By Andy Griffin, CPA, Supervisor and Keith A. Arner, CPA, CVA, Partner
“Do I really need to spend money to have an engineer prepare a reserve report for me?” As an oil and gas producer, you may have asked this question before. Reserves are the most significant measure of the value of your company to an outside party. Whether you’re trying to obtain financing from a bank, attract outside investors to a drilling program, or buy or sell an oil and gas producer, the ultimate question that will have to be answered is ”What is the value of what you have in the ground?”
Some companies produce their own reports using the data they have on hand and pricing based on the situation (e.g., year-end NYMEX or possibly escalated pricing based on estimated future commodity prices); however, more common is the use of an outside petroleum engineer with experience in the field.
One additional situation that often gets overlooked compared to the others listed above is the importance of reserve reports in producing statements that comply with generally accepted accounting principles (GAAP).
Your calculation of depletion expense is a critical area where reserve reports play a part. One of the interesting and tricky parts of depletion is the fact that total reserves change every year. Factors such as how much you produced in the past year, and commodity price changes dictate the remaining reserves. Thus, an updated reserve report is essential in the calculation of this number. Remember, there is no way of knowing how much you depleted unless you know what you have left.
A second item that the reserve report is needed for is the calculation of your asset retirement obligation, which we have discussed in our blog in the series. Simply put, how are you going to calculate a retirement obligation or plugging liability on each well without estimating when that well is going to be plugged? Again, this is where the reserve report comes into play. The report should have an estimate of the remaining useful life of each well, or at a minimum the life remaining in each group of wells or field that you have.
Yet another important use of the reserve report is in calculating potential impairment of the value of your oil and gas properties. GAAP requires the evaluation of whether or not the fair value of an asset has fallen below the reported value on the financial statements. If the future value is less, an impairment has to be recorded, and the asset is written down to the fair value. The best way to calculate the value of your oil and gas properties to make this calculation is a reserve report using reasonable and supportable estimates of the future value of your wells/acreage/properties.
A unique twist we want to note that affects any companies following the full cost method of accounting (rather than the more common successful efforts method) is what’s called a cost ceiling test. Without getting into the intricacies of the calculation, it is similar in concept to the impairment calculation described above but is much more complex. So once again, the reserve report plays a significant role.
As you can see, it’s essential that your company has a solid and reasonable estimate of the value of “what you have in the ground.” A reserve report will allow you to make the calculations necessary to produce GAAP-compliant financial statements.
In our next blog post, we will discuss financial statement footnotes and disclosures related to oil and gas exploration and production companies.
For other blog posts on this topic, search under the Category “Oil & Gas.” You can also subscribe to our newsletter or contact us at 330-453-7633 for more information about your oil and gas accounting needs.
Hall, Kistler & Company has been helping producers in the oil and gas industry 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 of the sidelines and BACK INTO THE GAME.