost of a dry hole be capitalized as a cost of finding oil and gas reserves? Suppose a company drills five exploratory wells costing $1 million each, but only one well finds a reservoir and that reservoir is worth $20 million to the company, should the company recognize an asset for the total $5 million of cost, the $1 million cost of the successful well, the $20 million value of the production property, or some other amount?

Controversial Issues in Accounting for Exploration and Development Costs.Cont. 3. The sales prices of oil and gas can fluctuate widely over time. Hence, the value of rights to produce oil and gas may fluctuate widely. Should such value affect the amount of the related issues presented in financial statements? 4. If production declines over time and production life varies by property, how should capitalized costs be amortized and depreciated? 5. Should DR & A costs be recognized when incurred or should an estimate of future DR & A costs be amortized over the well s estimated production life? 6. If the oil company forms a joint venture and sells portions of the lease to its venture partners, should gain or loss be recognized on the sale?

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