1. FUNDAMENTALS OF PETROLEUM ACCOUNTING: PRINCIPLES, PROCEDURES & ISSUES (PART I) FACILITATOR KWAME BOASIAKO OMANE-ANTWI UNIVERSITY TEACHER 1

2. AGENDA  Overview of Oil and Gas Business  Fundamentals of Oil and Gas Accounting  Successful Efforts Accounting  Full Cost Pool Accounting  Related Exploration and Production Costs  IAS and IFRS Considerations  Accounting for Joint Venture  ‘Food for Thought’ Part I of the Oil and Gas Seminar provides theoretical understanding of Fundamentals of Petroleum Accounting. Part II is application. 2

3. OVERVIEW OF THE OIL AND INDUSTRY The following vital documents should be read for better understanding of Oil and Gas industry in Ghana:  History of Oil and Gas Industry in Ghana – GNPC  GNPC Establishment  GNPC Law 1983 (PNDCL 64)  GNPC Law 1984 (PNDCL 84)  GNPC Law 1987 (PNDCL 188)  GNPC Model Petroleum Agreement  Petroleum Revenue Management Bill 3

4. AN INTRODUCTION TO THE PETROLEUM INDUSTRY “As I began my business life as a bookkeeper, I learned to have great respect for figures and facts no matter how small they were” John D. Rockefeller, petroleum tycoon and the richest man of his time who gave away over $500 million to charity. Born 1839 and Died 1937 4

5.  It’s a lousy business  Commodity business  Violent swings form surplus/shortage/surplus, etc.  Depleting assets/capital intensive  Highly price elasticity  High risk 5

6.  Surprisingly low barriers to entry  100 hunters – 2 rabbits  Only low-cost suppliers win  Business is only and always about value creation TWO CORE BELIEF’S  In a commodity business – there are no competitive advantages. Only lowest cost producers survive and prosper  The industry’s value creation event is the turning to the right of the exploration drill bit 6

7.  What can one do to create value?  Find and develop natural gas and oil at an economically attractive price  What can happen to destroy value?  Drill a bunch of dry holes  Run out of money  Have too much debt/G & A  Big drop in oil and gas prices 7

8.  How do you value a depleting asset of oil and gas exploration company?  Present value of future cash flow plus the “black box”  Clues to what’s in the black box:  Management’s integrity  Macro environment  Industry environment  Management’s track record  Management’s incentives 8

9.  Accounting book value bears only a coincidental relationship to intrinsic value  Full cost vs. successful efforts  Never, never, never let accounting consequences influence a decision  “If thought corrupts language, language can also corrupt thought” George Orwell 9

10.  Overconfidence  Immediate gratification  Loss aversion  Incentives everywhere, only, and always drive behaviour. “The first principle is that you must not fool yourself and you’re the easiest person to fool.” Richard Feynman Nobel Laureate Physicist 10

11. BASIC TERMS AND CONCEPTS  Petroleum refers to crude oil and natural gas or simply oil and gas.  Oil and gas are mixtures of hydrocarbon – molecules of hydrogen and carbon atoms found in petroleum reservoirs.  Petroleum reservoirs are generally thousands of feet below the surface.  Crude oil and natural gas are believed to be remains of plants and animals (small marine life) that lived many millions of years ago. 11

12. BASIC TERMS AND CONCEPTS CONTINUED  Oil and gas are discovered and produced through wells drilled down to the reservoirs.  Explanatory well is drilled to discover or delineate petroleum reservoirs.  Development well is one drilled to produce a portion of previously discovered oil and gas.  Estimated volumes of recoverable oil and gas within the petroleum reservoir are called oil and gas reservoirs.  Reserves are classified as proved, probable or possible depending on its likelihood of economic production and volumes. 12

