If You Don’t Catch Up On Your Accounting, Your Accounting Might Catch Up With You
Proper accounting for oil and gas equipment charges is critical to proper valuation of your assets and calculation of well income.
The recent oil and gas renaissance has driven a growth in production that the industry has worked furiously to accommodate. Equipment has moved from well to well much faster than in prior years and many operators have not adjusted their systems to keep pace with the drilling programs. The rules that govern the accounting for this equipment have been in place for years. But this latest shale boom hit so suddenly and unexpectedly that the processes used to track equipment costs haven’t evolved quickly enough to comply with the rules in the current environment.
Operators and non-operators alike need to understand the rules in order to fulfill their legal requirements, make sure that their books are in compliance, and track revenue and costs accurately. From the operator’s standpoint, processes need to be reviewed to make sure that the equipment charged to each well matches the well inventory, and any movement taking place is accounted for accurately. Non-operators should consider a possible audit of equipment charges to determine if they have received proper credits for the equipment items that have moved to other sites or get allocated among multiple wells, as in the case of a shared well pad.
The goal of the accounting rules for controllable equipment is to charge each well for the use of equipment on the well. When new equipment is placed in service for the first time, the well should be charged for the cost of that equipment. Controllable equipment should be tracked by serial number from the beginning. If the equipment moves to another well, it gets credited to that well in a used condition typically rated by a letter grade (such as B at 75% or 65% of original costs, or a lower value based on usage represented as C, D, or E). The condition is usually determined based on criteria set forth in the Joint Operating Agreement (JOA) and the attached Exhibit C as interpreted by the Council of Petroleum Accountants Societies (COPAS). This means that the second well is charged a specific percentage of the current market value at the time it receives the equipment and the disposing well gets a credit back based on that percentage.
A similar process governs the accounting for the cost of a piece of equipment originally placed in service on a single well but later shared among multiple wells drilled on the same pad. Due to delays in drilling subsequent wells on the pad, the first well often winds up burdened with all of the initial expenditures. While it’s appropriate to charge the full cost to the initial well at the outset, amounts should be credited back to that well in order to allocate expenses among the other wells on the pad as the drilling program progresses. Unless the equipment is brought on line at the same time for the other well, the COPAS condition rules would apply. In order to facilitate accurate booking, operator accountants should refer back to well pad schematics and drilling plans and consult the operations team to determine that costs are being charged accurately for each well.
Operators have been inundated with drilling schedules and time constraints requiring them to get equipment where it needs to be in a hurry. This has resulted in some ineffective and inaccurate tracking of equipment. While the rules have remained fairly constant over the years, the process of oil extraction has changed significantly. Today’s practices, such as horizontal drilling, the sharing of equipment among multiple wells, and the extraction of oil from shale, has made it much more complicated for the operator to comply with equipment tracking requirements. Many accounting personnel hired during this boom have neither the training nor the experience to understand proper accounting for these costs. Most operators need to take a few steps back in order to fix this problem going forward.
Typically the JOAs specify a two-year window for audits of well cost activities reflected in the operator’s Joint Interest Billing (JIB) of the partners, and that deadline in 2015 is approaching for 2013-2014 operations. In light of higher costs for horizontal drilling activities, non-operators are learning from a variety of sources that many operations have failed to properly account for these high-cost equipment items. That awareness is leading to an uptick in audits by non-operators. A proactive review initiated by the operator in advance of an audit will show good faith to the partners that may help non-operators get comfortable about the accounting practices without the potential burdens of an audit. In the event that an audit of the JOA is initiated, an effective review prior to the audit may help to limit exposure to exceptions and ultimately mitigate possible litigation concerns.
The cost of extracting petroleum and natural gas has increased significantly in recent years since horizontal drilling requires longer drilling footage and technologies are more complex. It is apparent that the development of natural resource plays in recent years has resulted in an increase in costs due to competition. The failure to track equipment credits properly can have a significant impact on the Return on Investment (ROI) from any well. Improper accounting can also have an impact on reserve engineering and the calculation of estimated ultimate recoveries (EURs), again affecting the economics of the well. Any non-operator who wants to maintain a profitable partnership in a well should be on notice that the numbers feeding their reserve reports may be off with a primary driver being the inaccurate tracking of equipment costs by operators.
A non-operator can seek recourse to recover some of the costs by having an audit performed. However, most JOAs limit the time for an audit of the JIBs to two years. That means time is running out to make sure that costs were properly accounted for in 2013, a year that saw significant increases in drilling costs due to enhanced competition and new technologies.
In conclusion, there’s certainly plenty to celebrate when an industry shows the kind of recovery and growth that oil and gas exploration has in recent years. At the same time, the rapid growth has outstripped the ability of some operators to track costs accurately. Until recently, investors have been so happy with numbers on the income side these last few years that many have failed to question whether the costs charged to generate the income are being properly accounted for. It’s important to perform a timely and consistent review of the accounting processes and make sure that costs related to shared equipment, equipment movement from well to well, and contract compliance issues are properly handled and, if they aren’t, to correct the processes as soon as possible. Additionally, if your company is looking to acquire assets and take advantage of the economic downturn, a deep dive into the JIBs supporting post-closing settlement adjustments will also be important as it relates to this issue.
The business of oil extraction involves a lot of moving parts—both literally, in terms of the equipment used, and figuratively, in terms of the dynamic between operators and non-operators. Whether you are an operator considering a review of your accounting practices or a non-operator considering an audit of your JOA, you need to work with an accounting firm who understands the industry as well as the business process that investors and operators rely on. Our team has the knowledge, experience and insights necessary to work effectively with operators and non-operators alike and deliver essential value to your organization.
November 3, 2015