Due to the capital intensive, high-risk nature of developing oil and gas properties, companies routinely combine their capital and knowledge in joint operations to share the cost and reduce risk. These sharing arrangements usually involve the transfer an operating interest or non-operating interest by one party to another in exchange for a contribution to the project.
Here’s some of what you need to know for oil & gas accounting…
In order to develop a property, the owner of an operating interest (working interest) may transfer (farm-out) the operating interest. In a farm-out arrangement some of the entire burden for developing the property is transferred to another person. In exchange for assuming the burden, the transferee receives the operating interest in the property.
As a part of the transaction, a non-operating interest is partitioned out of the operating interest and retained by the owner. The retained interest is usually an overriding royalty, but could also be a net profits interest or a production payment. In a farm-out arrangement, the assignor of the mineral interest will transfer any leasehold cost from the operating interest to the non-operating interest.
Joint ventures are a type of sharing arrangement. A joint venture is a nonincorporated association of two or more persons or companies who pool their resources to drill, develop, and operate an oil and gas property or properties.
Each owner has an undivided interest in the property. Joint ventures may be created in several ways, some of the most common being:
An operator’s expenses associated with the operation of oil & gas wells could consist of:
Intangible drilling costs (IDCs) include all expenses made by an operator incidental to and necessary in the drilling and preparation of wells for the production of oil and gas, such as survey work, ground clearing, drainage, wages, fuel, repairs, supplies and so on. Broadly speaking, expenditures are classified as IDCs if they have no salvage value.
The following is a nonexhaustive list of potential IDCs incurred in the exploration and development of oil & gas wells.
Similar to IDCs these expenses are related to nonsalvageable completion costs, including labor, completion materials used, ompletion rig time, drilling fluids etc. Intangible completion costs are also almost always deductible in the same year they take place, and usually make up about 15% of the overall well cost.
Expenditures necessary to develop oil or gas wells, including acquisition, transportation and storage costs, which typically are capitalized and depreciated for federal income tax purposes.
Examples of such expenditures include:
The cost and expenses associated with acquiring properties, including:
The costs associated with operating a producing well. Lease operating expenses can include:
As you can see, there are several different types of costs associated with drilling and producing wells and they are treated differently depending on how the joint venture or partnership is setup. Having a good oil and gas accounting software package is critical to keeping track of these expenses.
Source: SherWare Blog
Most small independent producers, who are not required to use a GAAP method of accounting, use a tax method of accounting or a hybrid of successful efforts and tax.
The rules for tax accounting are set forth in the Internal Revenue Code and the corresponding Treasury Regulations.
The general rule for accounting methods in the Internal Revenue Code states:
Taxable income shall be computed under the method of accounting on the
basis of which the taxpayer regularly computes his income in keeping his books. (IRC Sec. 466(a))
This means that your taxable income is calculated using the same method you use doing your monthly accounting. That’s what “keeping your books” means.
This code section goes on to define the permissible methods. The permissible accounting methods under IRC Sec. 466(c) are:
The accounting method used must clearly reflect income and be consistently applied. Treas. Reg. Sec. 1.446-1 states:
It is recognized that no uniform method of accounting can be prescribed for all taxpayers.Each taxpayer shall adopt such forms and systems as are in his judgment best suited to his needs. However, no method of accounting is acceptable unless it clearly reflects income…provided all items are treated consistently from year to year.
The cash method means that you recognize income when you receive payment, either for the oil & gas produced or for services performed. It also means that you recognize expense when you pay the bill for the expense.
The accrual method means that you recognize income when the oil or gas is produced and expenses when the expense is incurred. So gas produced in March would be March revenue even though you might not receive the payment from the first purchaser until May. Expenses are incurred when you receive the bill for the expense instead of when you pay the bill.
This generally doesn’t apply to oil & gas accounting. It deals with methods such as the “crop method of accounting” and the “long-term contract method”
You can combine methods such as using the cash method for receivables (revenue), and the accrual method for payables (expenses).
Notice that the accounting method can be the cash method, the accrual method or a hybrid method of cash and accrual as long as you stay consistent.
Source: SherWare Blog
The percentages that determine the amounts paid to the different people or entities participating in the well is called the Division of Interests or Division Order. The division order is a document spelling out what the owners in the well are to be paid and when.
The interests (percentages) that make up the division of interests are typically determined in the following manner:
Royalty Owners – paid the percentage their land makes up of the entire drilling unit. If they own 100% of the land the well is drilled on they would typically get a 12.5% royalty.
Overriding Royalty Owners – typically paid around 3%.
