An Essential Way to Improve Economics in an Energy Industry Downturn
With oil prices dropping to their lowest levels in the last decade, many operators and investors are realizing that the practice of getting oil to market as soon as possible, in some cases, made the accounting for key items such as overhead costs an afterthought. While oil prices were hitting record highs, this wasn’t such an issue. But now that prices are falling and may continue to do so, operators and investors alike need to review Joint Operating Agreements (JOAs) to make sure that overhead is billed and collected properly.
As demand slows and prices drop, everyone in this industry should commit some time to examining how costs are being charged to their joint accounts. The various types of overhead charged to the joint account provide a prime example of costs that may not be as fixed as some believe. A close review of these charges between operators and investors could provide expense reductions that help stabilize costs and enhance well economics to joint ventures during this time of low prices and high commodity volatility.
Four Types of Overhead Considerations
Most JOAs highlight up to four different types of overhead related to drilling and producing rates that are chargeable by the operator to the owners of a joint venture. They include:
- Production Overhead that can be charged once a month if any production activity has occurred on the well in question during a particular calendar month.
- Drilling Overhead for Drilling, Completion, Workover and Recompletion Activity that cannot be charged if a well is inactive for 15 or more consecutive days.
- Drilling Overhead for Workover and Recompletion Activity chargeability is dependent on the agreement’s accounting procedure and is often dictated by the number of days of activity.
- Major Construction and Catastrophe Overhead is billed as a result of major work incurred on the well. This type of overhead is determined by a unique calculation related to the major repair. (i.e., building or repair of a facility, building or repair of a platform for offshore work, or building a pipeline).
To understand whether the overhead being charged for a particular well is appropriate under the JOA, the first step is to determine the activity level on the well in question. This information can be gleaned from a variety of sources, such as:
- State or Bureau of Land Management (BLM) websites
- Daily activity reports
- Tour reports
- Production reports
- Authorization for Expenditures (AFEs)
Five Common Overhead Mistakes
Once an understanding is gained for the types of overhead that may be charged based on the activity taking place, the next step is to understand the common errors resulting from overhead calculations that lead to inaccurate billing.
Mistake 1-Failure to Follow COPAS Guidelines and Interpretations for Setting Overhead Rates
The Council of Petroleum Accountants Societies (COPAS) (online at www.copas.org) provides guidelines to help an operator determine its overhead rates. In recent years, operators who focused on getting agreements in place in order to start production as quickly as possible may have relied on overhead rates from other contracts. They may have done this without checking the specifics of the new well against current economics of running the operations for the particular well in question.
A good source of information for accountants to determine overhead rates in the extraction industry is COPAS Model Form Interpretations (MFIs) and Accounting Guidelines (AGs). Depending on the JOA, COPAS guidelines for proper overhead determination and accounting treatment include:
- AG-23, Overhead Negotiation and Calculation
- MFI-21, Overhead Joint Operations
- MFI-40, 24-Month Adjustment Period for Joint Account Adjustments
- MFI-48, Drilling Overhead – Application and Calculation
- MFI-51, 2005 Accounting Procedure Joint Operations
- MFI-52, Catastrophe-Related Costs
- MFI-53, Deepwater Accounting Procedure
Mistake 2-Failure to Reconcile Production Overhead
As production ramped up in recent years, many billing processes were automated and the systems were set to assume that activity thresholds were met for production overhead billings. With the recent shift to horizontal shale drilling, it is much more common to see wells go inactive for the month. In order to make sure that the correct amounts are billed and paid:
- Operators should review well activity before billing producing overhead, and
- Investors should verify the producing well activity before paying the Joint Interest Billing (JIB).
If the operator does not provide production reports, a good alternate way to verify well activity is with information reported by the operator to the appropriate state or the federal BLM, depending on the property’s location and governing authority. These reports can usually be obtained by going to the applicable website.
Mistake 3-Failure to Identify and Properly Apply Inactivity Requirements for Drilling Overhead
Drilling, completion, recompletion and workover operations may be charged at the drilling overhead rate for wells when less than 15 days have passed between drilling activity. In some cases, drilling on multiple wells with staggered activity between wells might lead to a greater than 15-day period of inactivity on a particular well or delays between drilling and completion operations. Operators need to review the daily drilling and completion reports and/or tour reports to ensure that continued drilling activity does not have a gap of more than 15 days on any one well.
Workover and recompletions may be charged at the drilling overhead rate only if the well has a minimum of five days or more of consecutive activity on the well to be chargeable at the higher rates.
It is important to note that the above recommendations relate to more recently published JOAs and may differ, depending on the agreement. The most helpful industry model form related to drilling overhead is COPAS MFI-48 Drilling Overhead – Application and Calculation. If overhead limitations are not assessed appropriately, the operator may overlook the proper charging of workover, drilling and completion overhead rates to the well for that period.
Mistake 4-Failure to Distinguish Between Production and Drilling Overhead Rates Allowable During Flowback or Production Testing
During flowback or production testing, the well is capable of producing. At this stage, production overhead is chargeable but drilling overhead is not. The operator should charge only the allowable production overhead rate, not the drilling overhead rate. Identifying this issue can work to the non-operator’s advantage because the production rate is typically 10% of the completion overhead rate.
Operators who want to meet the requirements necessary to charge the higher drilling rate should review daily reports to make sure that some kind of completion unit is being employed by the crew on the property for purposes of completing the well.
Mistake 5-Failure to Adjust Overhead Charges
COPAS rules provide for the annual indexing of overhead charges with factors announced prior to April 1 of each year. Operators need to make the necessary adjustment to overhead charges annually, as most JOAs allow for this adjustment. The COPAS Index Overhead Adjustment Factors can be found by searching for “Overhead Adjustment Factor” on the COPAS website at www.copas.org every year. If this accounting review has not taken place before now, it’s important to begin looking at the available two years for billing out overhead (refer to COPAS MFI-40 24-Month Adjustment Period for Joint Account Adjustments) to make up for any under or over charging of overhead. Failure to evaluate and factor in escalation rates can result in large losses for an operating company today and far into the future if accounting practices are not corrected during the life of the property.
This is an important time for operators and investors alike to review overhead charges and make sure that they comply with JOAs and applicable COPAS interpretations and guidelines. Operators who do not comply with appropriate overhead billing during the 24-month adjustment period allowable per the JOA lose the ability to collect on previous billing errors. Also, non-operators may miss out on refunds if they are not diligent about reconciling and calling attention to overhead discrepancies within the 24-month adjustment period. Action should be taken quickly to make any necessary adjustments and collect additional charges or refunds from the responsible party.
The issues described in this article may not be all encompassing—much will depend on the specific JOA in place for the operations of the properties. It pays to be mindful of your company’s joint venture exposures and leverage the expertise of Hein. Our experience in this area will guide you and provide the insights necessary to help you better understand your exposures both from an operator’s and a non-operator’s perspective to ensure the accuracy and timeliness of your joint interest billings.
March 9, 2016