13. PETROLEUM USEFUL PRODUCTS  Transportation fuels  Heating fuels  Sources of electricity  Petrochemicals 13

14. DIFFERENT MIXTURES OF HYDROCARBONS  Crude Oil – hydrocarbon mixture, liquid at normal atmospheric pressure and temperature.  Natural Gas – hydrocarbon mixture, not liquid but gaseous at normal atmospheric pressures and temperature.  Gas mixtures consist largely of methane (the smallest natural hydrocarbon molecule (C 1 H 4 ) 14

15. NATURAL GAS  Natural Gas liquids are:  Ethane – C 2 H 6  Profane – C 5 H 8  Butane – C 4 H 10  Natural gasoline – C 5 H 12 to C 10 H 22  Measurement of Natural Gas:  By amount of energy or heating potential expressed in million British thermal units (abbreviated as MMBTU) 15

16. NATURAL GAS MEASUREMENT CONTINUED  By volume, generally expressed in thousand cubic feet (abbreviated as mcf) -Million cubic feet (abbreviated as mmcf) -Billion cubic feet (abbreviated as bcf) -Trillion cubic feet (abbreviated as tcf) 16

17. SEGMENTS OF THE PETROLEUM INDUSTRY  Exploration and Production or E & P – Oil Companies.  Hydrocarbon Processing – Petro Chemical Plants.  Transportation, Distribution and Storage.  Retail or marketing. 17

18. PETROLEUM EXPLORATION AND PRODUCTION – THE BASICS  Preliminary Exploration  Leasing the Rights to Find and Produce  Exploring the leased Property  Developing the Property  Producing the Property  Plugging and Abandoning the Financial Property 18

19. PROSPECTINGEXPLORATION EVALUATION CONSTRUCTION & DEVELOPMENT PRODUCTION CLOSURE Prospects identified/ Access secured Confirms geological presence of hydrocarbons Exploration Data interpreted/ Commercial aspects assessed Significant Investments/ risk of recovery Execution risk remains Throughout Life of Field Assess Abandonm ent Liability throughout Life of Field 19

20. Process conducted in accordance with license requirements and relevant legislation and practice to:  Plug and abandon wells  Dismantle wellhead, production and transport facilities  Remediate and restore producing areas 20

21. Decommissioning Provisions are recognised when there is: Legal obligation Constructive obligation:  Establishing a pattern of past practice.  Publishing policies.  Making statement to other parties that the company will accept responsibilities.  Creating a reasonable expectation that the company will act in a certain way.  Decommissioning costs are typically cost recoverable based on actual cash funding. 21

22.  How to treat preliminary exploration cost - asset or expense?  Given low success rates of exploratory wells - should well costs be treated as asset or expense?  Sales prices of oil and gas fluctuate widely over time hence affecting the values of rights to produce oil and gas – should such value fluctuation affect related assets presented in financial statements. 22

23.  If production declines over time and productive life varies by property, how should capitalised costs be amortised and depreciated?  Dismantlement, restoration and abundant costs (or DR & A) costs be recognised when incurred or should an estimate of future DR & A costs be amortised over the well’s estimated productive life?  If the oil company forms a joint venture and sells portions of the lease to its venture partners, should gain or loss be recognised on the sale? 23

24.  Petroleum exploration and production economics centre on the size and nature of oil and gas reserves in relation to oil and gas prices.  An E & P company may be said to have two key assets:  Its people and their ability to profitably find (or acquire), develop and produce oil and gas reserves and  Its existing reserves and their ability, when produced, to generate positive cash flow. 24

25.  An E & P company financial statement accounting recognises the economic importance of reserves in three ways :  Capitalised costs of properties with proved reserves (proved properties) are amortised on a units-of- production method based on the ratio of volumes currently produced to the sum of those volumes and remaining proved reserves. 25

26.  Proved properties net capitalised costs are limited to certain computations of value of the underlying proved reserves; and  Public companies must disclose, with audited financial statements, certain supplemental unaudited information on the proved reserve volumes and certain related values 26

