Petroleum Accounting(Chapter One part (1))

AN INTRODUCTION TO THE
PETROLEUM INDUSTRY

BASIC TERMS AND CONCEPTS

Petroleum refers to crude oil and natural gas or simply oil and gas.
These are mixtures of hydrocarbons which are molecules, in various
shapes and sizes, of hydrogen and carbon atoms found in the small,
connected pore spaces of some underground rock formations. These
petroleum reservoirs are generally thousands of feet below the surface.
Crude oil and natural gas are believed to be the remains of plants and
animals, mostly small marine life, that lived many millions of years ago.
Oil and gas are discovered and produced through wells drilled down to
the reservoirs. An exploratory well is one drilled to discover or delineate
petroleum reservoirs. A development well is one drilled to produce a
portion of previously discovered oil and gas. A large producing reservoir
may have one or more producing exploratory wells and several producing
development wells.
Estimated volumes of recoverable oil and gas within the petroleum
reservoir are called oil and gas reserves. Reserves are classified as
proved, probable, or possible, depending on the likelihood that the
estimated volumes can be economically produced.
From petroleum we get numerous useful products:
♦ Transportation fuels, such as gasoline, diesel fuel, jet fuel,
compressed natural gas (or CNG) and propane;
♦ Heating fuels, such as propane, liquefied petroleum gas, heating
oil, and natural gas burned to heat buildings;

♦ Sources of electricity, such as natural gas and residual fuel oil
burned to generate 14 percent of U.S. electricity (with coal, nuclear
energy, and renewable sources generating the rest); and
♦ Petrochemicals from which plastics as well as some clothing,
building materials, and other diverse products are made.
Different mixtures of hydrocarbons have different uses and different
economic values. It is necessary to recognize some basic types of
hydrocarbon mixtures to understand portions of this book. Crude oil refers
to hydrocarbon mixtures produced from underground reservoirs that are
liquid at normal atmospheric pressure and temperature. Natural gas refers
to hydrocarbon mixtures that are not liquid, but gaseous, at normal
atmospheric pressure and temperature.
The gas mixtures consist largely of methane (the smallest natural
hydrocarbon molecule consisting of one carbon atom and four hydrogen
atoms). Natural gas usually contains some of the next smallest
hydrocarbon molecules commonly found in nature:
Ethane (two carbon, six hydrogen atoms, abbreviated C2H6),
Propane (C5H8),
Butane (C4 H10), and
Natural gasolines (C5H12 to C10H22).
These four types of hydrocarbons are collectively called natural gas
liquids (abbreviated NGL1) which are valuable feedstock for the
petrochemical industry. When removed from the natural gas mixture,
these larger, heavier molecules become liquid under various combinations
of increased pressure and lower temperature. Liquefied petroleum gas
(abbreviated LPG) usually refers to an NGL mix of primarily propane and
butane typically stored in a liquid state under pressure. LPG (alias bottled
gas) is the fuel in those pressurized tanks used in portable "gas" barbeque
grills. Sometimes the term LPG is used loosely to refer to NGL or
propane.
In the United States natural gas is measured in two ways, both
important in petroleum accounting:

♦ by the amount of energy or heating potential when burned,
generally expressed in million British thermal units (abbreviated
mmBtu) and
♦ by volume, generally expressed in
- thousand cubic feet (abbreviated as mcf),
- million cubic feet (abbreviated as mmcf),
- billion cubic feet (abbreviated as bcf), or
- trillion cubic feet (abbreviated as tcf).
In many other parts of the world, gas volumes are measured in cubic
meters (kiloliters) and energy is measured in gigajoules. A kiloliter (or
cubic meter) approximates 1.31 cubic yards and 35.3 cubic feet. A
gigajoule (or a billion joules) approximates 0.95 mmBtu.
Gas volumes are necessarily measured at a standard pressure and
temperature, typically at an atmospheric pressure base of 14.65 to 15.025
pounds per square inch absolute (or psia) and a temperature of 60 degrees
Fahrenheit.2
The ratio of mmBtu (energy) to mcf (volume) varies from
approximately 1:1 to 1.3:1. The more natural gas liquids in the gas
mixture, the higher the ratio, the greater the energy, and the "richer" or
"wetter" the gas.
For various economic reasons, wet gas is commonly sent by pipeline to
a gas processing plant for removal of substantially all natural gas liquids.
The NGL are sold. The remaining gas mixture, called residue gas or dry
gas, is over 90 percent methane and is the natural gas burned for home
heating, gas fireplaces, and many other uses.
As wet gas is produced to the surface and sent through a mechanical
separator near the well, some natural gasolines within the gas condense
into a liquid classified as a light crude oil and called condensate. Crude
oil is measured in the U.S. by volume expressed as barrels (abbreviated as
bbl).3 A barrel equates to 42 U.S. gallons. In some other parts of the
world, crude oil is measured by weight, such as metric tons, or by volume