Working Interest Owners – pay their share of the expenses based on the amount they invested in the well. If they put up 50% of the cost of the well, they would get a 50% working interest. The working interest owner’s share of the revenue is determined by first subtracting the royalties paid from 100 and then multiplying the remainder by their working interest.
Assume a well has a 12.5% royalty and an overriding royalty of 3.0%. The royalties are paid first so this would leave 84.5% for the working interest owners.
100.0% – 12.5% – 3.0% = 84.5%
|Owner Type||Expense Pct||Revenue Pct|
|Working Int 1||75.00% * 84.50% =||63.375%|
|Working Int 2||25.00% * 84.50% =||21.125%|
Source: SherWare Blog
Spreadsheets have long been the go-to tool for oil and gas companies looking to track expenses and revenue because essentially everyone knows how to work a spreadsheet.
But, if you’ve been using spreadsheets to track your distribution processes, you’ll have experienced at some point an error in a formula or the wrong cells copied over to the wrong column…. the possibiltiies are endless in the tiny, yet time-consuming-to-find mistakes that have been made.
Spend Less Time Fiddling with Spreadsheets
There’s a reason why spreadsheets are so popular across the business world. They’re no-frills and adaptable, so they’re a “good enough” solution for most businesses.
However, their strength is also their biggest weakness: they’re not specifically designed for any one industry.
That’s where oil and gas accounting software enters the scene to help with distributions and joint interest billing. If you’ve never considered it before, dedicated oil and gas software automates processes in a way that spreadsheets can’t match, saving you enormous amounts of time. In fact, once you get your software set up, you can track and list expenses, revenue, and distribution at the click of a button.
Or you could spend hours manually entering all of the information every month and praying the calculations were the same from the last time you opened the spreadsheet.
Keep Your Costs Low by Eliminating Mistakes
In big business, mistakes cost money. In the oil and gas industry, operator mistakes can lead to incorrectly reporting expenses and revenues, erroneously distributing incomes, or simply increasing accounting times.
All of these mistakes can be expensive. With a dedicated accounting software – unlike a spreadsheet – you can streamline the process and have in-system auditing. This ensures you don’t make mistakes, and also makes sure you keep your data safe and backed-up.
Spreadsheets, on the other hand, know nothing about your business. All they know is their own complicated formulas – so if you screw up, they won’t catch it…and neither will you, until it’s already cost you money.
Pick the Right Tool for the Job
Accounting for the oil and gas industry is a specialized beast. It takes specific tools and know-how, and it’s just not feasible for a generic spreadsheet program to give you all of the bells and whistles you need.
To read more about spreadsheet risk and some tips for using spreadsheets if you’re currently using them, check out our free Ebook: Spreadsheet Risk.
Source: SherWare Blog
The lessor’s share of the production is known as the royalty or landowner’s royalty. It is common for the share to be stated as a fraction of the oil and gas produced, for example 1/8. The lessee acquires the right to the oil and gas produced less the landowner’s royalty.
The lessee does not take on a specific obligation to develop the property or to pay delay rentals, but does agree that the lease will expire if the property is not developed or rentals are not paid. Normally the lessee can abandon the lease without penalty.
When the landowner signs the lease, the owner will be given a “Bonus.” The bonus is a sum of money, agreed upon both the Lessor and the Lessee to be given on signing of the oil and gas lease. If there are producing wells near the land, the bonus is usually higher than when there is no drilling yet or none of the existing wells are not producing.
The length of time established in the oil and gas lease is called the “term.” This is the primary length of the lease. The term is usually a fixed length of time, such as one to five years.
Another part of the oil and gas lease is royalty payments. It is an agreed on percentage of the profits of the oil and gas. The lease will specify what, if anything, can be deducted from the royalty payments such as, severance taxes and/or gathering or marketing charges.
If the term of the oil or gas lease extends beyond the time that the bonus was paid, and a well was not drilled, then the Lessee is required to pay the landowner an agreed on sum. This sum could be $1.00 or more per acre. This is called a delay rental. The payment is due on or around the anniversary of the lease. Occasionally oil and gas companies pay this fee up front when an oil lease is negotiated and signed. The company’s failure to pay a delay rental on time cancels the lease.
Source: SherWare Blog
For small or medium sized oil and gas companies, software is often an overlooked part of their business process. People often assume that software is too costly and does not provide a good return on investment (ROI). Here are some important things that aren’t always at the top of your list to consider when deciding whether to upgrade your current software systems that probably should be when dealing with oil and gas disbursement software.
If your business operates wells, tracking income and expenses is incredibly important. Without proper tracking and accounting integration, you could be setting yourself up for problems between your investors and well owners and other parts of the distribution chain – because it all comes down to one thing: accurate numbers.