27. BALANCE SHEETINCOME STATEMENT  Focus on Assets  Definition of Asset  When is Asset Created  Valuation of Asset  Point in time orientation  Focus on Activities  Revenue generation  Periodic cost incurred  Amortisation of capital costs  Period of time orientation 27

28. SIGNIFICANT ACTIVITY OVER LIFE OF FIELDFINANCIAL STATEMENT IMPACTS Timeframe of years, possibly decades Expenditures are made without certainty as to total return Investments made with intent to produce Even production phase has risk associated with it Multiple financial statements published during life of field (LOF) Both assets and activities must be accounted for Assets are important for liquidity analysis Most focus will be on earnings as a guide to future cash flow generation 28

29. SIGNIFICANT ACTIVITY OVER LIFE OF FIELD FINANCIAL STATEMENT IMPACTS Portfolio effect results in multiple stages of life cycle all present at the same time Investors focused on return on capital invested Cash Flow is realised upon production (and sale). Cash Flow is realised upon production (and sale). Management manages to profitability (or maximising return on investment) Annual financial statements only provide a partial view of LOF cash flow 29

30. (a) Which asset is “the” asset Focus is on reserves Reserves represent future production However: Reserves are estimable not auditable Quantities not determinable early in Life Cycle Historical or Prospective valuation Activities result in other outcomes that meet the conceptual definition of an asset 30

31. (b) Conceptual Framework Definition Current Framework  A resource controlled by the entity as a result of past events and from which future economic benefits are expected Assets prior to reserves booked  Right to access prospect  Information indicative of existence of hydrocarbons  Exploration tangible equipment (wells) 31

32. (c) Option value is evidence of expected future benefits Assets after reserves booked  Right to extract production  Control of operations  Equipment (wells, pipelines)  Land (d) A producing property is more than reserves in the ground 32

33. STAKEHOLDERS’ EXPECTATION Users will not accept management valuation Users desire information to make their own valuations Volatility and constant remeasuring will not be helpful Realisation is important to shareholder Lack of clarity as to when numbers are estimates 33

34. Board of Directors Audit Committee President General Manager Vice President Exploration Internal Audit Vice President Production Vice President Marketing Vice President Fin. Adm. 34

35. Vice President Fin/Admin HRMFinanceMIS Accounting Public Relations Legal 35

36. Field Clerical & Services Equipment and supplies Inventory Revenue Accounting Accounts Payable Property Accounting Controller Taxes & Regulatory Complains Joint Interest Accounting General Accounting 36

37. Vice President Fin/Admin Financial Accounting & Reporting Budget Cost Analysis Corporate Taxes Production Accounting Accounting Policy Research Pipeline & Crude Oil Trading Accounting Refining Accounting Marketing Accounting 37

38.  There are two alternative methods for accounting for acquisition, exploration and development costs, Viz: 1. Successful Efforts Method (SEM) 2. Full Cost Method (FCM) 38

39. Description: “Under SEM, generally only those costs that lead directly to the discovery acquisition, or development of specific, direct oil and gas reserves are capitalised and become part of the capitalised cost of the cost centre. Costs that are unknown at the time of incurrence to fail to meet this criterion are generally charged to expense in the period they are incurred. When the outcome of such costs is unknown at the time they are incurred, they are recorded as capital – work-in-progress and written off when the cost are determined to be non-productive” (used by 50% of global E & P companies). 39

40. Reflects the normal concept of an asset. The propriety of carrying forward costs incurred and subsequently matching them against future revenues depends on whether a specific cost can be identified with specific reserves. If the direct relationship does not exist, the cost should be charged to expense. SEM accounting comes closer than other cost-based accounting methods in reflecting management’s success or failures in its efforts to find new oil and gas reserves. 40

