14 Mar, 2016
Part 2 - Budgeting Production Activities
The article is an excerpt from Economics of Worldwide Petroleum Production, by Dr. Richard D. Seba
For Part 1, see Budgeting Exploration Activities
In this section, we will examine the three categories of production costs:
- Direct Production Costs
- Allocated Production Costs
- Work in Progress at End of Accounting Period
Direct Production Costs
Production expenses include:
- Labor costs to operate the wells and service equipment, including personnel benefits
- Well and equipment repairs and maintenance
- Materials and supplies
- Fuel, water and services
- Property taxes
Also included as expenses:
- Depreciation and amortization of all previously capitalized expenditures for production per se may be included
- Costs of well repairs, or workovers, including labor, outside service companies, cement, acidizing and frac materials, etc.
NOT included as an expense:
- Costs of recompleting to another producing horizon are capitalized and depreciated out of the ensuing production.
Allocated Production Costs
This is a far-ranging category. Most NOCs and private sector oil companies operating outside the jurisdictional boundaries of their home country prefer to handle production costs on a country-by-country basis. In some countries, a "ring fence" rule is imposed, which requires that all expenses be allocated and charged on a prospect-by prospect basis. Ideally, this means a field-by-field basis if exploration is successful. In the U.S., for example, the government requires that accounts be kept on an individual lease, or property-by-property basis. The direct charges pertain specifically to wells, lease roads, tank batteries, flow lines, etc.
Allocated costs are those incurred by higher offices which benefit a broad range of the firm's activities. A portion of those costs is properly allocated to each of the several producing properties which benefit from the cost or activity. One must consider the costs of the office that looks after a large number of properties scattered over a geographical region, with a number of field vehicles, a pipe yard, etc. These and a host of other charges at the field level have to be prorated, or allocated to the various properties which they serve. The salary of the superintendent who is responsible for the whole group of leases is allocated on a per well, or per property basis, along with the corresponding expenses of his staff. Then, the cost of the employee benefits for the superintendent and staff must be added, including such items as the prorated portion of the company's contribution to the employee pension fund, group hospitalization insurance, and the like. Charging employee benefits to outside owners of a jointly-owned property is sometimes limited to a maximum percent of payroll under the terms of the Operating Agreement.
It should also be recognized that every level of management in a company organization does work which directly benefits each individual property, or lease. Each company has its own procedures for furnishing operating cost figures (i.e. the totals of the direct and allocated expenses) back to the specific lease on a periodic basis. Summary totals are also provided for each supervisory grouping of leases and operating level. These figures are used by management to appraise the performance of supervisors at subordinate levels. In this regard, timing of posting charges can sometimes result in misleading indications of cost control performance. Not all fixed charges are allocated costs.
The "cost oil" provisions of production sharing contracts should include all of the expense of the producing operations, although there requently are limitations. Under concession agreements, production costs are the responsibility of the working interest owners.
Work in Progress at End of Accounting Period
Another troublesome aspect of non-cash charges in the matter of accounting reserve for various types of work that are incomplete at year-end. One of these may be the incomplete well account. As an example, it is assumed that there is a major gas well development program in which it is important to get a number of wells drilled to hold a group of leases that are about to expire. However, there is no immediate opportunity to connect the production to a gas market. In this scenario, the possiblity exists of a well in which the drilling has been accomplished, and at year-end the well is waiting on a completion rig.
The account handling this situation in most companies will total up the work done to that point, and charge the costs associated with this incomplete well to expense, with a corresponding reduction in profit for financtial and tax purposes. The costs related to an identical offset well tested, and completed as a producer, before year-end would be largely capitalized, and only a part of the total expenditure expensed, with a resulting increase in reported profit for the year.
For more information on these topics, see:
Basic Petroleum Economics - BEC3
Expanded Basic Petroleum Economics - BEC
Economics of Worldwide Petroleum Production - EWP