If you can’t be sure that you 1) have all the pertinent bills, lease details, division of interest breakdowns and production receipts entered correctly for the month and 2) that your math to split it out evenly between 10 or 100 owners in a well is correct, then essentially the work you’re putting in is useless.
What good is it to you if you have the division of interest equations right to divvy up income flowing in, but some bills that were supposed to run through in April were entered with the wrong date and weren’t processed in April’s distribution that you just mailed checks out for?
While there are many things that software can do, the most important thing to look for in a software program is how it handles the data you enter. How much of the software is run on automated processes either you set up or are already set up within the software?
Are there checks in place to be make sure everything you’ve entered for the period you’re processing is showing up? How do you know if the division of interest has been added up correctly? Does the software automatically link bills to wells to owners or do you manually type that in? How much room for error is there?
From well-specific to owner-specific information, data in your business needs to be accessible and available to interested parties. When considering a software upgrade, your data needs are nearly as important as managing distribution. The more parties which you need to interact with on a daily, weekly, quarterly or yearly basis, the more oil and gas software can produce positive results. The next thing you should consider is how easily can your data be shared with others?
What reports can be created? How quickly can they be reproduced? How will I get monthly distribution statements out? Can I email reports to investors when they call in? Can I create tailored reports for the accountant and COO to get the numbers they need?
What if I need to go back and look at reports from January? Will they still be available?
Getting answers to your questions regarding how proficient the software’s reporting capabilities are is paramount. Automation does you no good if it’s cumbersome to share the data with those asking the tough number questions.
And finally, your business’s need for information management needs to be balanced with your budgeting priorities. In order to decide when start with a new software program, you must address the price of software versus the cost of labor to manage your information without the software.
For businesses, one of the chief ways to decide whether the cost of upgrades are worth more than the expense is through the simple accounting equation to analyze profits – income (or money saved) minus expenses (and labor) equals profit. Installing a new software system makes sense if the money saved (or earned) is worth more than the costs of installing and training on the new software.
So the final piece to look at, and the one that often is the only piece looked at, is to ask yourself, is it worth it?
How much time could be saved with new software? What personnel changes could I make with new software? Will I no longer need an accountant to handle this aspect of my business? Can my office manager finish disbursements in less time – leaving her more time to complete all the other tasks?
What costs can be saved by handling everything in one place? If I am able to handle AFEs, leases, directly deposit revenue into an owner’s account and no longer need to print and mail statements, for example, how much time, office supplies and money could I save per month?
Now the final question is does your current system for handling distributions and joint interest billing meet all of these requirements you’ve just answered for yourself?
Source: SherWare Blog
To be able to work effectively in Oil & Gas Accounting, you need to understand some of the terminology for the oil & gas industry. Here are some of the terms you’ll encounter…
Source: SherWare Blog
As we’ve said in a prior post, “Accounting is Accounting”. This means that all accounting is essentially the same except for what you’re “accounting” for. What are you keeping track of? In the case of oil & gas accounting, you’re keeping track of wells that are being drilling and the products those wells produce over their lifespan.
In order to understand this accounting process, it’s good to take a look at how a well comes to be.
So how does a well get drilled? How do they determine where to drill the well? How are they sure where oil & gas will be found?
An oil & gas operator will research different areas where oil & gas has been found in the past. But before they can begin drilling, they have to have permission to drill from the landowner and/or mineral owner where the well is to be drilled. They will need to get a Lease from the landowner and/or mineral owner in order to drill on their property. A lease is a legal document that spells out what the operator or owner of the lease will do for the landowner for the permission or right to drill wells on their property. There are also payments involved in order to get the lease. These payments consist of a lease bonus of so many $ per acre being leased.
Usually, in order to keep the lease until a well is drilled, the operator has to pay Delay Rental Payments to the landowner of so much per acre per year. This keeps the lease in effect until a well is drilled on the property.
Production from the well will be paid to the mineral owner, (hereinafter called the Royalty owner). The amount paid is typically 12.5% – 25% of the production before expenses.
Sometimes, the person who found the lease and did all the work in getting it signed, called the Landman, is paid by giving them a percentage of the production from the wells on the lease. This is called an Overriding Royalty. This percentage usually varies from 1% – 5%.
The people who provide the money to drill the well are called Working Interest owners. Their percentage is based on the amount of money they invested. Working interest owners share in the expenses incurred during the drilling and production phases of a well.
Find out more by downloading our free Oil & Gas Accounting 101 ebook below!
Source: SherWare Blog