41. Description “Under FCM, all costs incurred in prospecting, acquiring mineral interest, exploration, and development, are accumulated in large cost centres that may not be related to geological factors. The cost centre, under FCM, is not normally smaller than a country except where warranted by major differences in economic, fiscal or other factors in the country. The capitalised costs of each cost centre are depreciated as the reserves in each cost centre are produced “(used by 50% of Global E & P companies). 41

42. FCM reflects the way in which enterprise search for, acquire, and develop mineral resources. FCM provides better matching of income and expenses. FCM is like absorption costing for manufactured inventories. FCM avoids distortion of reported earnings. 42

43. Under FCM, many costs that are capitalised failed to meet the definition of an ‘asset’ under the ‘Framework for the Preparation and Presentation of Financial Statements’. FCM delays loss recognition FCM impedes measurement of the efficiency and effectiveness of the enterprise’s exploration and development activities. 43

44. COSTSEMFCM Acquisition Cap G & G Cap (E&P)Cap Exploration Dry Hole (E&P)Cap Exploration Good well Cap Dev. Dry Hole Cap Dev. Good well Cap Lifting Costs (E&P) Cost Centre Field Country 44

45. On an overall consideration, the advantages of the SEM far outweigh its disadvantages particularly keeping in view its conceptual superiority over FCM. Accordingly, Kwame Boasiako Omane-Antwi finds SEM meaningful and acceptable method. What is your opinion? Remember that in practice an enterprise is also permitted to follow the FCM!!! 45

46. PriceWaterHouseCoopers Opinion Potential for unlocking value “A move to wider reporting is seen by companies, investors and analysts as likely to lead to tangible gains for companies. The consensus view is that the potential rewards of improved disclosure are immense. Investors emphasize this particularly. Eighty per cent of investors believe better disclosure is key to enhancing the credibility of management. 46

47. Investors, more than companies, also identify improved access to new capital and new joint venture partners among the potential benefits. In common with investors, companies identify increased share value, more long-term investors, increased p/e ratios and reduced share volatility among the specific benefits to be derived from better disclosure” 47

48.  Successful efforts versus full cost. The oil and gas sector is the only industry in which companies are allowed to choose between two considerably disparate accounting methods: successful efforts (SE) and full cost (FC). The primary differences are the following: - SE expenses while FC capitalises exploratory dry hole costs; - SE expenses while FC capitalises geologic and geophysical (G & G) and other ancillary exploration expenses; - Methodology for reserve write-down tests; - Delineation of cost centres (country by country for FC versus field by field for SE) for calculating DD & A rate; and - Ability to capitalise certain G & A costs allowed for FC accounting 48

49. Successful Efforts vs Full Cost Method Currently, there is no specific guidance for the oil and gas industry’s upstream activities under IFRS, though some activities, for example IAS 16 “Property, Plant and Equipment” and IAS 38 “Intangible Assets” are scoped out in several relevant standards. The two primary methods commonly used, to account for upstream oil and gas activities are the ‘successful efforts method’ and the ‘full cost method’, both allowed under US GAAP 49

50. Exploration and Evaluation Expenditures  IFRS 6 segregates capital expenditures into three (3) categories or phases: (i) Pre-exploration; (ii) Exploration and Evaluation (E & E); and (iii) Post-exploration development and production  IFRS 6 only applies to the E & E phase and does not address Pre-exploration and Post Exploration costs. 50

51. Pre-exploration cost expensed unless it can meet the test of asset under IAS 38 (Intangible Asset definition). Post-exploration phase treated under IAS 16 (Property, plant and Equipment) All other expenditures are recognised in profit or loss as incurred. IFRS 6 refers to neither FCM nor SEM accounting however the standard permits an oil and gas entity to select an accounting policy of either immediately expensing or capitalising E & E expenditures 51

52. IFRS requires significant components of PP & E, for which depreciation methods or rates are applicable to be depreciated separately. IFRS also requires the separate recognition and depreciation of certain non-physical components such as major overhauls and refurbishments Component accounting used under IAS 16. 52

