Understanding the oil and gas industry

By Ma. Johanna D. Agudo

First Published in Business World (2/3/2014)

We live in a world powered, if not driven, by fossil fuels. Until more strides in green energy and technology can be made, fossil fuels will continue to impact every sector of society. Given the importance of oil and gas to our national development, however, care should be taken that they are used and accounted for correctly to promote transparency, financial accuracy and sustained investor confidence.

In general, the oil and gas industry is controlled through either of the two forms – through the national oil companies (NOCs), which are government-owned organizations holding a bigger share in terms of reserves and production; and through licenses granted to the international oil companies (IOCs) that are private organizations. The industry is composed of an integrated set of interdependent segments which are:

(a) Upstream, which includes exploration and production;
(b) Midstream, which covers processing and transportation, and;
(c) Downstream, which involves refining or “cracking” the resource into different products, storage and distribution.

A company can operate in one segment of the industry. However, an integrated oil company can operate across the different segments.

Each product that results from the refining process has an independent value and is sold or traded independently. Trading the “crack spread” aims to capitalize on the differential between the crude and the resulting products, and is used for refinery hedging as well as arbitrage and speculation.

Each industry segment has its own accounting implications and the companies must be cautious in applying the right accounting principles to ensure accurate reporting.

To maximize its natural resources, a country may decide to set up an NOC or partner with an IOC. This kind of a set up may require a joint agreement. In this case, the parties involved will need to consider the relevant provisions of Philippine Financial Reporting Standards (PFRS) 11, Joint Arrangements. In other cases, the land where the resources are located may belong to an individual owner which would necessitate signing a lease contract to gain access and thereby considering the guidance under Philippine Accounting Standards (PAS) 17, Leases. Additionally, securing the necessary licenses and rights may involve assessing whether the right obtained will result in recognizing intangible assets based on the provisions of PAS 38, Intangible Assets.

PFRS 6, Exploration for and Evaluation of, Mineral Resources, provides the accounting guidance for the exploration and evaluation phases. However, after the exploration phase, there is little specific guidance for oil and gas accounting, which is why companies may wish to consider several relevant standards, such as PAS 16, Property, Plant and Equipment, and PFRS 11, among others.

As consumption increases, the question arises whether reserves are likewise increasing. There is certainly a finite amount of oil and it is uncertain how much remains and how long it will last. According to Ernst & Young’s An Overview of the Oil and Gas Industry, optimists believe that there is a sufficient supply of oil for the next 40 years, while reserves for gas are estimated to be much higher with approximately 60 years of supply remaining. However, reserves should be limited to resources that can be physically and economically acquired.

In financial reporting, identifying the available reserves is the most important estimate considering that reserves are the most important indicator of value. However, this is not reflected on the balance sheet as most countries have no accounting guidance on the subject. While US Generally Accepted Accounting Principles provide detailed guidance, similar guidance is not given by the PFRS.

Valuation of reserves
Valuation of reserves requires the preparation of a discounted cash flow model using cost and market information. This is normally done by analysts who consider the quality of reserves, and not just the quantity of oil and gas. This also forms the basis of advice to private investors, since the metrics derived from the reserves are also key indicators of a company’s ability to create value through its exploration efforts and provide future production growth.

It should be noted that measuring natural gas requires a subjective determination as to when the measurement is to be taken. This is because gas normally expands under hot temperatures and contracts under cold temperatures. Performing an inventory count of the extracted oil and gas will yield different results early in the morning, at midday or early evening. Most players conduct the inventory count is in the late afternoon when the gas has reached full expansion. While others may disagree, what is essential is the consistency in the method and timing of the count.

Impairment Assessment
PFRS 6 provides impairment indicators for exploration and evaluation assets which include the following:
• The period for which the entity has the right to explore in the specific area has expired during the period or will expire in the near future, and is not expected to be renewed.
• Substantive expenditure on further exploration for and evaluation of mineral resources in the specific area is neither budgeted nor planned.
• Exploration for and evaluation of mineral resources in the specific area have not led to the discovery of commercially viable quantities of mineral resources and the entity has decided to discontinue such activities in the specific area.
• Sufficient data exists to indicate that, although a development in the specific area is likely to proceed, the carrying amount of the exploration and evaluation asset is unlikely to be recovered in full from successful development or by sale.

In addition, once assets are reclassified as development assets, the impairment requirements of PAS 36, Impairment of Assets, shall apply. However, there are also challenges in identifying and gathering the relevant information to be able to reasonably conclude that the asset is impaired. For example, challenges in securing the requisite licenses, although the company has no plans to dissolve, may raise concerns of impairment. Also, non-segregation of cost over several areas may also pose a challenge in determining which cost component should be impaired. In these scenarios, further information and management’s intent are needed before one can reasonably make a conclusion whether or not to recognize impairment.

Most natural resource companies are required, by contract, local regulations or environmental policies, to provide for a decommissioning cost to restore the area to its natural state. For the upstream chain, the decommissioning effort can cost tens of millions of dollars and will involve well-plugging, pipe-cutting below the seabed and seabed restoration, subsea installation/equipment removal, platform removal, and others. However, certain risk sharing agreements exclude decommissioning particularly older Production Sharing Contracts/Agreements where the assets revert to the NOC prior to decommissioning.

In accounting for decommissioning costs, the relevant provisions of PAS 16 and PAS 37, Provisions, Contingent Assets and Contingent Liabilities, should be considered. The companies should also refer to Philippine Interpretation IFRIC 1, Changes in Existing Decommissioning, Restoration and Similar Liabilities, when accounting for the changes in the measurement of any existing decommissioning, restoration or similar liability.

The above discussion provides an overview of the principles to be considered in the oil and gas industry. However, as regulations and accounting interpretations continue to evolve, companies should ensure that they remain abreast of the latest developments and assess the impact of these on current and future arrangements. After all, it is vital that the country should be able to access, extract and make use of its natural resources as the rightful patrimony of all Filipinos. Having clear, consistent and reliable financial reporting will only redound to the benefit of all concerned parties.

Ma. Johanna D. Agudo is a Senior Director of SGV & Co.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.