As we’ve described previously, one of the components of “getting back in the game” for small independent E&P companies is producing financial statements that are compliant with Generally Accepted Accounting Principles (GAAP). One of the items required by GAAP is something called an asset retirement obligation liability.
So what does this mean? And how is it calculated?
To put it simply, an asset retirement obligation (ARO) liability represents your costs to plug a well. However, it does not necessarily mean the amount you’re laying out today in cash to have someone plug a well for you (or to do it yourself). What it really measures is your liability today for wells to be plugged in the future. Per GAAP, you can’t just wait to expense those costs as they occur.
GAAP dictates that liability is created once a legal obligation to retire an asset exists. So once you commence drilling a well (or acquire a well) you have already established a liability; in other words, once you’ve punched a hole in the ground, that hole has to be plugged at some point by state law. The questions now become:
1) How long is this well going to last and when are we going to plug it?
2) How much is it going to cost to plug the well, at the point that we’re
actually going to plug it?
One thing to remember when thinking about an ARO calculation: it’s an estimate. Obviously, we don’t know how long each well is going to last. We don’t know to the penny how much it’s going to cost to plug each well. And we don’t know where commodity prices are headed, which might have an effect on which wells get plugged and when. However, even though it’s an estimate, it’s still critical to calculate the amount using solid, reasonable assumptions that can be supported with evidence.
The best way to determine “well lives” is to obtain an engineer’s reserve report on all of your wells. This step may be expensive, but it is essential for a reasonable basis of determining the life of a well. Most companies have this report done every year, due to changes in the market that might change “well lives” and thus affect the calculation. For example, if price per MCF is $2, that might mean many more of your wells are going to be uneconomical to operate and may dictate candidates for plugging. If the price per MCF is $8, now those wells are economic and viable, and plugging is going to get pushed further into the future. An engineer will use estimates of future pricing and other factors such as the formation the wells are in to generate an estimated life for each well.
As mentioned above, the other question is how much is it going to cost? Remember, these wells might be plugged 30 years (or more) from now. Calculating an ARO involves inflation factors and also a present value factor to determine what the obligation in the future is valued at in today’s dollars. However, to do that correctly, you have to start with a sound, reasonable estimate that can be supported (sound familiar?). This might require an analysis by company engineers of the depth of a certain type of well, or how much cement might be needed, or the cost of labor to have a crew plug the well, or how much it would cost to do it internally vs. outsourcing, or vice versa. It might also require looking at the Department of Natural Resources filings. It might even be helpful to talk to other companies in the industry to get a feel for what they see regarding costs to plug their wells.
As you can see, calculating an ARO requires some critical thought and analysis, and good, conservative judgment. These are the most critical and essential steps for any accounting estimate. It may seem like a lot of work for something that just exists on paper, but remember, it’s a critical part of producing GAAP-compliant statements. Proper financial statements are going to be a necessity as your company grows.
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Hall, Kistler & Company has been helping producers in the oil and gas field since we opened our doors in 1941. We know what it takes to produce proper GAAP financial statements for oil and gas companies and can provide guidance along the way. Let us help when you are coming off the sidelines and BACK INTO THE GAME.