53.  Under IFRS impairment includes license acquisition cost and exploration and appraisal costs.  Exploration licenses in unapproved properties must be assessed periodically (at least annually).  If dry hole has been drilled and there are no firm plans for further drilling or appraisal activities, the property would be impaired. 53

54.  Identifiable assets, liabilities and contingent liabilities at full fair value  Intangible assets recognised separately at fair value impairment test  Negative goodwill recognised immediately in income  Restructuring provision 54

55.  The benchmark treatment is to recognise the borrowing costs as an expense in the period in which they are incurred.  The allowed alternative treatment permits the capitalisation of borrowing costs.  Key difference is that it is an option under IFRS to capitalise 55

56.  PP & E impairment (IAS 36: Impairment of Assets)  Scope include longer term non-financial assets with certain exceptions (e.g., investment property at fair value, assets held-for-sale).  If impairment is indicated, write down assets to higher of fair value less costs to sell and value in use based on discounted cash flows. 56

57.  PP & E (IAS 16)  Limitation on capitalising start-up and pre- production costs  Depreciation  Components and replacements  Provisions and contingent liabilities (IAS 37)  Measurement utilising best estimate  Discounting required if cash flows are involved  Utilizes rate that reflects time value of money and risk of the liability (vs credit adjusted risk free rate) 57

58. Acquisition costCapitalise as long as meet with IFRS asset recognition Exploration Expenditures: Dry Hole Successful Appraisal Drilling Expense Capitalise A dry appraisal could still be carried forward in the Balance sheet, provided that the intend to drill more wells or to develop the field still exists Development Expenditure: Dry Hole Not specified. Capitalised as long s meet with IFRS assets recognition criteria 58

59. Successful Not specified. Capitalised as long as meet with IFRS assets recognition criteria Supporting Equip and Facilities DD & A Capital Costs Capitalised Not specified, to be allocated over useful life, reflecting consumption of assets’ benefits Non-Capital InventoryExpenses as consumed Obsolete inventory or assetsExpensed/impaired upon identified. 59

60. Abandonment/decommissioning liabilities Accrual basis- based on the discounted present value of the expected expenditures required to settle the obligation. The provision should be provided as the decommissioning obligation is created, which is normally when the facility is constructed and the damage that needs to be restored is done. 60

61. Impairment All impairments are recognised in the income statement. An impairment loss (downward) revaluation) may be offset against revaluation surpluses to the extent that it relates to the same asset; any uncovered deficit is recorded to the income statement. 61

62. Balance Sheet/Income Statement/Cash Flow  Carrying value of assets  Revenue earned  Expenses incurred  Amortisation of asset value (or valuation change)  Capital invested  Primary Financial Statements would be different depending on historical costs or valuation basis 62

63.  Are these the “right” disclosures?  Consistency of definitions  Consistency among companies  Expenses incurred  Interaction with basis of financial statements  Uncertainty of predictive information 63

64.  Geographical segments  Expenses for producing, exploration, other activities  Consistency among companies  Capital spending for exploration vs. development  Interaction with basis of financial statements  Amortisation inclusive of impairments 64

65.  Volumes by geographical location  Breakout between oil and gas  Standardised valuation  Nature of change activity between periods (including production) 65

66.  Well counts  Drilling activity  Production  Property Descriptions 66

67.  Both proved property acquisition costs and proved property well and development costs are to be amortised on a UNIT-OF-PRODUCTION basis as the related proved reserves are produced.  Formula – The basic computation of unit-of- production amortising is expressed by either of the following essentially identical formulas: (a) Unamortised Cost at End of Period Reserves at Beginning of Period x Production for Period OR (b) Production for the period________ Reserves at Beginning of Period x Unamortised Cost at End of Period 67