expressed in kiloliters (equivalent to 6.29 barrels). A metric ton of crude
oil approximates 7.33 barrels of crude oil, but the ratio varies since some
crude oil mixtures are heavier per barrel than others.
Volumes of crude oil and natural gas combined are often expressed in
barrels of oil equivalent (abbreviated boe) whereby gas volumes in mcf
are converted to barrels on the basis of energy content or sales value. In
general, approximately 5.6 mcf of dry gas have the same 5.8 mmBtu
energy content as one average U.S. barrel of oil. However, one mcf of gas
might be selling for $1.50 when oil is selling for $15 per barrel whereby
ten mcf equate to one barrel of oil, based on the given sales prices. For
one million boe of gas, the corresponding mcf are shown below for the
aforementioned conversion ratios.

Note that many companies use an energy conversion ratio of 6 mcf per
barrel, which is the required ratio for certain income tax rules in Internal
Revenue Code Section 613A(c)(4).
Crude oil can be many different mixtures of liquid hydrocarbons.
Crude oil is classified as light or heavy, depending on the density of the
mixture. Density is measured in API gravity as explained in Chapter
Eleven. Heavy crude oil has more of the longer, larger hydrocarbon
molecules and, thus, has greater density than light crude oil. Heavy crude
oil may be so dense and thick that it is difficult to produce and transport to
market. Heavy crude oil is also more expensive to process into valuable
products such as gasoline. Consequently, heavy crude oils sell for much
less per barrel than light crude oils but weigh more per barrel.
Both natural gas and crude oil may contain contaminants, such as
sulphur compounds and carbon dioxide (CO2), that must be substantially
removed before marketing the oil and gas. The contaminant hydrogen
sulfide (H2S) is poisonous and, when dissolved in water, corrosive to
metals. Natural gas and crude oil high in sulfur compounds are called
sour gas and sour crude oil as opposed to sweet crude oil or intermediate
(between sour and sweet). Some crude oils contain small amounts of
metals that require special equipment for refining the crude.
The petroleum industry, commonly referred to as the oil and gas
industry, has four major segments:
1. Exploration and Production, or E&P, by which petroleum
companies (referred to as "oil and gas companies" or simply "oil
companies") which explore for underground reservoirs of oil and
gas and produce the discovered oil and gas using drilled wells
through which the reservoir's oil, gas, and water are brought to the
surface and separated (Figure 1-1)
2. Hydrocarbon Processing by which crude oil refineries and gas
processing plants separate and process the hydrocarbon fluids and
gases into various marketable products (Figure 1-1). Refined
products and NGL may be processed further in "petrochemical
plants" for making petrochemicals. Some petrochemicals may, in
turn, be sent to the crude oil refineries for mixing or processing with
other liquid hydrocarbons to make various refined products, such as
gasoline.
3. Transportation, Distribution, and Storage by which petroleum is
moved from the producing well areas to the crude oil refineries and
gas processing plants. Crude oil is moved by pipeline, truck, barge,
or tanker. Natural gas is moved by pipeline. Refined products and
natural gas are similarly transported by various means to retail
distribution points, such as gasoline stations and home furnaces. In
unusual cases, African, South Pacific, and Caribbean countries are
exporting natural gas across the oceans and seas by chilling the
mixture to a liquid state at -160 degrees centigrade for hauling in
special tankers with high pressure, cryogenic containers. This
chilled gas is called liquefied natural gas (abbreviated LNG).
4. Retail or Marketing which ultimately markets in various ways the
refined products, natural gas liquids, and natural gas to various
consumers.
Variations of new, but promising, processes (not illustrated in Figure
1-1) convert natural gas to liquids equivalent to refined product fuels,
such as diesel. This gas-to-liquids (GTL) approach may enable
substantial gas reserves in remote areas to be profitably produced,
transported, and sold. Several petroleum companies are conducting
pilot tests of such processes.

