One of the most important task investors face involves identifying distortions in a company’s financial statements which may obscure actual economic performance or distort comparisons with other firms in the same industry. For purposes of this discussion, we are not referring to cases of financial fraud where company executives purposely seek to mislead users of financial statements.  Although cases of fraud are often well publicized, for the most part executives do attempt to work within the guidelines of generally accepted accounting principles (GAAP).  However, GAAP itself is often vague on important points and sometimes offers executives more than one fully sanctioned approach.  In this article, we take a brief look at one aspect of accounting for oil and gas exploration companies that often leads to investor confusion.

Valuation of Oil and Gas Reserves

Exploration and production (E&P) companies attempt to use their capital to find new sources of oil and gas that were previously unknown.  Companies typically use geological surveys and other data to identify promising sites and then obtain leases giving them the right to drill.  Wildcat exploration involves drilling exploratory wells that may or may not result in the discovery of economically sufficient reserves of oil and gas.  In cases where oil or gas is discovered, the company has found an asset that has to be reflected on the balance sheet.

Once the reserves have been found and accounted for as an asset on the balance sheet, production activities will begin and the company will take periodic depletion charges against the asset as resources are extracted.  This is in line with the matching principle of accounting where the revenue that is being generated is matched with the cost associated with the revenue.  Over time, the resource will be fully exploited and the asset will be worthless.  The company will have benefited from the revenues produced by the resource over time and will have fully recognized the cost of exploration required to discover the resource.  In addition, the company will expense production costs as they are incurred.

Successful Efforts vs. Full Cost Accounting

GAAP accounting requires E&P companies to choose either “successful efforts” or “full cost” accounting when it comes to tracking the value of reserves.  We are only providing a cursory overview here to make some high level points.  This is a complex topic and we refer readers interested in a more in depth treatment to read Fundamentals of Oil & Gas Accounting which provides a relatively brief overview in Chapter 2.  This is not an inexpensive book so we suggest that readers only interested in this specific topic refer to Google Books which should allow readers to review enough pages to cover most of Chapter 2.

Both successful efforts and full cost accounting are historical cost accounting methods which attempt to record an accurate valuation for reserves based on funds that the E&P company has spent on the process of securing leases and drilling exploration wells.  This means that both methods can fail to reflect reality since the value of the reserves that are found may have little relationship to the cost of finding the reserves.  Indeed, the entire point of exploration is to locate reserves that are much more valuable than the funds required to make the discovery.

The most important difference between successful efforts and full cost accounting is that a successful efforts company does not capitalize the cost of “dry holes”, or exploration wells that do not result in the discovery of new reserves.  In contrast, full cost companies will capitalize the cost of all exploration activity into a full cost “pool” regardless of the success or failure of individual exploration wells.  As a result, a full cost accounting company will typically carry reserves at a higher valuation on the balance sheet compared to a successful efforts company. The more dry holes that are drilled, the greater the potential difference between the reserve valuation recorded by a full cost company versus a successful efforts company.

The full cost company will have higher periodic depletion expenses compared to a successful efforts company since the higher valuation of the reserves will require higher levels of amortization as resources are produced.  In contrast, the successful efforts company will have “lumpy” earnings compared to a full cost company since all dry holes will be booked as an expense immediately.

Both successful efforts and full cost companies are required to take impairment charges if the book value of reserves fall below the “standardized measure” that attempts to calculate the value of reserves based on commodity pricing on the balance sheet date.  However, due to the higher reserve valuation carried by full cost accounting firms, impairments are far more likely for a full cost company especially if many dry holes have been drilled over time.

Implications for Investors

There are a number of important implications for investors evaluating a E&P company or attempting to compare multiple companies that are not all using the same accounting method.

First, investors must account for the fact that both successful efforts and full cost accounting are historical accounting methods and the book value of reserves on the balance sheet will almost never match the actual economic value of the reserves.  Particularly for companies that use successful efforts accounting and also have a good track record of avoiding dry holes, the value of reserves on the balance sheet could be far lower than the actual economic value of the reserves.

Second, investors should be aware that companies using full cost accounting are more likely to have the book value of reserves at a level closer to economic value when compared to a successful efforts company.  Since all exploration costs including dry holes are capitalized into a full cost pool, the book value of reserves will always be higher than under successful efforts accounting unless the company never drills dry holes, an outcome that is very unlikely.  Due to the higher book value of reserves, it is more likely that a full cost accounting company will face impairment charges during periods when commodity prices are very low.

Third, investors must be aware that impairment charges are never reversed when commodity prices increase.  In other words, impairments are one way streets:  Companies must write down the value of reserves if commodity prices make the reserves worth less than book value at the reporting date but can never “write up” the reserves when commodity prices rebound.  As a result, a full cost accounting company will often show relatively low depletion costs in subsequent accounting periods since the book value of the resources subject to depletion have been written down.

Which is More Conservative?

It appears clear that the successful efforts method of accounting is more conservative than full cost accounting since dry holes are immediately recognized as an expense rather than capitalized.  However, defenders of full cost accounting counter than successful efforts may suffer from showing a lower-than-realistic valuation for reserves.  Furthermore, the true cost of developing a “portfolio” of reserves should reflect both successful and unsuccessful attempts.

Management teams who we respect have made different choices.  For example, Contango Oil & Gas Company uses the successful efforts method and Loews Corporation has opted for the full cost accounting method for its HighMount subsidiary.  Ultimately, the choice between full cost and successful efforts accounting involves questions of philosophy as well as conservatism and investors are probably best served by remaining agnostic on the issue.  What is important is to understand the differences between the accounting methods particularly when comparing the book value of reserves and the depletion charges of companies using different accounting methods.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Contango Oil & Gas and Loews Corporation.