68. Assume the following data available at the end of an accounting period: Capitalised Costs, end of period$1,000,000 Amortisation taken in prior periods$ 250,000 Estimated Reserves at Beginning of Period$ 1,000,000 bbls Production during Period$ 40,000 bbls Amortisation for the period would thus be $30,000.00 $ 1,000,000 - $ 250,000 $1,000,000 bbls x 40,000 bbls = $30,000 68

69. Many oil and gas company activities involve jointly controlled operations, jointly controlled assets or jointly controlled entities. Joint control is defined under IFRS as the contractually agreed sharing of control over an economic activity. 69

70. The three forms of joint venture that IAS 31 addresses are summarised in the following table. A. Type of Joint Venture Description Accounting treatment by the Venture Jointly controlled operations Each venturer uses its own property, plant and equipment and carries its own inventories. It also incurs its own expenses and liabilities and raises its own finance. The joint venture (JV) agreement usually provides a means by which the revenue from the sale of the joint product and any expenses incurred in common are shared among the venturers. The venture should recognise: -The assets it controls and the liabilities it incurs - The expenses it incurs and its share of the income that it earn from the sale of goods or services by the JV 70

71. B. Type of Joint Venture Description Accounting treatment by the Venture Jointly controlled assets The venturers jointly control and jointly own one or more assets contributed to, or acquired for, the purpose of the JV and dedicated to the purposes of the JV. The assets are used to obtain benefits for the ventures. Each venturer may take a share of the output from the assets and each bears an agreed share of the expense incurred. The venturer should recognise: -Its share of the jointly controlled assets, classified according to the nature of the assets. - Any liabilities it has incurred jointly with the other venturers in relation to the JV. - Any income from the sale or use of its share of the output of the JV, together with its share or any expenses incurred by the JV. - Any expenses it has incurred in respect of its interest in the JV 71

72. C. Type of Joint Venture Description Accounting treatment by the Venture Jointly controlled entities A jointly controlled entity is a JV that involves the establishment of a corportation, partnership or other entity in which the venturer has an interest. The entity operates in the same way as other entities, except that a contractual arrangement between the venturers extablished joint control over the economic activity of share of the results of the jointly controlled entity, although some jointly controlled entities also involve a sharing of the output of the JV. There is a choice under IFRS. The venturer should account for its interests in jointly controlled entities consistently either: - By proportionate consolidation; or - Using the equity method 72

73. “African countries, whether oil importers or exporters, are severely affected by the volatility of international oil prices. Governments see their budget revenue and expenditure fluctuate greatly. Projects started when oil prices were high are abandoned when funds dry up, because of price falls. Oil consumers, such as transport companies, are often squeezed between the pressure of higher prices, and the potential discontent of their clients if they raise tariffs. Farmers see their terms of trade deteriorate when transport costs increase. Managing their risk exposure is no mean task. Trying to forecast prices is to no avail: the margin of error in price forecasts is so large that they cannot legitimately be used as a planning or budgeting tool. So how should Governments deal with this large risk exposure? 73

74. “Traditional tools such as domestic stabilisation funds have amply demonstrated their weaknesses. Compensatory finance, from the IMF or the World Bank, has rarely been available and if provided has fallen short and come late. Other measures such as privatising oil trade and adopting tax levels eliminate the risks for Governments, but not for their population. More innovative market-base tools, such as futures, options, swaps and commodity – price – linked loans, also have their limitation, but by and large, perform well. Access to these tools has much improved, particularly for Governments that can now use multilateral facilities. 74

75. Developing country Governments and African banks and oil companies should learn about these instruments, and explore how they can be used to mitigate the negative effects of oil price fluctuation on their economics and population” (UNCTAD/DIT/COM/11) Hey! Folks Think about your role as professional accountant in the oil & gas economy conundrum!!! 75

76. THANK YOU PROF. K. B. OMANE-ANTWI VICE RECTOR & DEAN PENTECOST UNIVERSITY COLLEGE TEL. 0244320448/0202011775 E’mail: kbomane-antwi@pentvars.edu.gh 76