When considering publicly traded O&G stocks or Master Limited Partnerships (MLPs), investors should spend some time with the audited financial statements. Companies that are involved in exploration and development may either account for their oil and gas activities under the successful efforts method or the full cost method. This choice has a material impact on the balance sheet, net income, and how cash flows are presented on the financial statements.
With the Successful Efforts accounting method, the oil company:
- Capitalizes costs only when the costs are associated with successfully finding or developing oil and gas reserves
- Expenses dry holes and any other costs associated with failed efforts at finding or developing oil and gas reserves
- Expenses production costs
- Recovers any capitalized costs through depletion
With the Full Cost accounting method, the oil company:
- Acknowledges that unsuccessful efforts are a necessary and unavoidable part of the business of exploration
- Capitalizes all costs related to acquiring, exploring, and developing reserves
- Expenses all production costs
- Recovers capitalized costs through depletion
- Performs the annual ceiling test: the capitalized amount carried on the balance sheet cannot exceed the present value of future cash flows (revenue net of future development and production costs) discounted at 10%. To the extent capitalized costs exceed the full cost ceiling, an expense is incurred to write off the excess.
Generally, in times of rising or high O&G commodity prices, the full cost accounting method will report higher net income because costs incurred in unsuccessful projects are capitalized. Consequently, the assets reported on the balance sheet will be higher assets. In times of falling or lower O&G commodity prices, however, the full cost method will report a lower net income and can have significant write downs because of the ceiling test. There are good arguments on both sides for choosing either the Successful Efforts method or the Full Cost accounting method. The key takeaway here is that during times of falling or lower commodity prices, companies that use the successful efforts accounting method may look artificially more successful than companies using the full cost accounting method. Be aware that you may not be comparing apples to apples when looking at the financial statements of companies that use different accounting methods.
Read the Footnote With Regard to Reserves
Another important disclosure, included with the annual financial statements, is the footnote discussing mineral reserves. This unaudited footnote is included with financial statements filed with the SEC, and it is generally the last footnote to the financial statements. It should outline (at least at a high level) how successful the developer has been at building reserves.
By carefully reading the footnote discussing the reserves and the management discussion and analysis section of the annual report, investors can learn where the drilling is happening, the biggest blocks of drillable acres, plans to complete or explore those areas and trends with regard to adding reserves. Understanding the plans of a developer to continue future exploration — such as where and to what extent — can support decisions on investment.
Scott Allen, CPA, joined Cornwell Jackson as a Tax Partner in 2016, bringing his expertise in the Construction and Oil and Gas industries and 25 years of experience in the accounting field. As the Partner in Charge of the Tax practice at Cornwell Jackson, Scott provides proactive tax planning and tax compliance to all Cornwell Jackson tax clients.
Contact him at Scott.Allen@cornwelljackson.com or 972-202-8032.