Oil and Gas - Financial Reporting and Analysis

Oil and gas companies’ financial statements are affected significantly by the method they choose to account for costs associated with exploration and production. The method chosen is some variation of the successful-efforts or full-costing methods, which will be explained along with their effects on the financial statements. The financial statements of oil and gas companies are also unique because they are required to disclose, in a footnote, supplementary information on oil and gas exploration, development, and production activities.

This requirement will be explained in this section.

Cash flow is important to all companies, but particularly to oil and gas companies. Therefore, cash flow must be part of the analysis of an oil or a gas company. In addition, most of the traditional financial ratios apply to oil and gas companies. This section will not cover special ratios that relate to oil and gas companies. The 1998 financial statements of Texaco will be used to illustrate oil and gas financial statements. Texaco’s major business is energy, principally petroleum.

Successful Efforts Versus Full Cost

A variation of one of two costing methods is used by an oil or a gas company to account for exploration and production costs: the successful-efforts method and the full-costing method.

The successful-efforts methodplaces only exploration and production costs of successful wells on the balance sheet under property, plant, and equipment. Exploration and production costs of unsuccessful (or dry) wells are expensed when it is determined that there is a dry hole. With the full-costing method, exploration and production costs of all the wells (successful and unsuccessful) are placed on the balance sheet under property, plant, and equipment.

Under both methods, exploration and production costs placed on the balance sheet are subsequently amortized as expense to the income statement. Amortization costs that relate to natural resources are called depletion expense.

The costing method used for exploration and production can have a very significant influence on the balance sheet and the income statement. Under both methods, exploration and production costs are eventually expensed, but a significant difference exists in the timing of the expense.

In theory, the successful-efforts method takes the position that a direct relationship exists between costs incurred and specific reserves discovered. These costs should be placed on the balance sheet. Costs associated with unsuccessful efforts are a period expense and should be charged to expense. In theory, the full-costing method takes the position that the drilling of all wells, successful and unsuccessful, is part of the process of finding successful wells. Therefore, all of the cost should be placed on the balance sheet.

In practice, the decision to use the successful-efforts method or the full-costing method is probably not significantly influenced by theory, but by practicalities. Most relatively small oil and gas companies select a variation of the full-costing method. This results in a much larger balance sheet. In the short run, it also usually results in higher reported profits. Small oil companies speculate that the larger balance sheet and the increased reported profits can be used to influence some banks and limited partners, which the small companies tend touse as sources of funds.

Large oil and gas companies tend to select a variation of the successful-efforts method. This results in a lower balance sheet amount and lower reported income in the short run.

The large companies usually depend on bonds and stock as their primary sources of outside capital. Investors in bonds and stock are not likely to be influenced by the larger balancesheet and higher income that results from capitalizing dry wells.

The method used can have a significant influence on the balance sheet and the income statement. The successful-efforts method is more conservative. Review Figure for a description of Texaco’s method of accounting for exploration and production costs.

Supplementary Information on Oil and GasExploration, Development, and Production Activities

As part of your review of an oil or a gas company, note the supplemental oil and gas information. Review Figure for a brief summary of the supplementary information presented by Texaco.

Cash Flow

Monitoring cash flow can be particularly important when following an oil or a gas company. The potential for a significant difference exists between the reported income and cash flow from operations. One reason is that large sums can be spent for exploration and

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development, years in advance of revenue from the found reserves. The other reason is that there can be significant differences between when expenses are deducted on the financial statements and when they are deducted on the tax return. Therefore, observe the operating cash flow.

Cash from operating activities for a three-year period will be disclosed on the statementof cash flows. For Texaco, net cash provided by operating activities was $2,544,000,000, $3,915,000,000, and $3,762,000,000 for 1998, 1997, and 1996, respectively. Net income for Texaco was $578,000,000, $2,664,000,000, and $2,018,000,000 for 1998, 1997, and 1996, respectively.

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