The E&P segment is sometimes called upstream operations, and the
other three segments are downstream operations. Companies having both
upstream and downstream operations are vertically integrated in the
petroleum industry and, hence, are called Integrated. Other companies
involved in upstream only are referred to as Independents. The several
largest integrated petroleum companies are called Majors.
In this book, petroleum accounting focuses on United States generally
accepted accounting principles (GAAP) for financial reporting of the
exploration and production of petroleum. Chapter Twenty-Five introduces
accounting for international operations. Chapters Twenty-Six and Twenty-
Seven touch upon accounting for income tax reporting of petroleum
exploration and production.

AN OVERVIEW OF PETROLEUM EXPLORATION
AND PRODUCTION

Preliminary Exploration. Before an oil company drills for oil, it first
evaluates where oil and gas reservoirs might be economically discovered
and developed (as explained more fully in Chapter Five).
Leasing the Rights to Find and Produce. When suitable prospects
are identified, the oil company determines who (usually a government in
international areas) owns rights to any oil and gas in the prospective areas.
In the United States, whoever owns "land" usually owns both the surface 

rights and mineral rights to the land. U.S. landowners may be individuals,
corporations, partnerships, trusts, and, of course, governments. A
landowner may sell the surface rights and then separately sell (or pass on
to heirs) the mineral rights. Whoever owns, (i.e., has title to), the mineral
rights negotiates a lease with the oil company for the rights to explore,
develop, and produce the oil and gas.
The lease requires the lessee (the oil company), and not the lessor, to
pay all exploration, development, and production costs and gives the oil
company ownership in a negotiated percentage (often 75 percent to 90
percent) of production. The lessor owns the remaining portion of
production. Leasing is explained further in Chapter Seven.
The oil company may choose to form a joint venture with other oil and
gas companies to co-own the lease and jointly explore and develop the
property as explained in Chapter Ten.
Exploring the Leased Property. To find underground petroleum
reservoirs requires drilling exploratory wells (as discussed in Chapter
Eight). Exploration is risky; two-thirds of U.S. exploration wells for 1998
were abandoned as dry holes, i.e., not commercially productive.4 Wildcat
wells are exploratory wells drilled far from producing fields on structures
with no prior production. Consequently, 80 to 90 percent of these wells
are dry holes. Several dry holes might be drilled on a large lease before an
economically producible reservoir is found.
To drill a well, a U.S. oil company typically subcontracts much of the
work to a drilling company that owns and operates rigs for drilling wells.
Evaluating and Completing a Well. After a well is drilled to its
targeted depth, sophisticated measuring tools are lowered into the hole to
help determine the nature, depth, and productive potential of the rock
formations encountered. If these recorded measurements, known as well
logs, along with recovered rock pieces, i.e., cuttings and core samples,
indicate the presence of sufficient oil and gas reserves, then the oil
company will elect to spend substantial sums to "complete" the well for
safely producing the oil and gas.
Developing the Property. After the reservoir (or field of reservoirs) is
found, additional wells may be drilled and surface equipment installed (as
explained in Chapters Eight and Eleven) to enable the field to be
efficiently and economically produced.
Producing the Property. Oil and gas are produced, separated at the
surface, and sold as explained further in Chapters Eleven and Twelve.
Any accompanying water production is usually pumped back into the reservoir or another nearby underground rock formation (Figure 1-1).
Production life varies widely by reservoir. Some U.S. oil and gas
reservoirs have produced over 50 years, some for only a few years, and
some for only a few days. The rate of production typically declines with
time because of the reduction in reservoir pressure from reducing the
volume of fluids and gas in the reservoir. Production costs are largely
fixed costs independent of the production rate. Eventually, a well's
production rate declines to a level at which revenues will no longer cover
production costs. Petroleum engineers refer to that level or time as the
well's economic limit.
Plugging and Abandoning the Financial Property. When a well
reaches its economic limit, the well is plugged, i.e., the hole is sealed off
at and below the surface, and the surface equipment is removed. Some
well and surface equipment can be salvaged for use elsewhere. Plugging
and abandonment costs, or P&A costs, are commonly referred to as
dismantlement, restoration, and abandonment costs or DR&A costs.
Equipment salvage values may offset the plugging and abandonment
costs of onshore wells so that net DR&A costs are zero. However, for
some offshore wells, estimated future net DR&A costs may exceed $1
million per well due to the cost of removing offshore platforms,
equipment, and perhaps pipelines.
When a leased property is no longer productive, the lease expires and
the oil company plugs the wells and abandons the property. All rights to
exploit the minerals revert back to the lessor as the mineral rights owner.

