10 Mar, 2016
Part 1 - Budgeting Exploration Activities
The article is an excerpt from Economics of Worldwide Petroleum Production, by Dr. Richard D. Seba
Exploration programs, due to their nature, are on-going over a period of years. They normally involve a phase of office study and environmental research, a leasing or concession acquisition, geophysical and perhaps geochemical work in the field followed by extensive interpretation and correlation. Each of these phases calls for budget allocation of time and experience in addition to the eventual exploratory drilling effort.
A well designed exploration program will attempt to spread out these activities as part of the budgeting process so that one year's budget doesn't have a disproportionate amount of geophysical field work with, say, little or no interpretative load this year with a revisal of the professional personnel requirements the following year.
Exploratory budgets tend to fluctuate widely in the initial stages of the budgeting process. Then, as the months go by there may be a sudden expansion, or sometimes curtailment of exploratory funds as the company gains a better feel of how the firm's earnings for the year are progressing. Operating people sometimes find difficulty in learning to accept this annual phenomenon. Drilling operations generally fall within the producing department's domain, and the engineers are called upon to handle the planning and execution of the exploratory drilling as well as their own development wells.
A wildcat well may have been designed, the pipe ordered and the contractor preparing to spud, only to see the whole venture suddenly canceled, or deferred until 'sometime next year.' The inverse of the situation also occurs in which a whole series of exploratory wells are suddenly authorized for drilling and hopefully completion just before year-end. This phenomenon makes it difficult for the engineer to comprehend why the exploration department's operations has many ups and downs, while the producing department appears much more able to set a series of budget goals and predictions, and to stick with them.
The major part of the exploration budget allocation in North America may be for lease acquisitions. Oil and gas leases are capitalized as tangible assets and amortized over their primary term. Undrilled leases normally also require an annual rental fee. Part of the cash flow of the firm must be earmarked for these lease acquisition, amortization and maintenance costs. A typical exploration budget also includes general exploration expense, which is comprised of overhead, staff, and support expenditures.
An exploration budget for a single twelve month period will represent expenditures for many individual programs in various stages of evolution. Some exploration programs will be in the initial "idea" stage, some in the follow-up phase, and others have advanced to the drilling stage.
Typical exploration activities move through part or all of the following seven phases:
The budget for any year will include numerous projects in various phases from I to VI. As an exploration prospect moves from one phase to the next, capital requirements expand accompanied by increasingly more sophisticated economic evaluation and technical effort.
Phase VII, termination of unsuccessful projects, can occur at any point in the evaluation process, as failure can occur during any of the other phases.
Examples of reasons for termination include:
Movement from one phase to the next may be delayed for many reasons, such as budgetary constraints, need to develop new technology, or in the case of Phase III, waiting for exploration rights to become available. For these reasons, a particular prospect may not appear in each successive year's budget as it moves from Phase I to Phase VI or VII. The typical exploration prospect will be funded over many years before it is either recognized as a success or failure. A particular prospect may change drastically between Phase I and Phase VI as additional information is acquired and the outcome of each expenditure is evaluated.
Impact of Accounting Methods on the Budgeting Process
Under the basic oil and gas accounting rules, it is necessary for a company to choose between the industry's two distinct types of accounting systems: successful efforts and full cost. The very significant difference between the two accounting systems shows up on the assets side of the balance sheet.
Successful Efforts Method
Under the Successful Efforts method, all exploration dry holes are expensed. The exploration cash budget allocation of these companies is approached with high regard for the company's profit target for the year on the assumption that all of the exploratory wells will be dry holes. The exploration allocation thus becomes the "swing" item in the overall budget. Most major oil companies employing the Successful Efforts method find that the number and cost of the occasional development dry holes very nearly offsets the expenditures for the successful wildcat discovery wells. Geological and geophysical (G&G) expenditures are mostly expensed under the Successful Efforts method, but capitalized in the alternative Full Cost method.
Full Cost Method
In comparison with the Successful Efforts method, budgeting under the Full Cost method is more of a business planning or forecasting exercise, rather than an allocation procedure.
The Full Cost method requires the budgeting of the organization's overhead costs consisting principally of salaries, office rent, utilities, etc. These costs must be forecast and provided for out of available funds. The cash demands of operating the firm's production have to also be anticipated. Since the expenditures for exploratory drilling, both successful and unsuccessful, are to be capitalized, the cash demand for this part of the firm's activity does not detract in a very substantial way from the company's profit objectives. The budget year's expenditure for this activity is thus determined only by the availability of cash from other activities, plus any sources outside of the company. Companies which employ the Full Cost method are generally most interested in the promotion of drilling funds and other means of raising cash to put into their exploration programs.
Proponents of both accounting methods are very interested in showing the best possible bottom line figures at year-end. In general, companies employing Full Cost accounting seem to be most concerned about immediate earnings per share, perhaps because these companies tend to be smaller and their EPS ratio may vary significantly from month to month.
Example of an exploration budget under different methods:
You can see that the differences in accounting methods result in approximately 70% of the total exploration budget being expensed with the Successful Efforts method, compared to less than 10% with the Full Cost method.
Stay tuned for Part 2 of our two-part series: Budgeting Oil Activities
For PetroSkills courses pertaining to today's topic, please see our Petroleum Business progression map.