ACCOUNTING DILEMMAS

The nature of petroleum exploration and production raises numerous
accounting problems. Here are a few:
♦ Should the cost of preliminary exploration be recorded as an asset or an
expense when no right or lease might be obtained?
♦ Given the low success rates for exploratory wells should the well costs
be treated as assets or as expenses? Should the cost of a dry hole be
capitalized as a cost of finding oil and gas reserves? Suppose a company
drills five exploratory wells costing $1 million each, but only one well
finds a reservoir and that reservoir is worth $20 million to the company.
Should the company recognize an asset for the total $5 million of cost,
the $1 million cost of the successful well, the $20 million value of the
productive property, or some other amount?

♦ The sales prices of oil and gas can fluctuate widely over time. Hence,
the value of rights to produce oil and gas may fluctuate widely. Should
such value fluctuations affect the amount of the related assets presented

in financial statements?

♦ If production declines over time and productive life varies by property,
how should capitalized costs be amortized and depreciated?
♦ Should DR&A costs be recognized when incurred, or should an estimate
of future DR&A costs be amortized over the well's estimated productive
life?
♦ If the oil company forms a joint venture and sells portions of the lease to
its venture partners, should gain or loss be recognized on the sale?
As will be explained in this book, the nature, complexity, and
importance of the petroleum E&P industry have caused the creation of an
unusual and complex set of rules and practices for petroleum accounting
and financial presentation

HISTORY OF THE PETROLEUM INDUSTRY IN THE
UNITED STATES

In order to understand the importance and nature of financial
accounting and reporting in the petroleum industry, it is helpful to briefly
review the industry's history, particularly in the United States over the past
twenty years.5 Several exhibits will be presented to show how the
industry's economic characteristics have changed over the years and to
portray the industry's current economic status.
In ancient history, pitch (a heavy, viscous petroleum) was used for
ancient Egyptian chariot axle grease. Early Chinese history reports the
first use of natural gas that seeped from the ground; a simple pipeline
made of hollowed bamboo poles transported the gas a short distance
where it fueled a fire used to boil water.
Seventeenth century missionaries to America reported a black
flammable fluid floating in creeks. From these creeks, Indians and
colonists skimmed the crude oil, then called rock oil, for medicinal and
other purposes. Later, the term rock oil would be replaced by the term
petroleum from petra (a Latin word for rock) and oleum (a Latin word for

oil). Eventually, the term petroleum came to refer to both crude oil and
natural gas.
By the early 1800s, whale oil was widely used as lamp fuel, but the
dwindling supply was uncertain, and people began using alternative
illuminating oils called kerosene or coal oil extracted from mined coal,
mined asphalt, and crude oil obtained from surface oil seepages. At the
same time, U.S. settlers were drilling wells to produce salt brine for salt
production and occasionally encountered crude oil mixed with the
produced brine. In 1856, George Bissell, an investor in the Pennsylvania
Rock Oil Company, surmised that similar wells could be drilled to find
and economically produce crude oil from which valuable kerosene could
be extracted.
The petroleum exploration and production industry may be said to have
begun in 1859. While there is mention of an oil discovery in Ontario,
Canada, in 1858, it is generally recognized that Bissell's company had the
first commercial oil drilling venture in 1859 near Titusville, Pennsylvania.
Colonel Edwin L. Drake, a retired railroad conductor, supervised the
drilling activity on behalf of the Pennsylvania Rock Oil Company. A
steam-powered, cable-tool rig with a wooden derrick was used to drill the
69-foot well, which produced approximately five barrels of crude oil per
day.
Soon after the Drake well began oil production, other wells were drilled
in the Titusville area using cable-tool rigs, and the supply of oil increased
dramatically, causing a decline in the price of crude oil from $10 per
barrel in January 1860 to about ten cents a barrel two years later. Shortly
thereafter, a number of refineries began distilling valuable kerosene from
crude oil, including facilities that had previously extracted kerosene from
other sources.

THE INDUSTRIAL REVOLUTION AND THE GROWTH OF "BIG OIL"

At the start of the U.S. Civil War, approximately 200 wells were
producing over one-half million barrels annually. The introduction of
petroleum-based lamp fuel was only the beginning of an increasing variety
of uses for crude oil and its refined products. For example, the Industrial
Revolution and the Civil War created a demand for lubricants as a
replacement for turpentine. By the year 1870, annual total production of
petroleum exceeded 25 million barrels.
Transportation of crude oil was a problem faced from the earliest days
of oil production. The coopers’ union constructed wooden barrels (with a
capacity of 42 to 50 gallons) that were filled with oil and hauled by

teamsters on horse-drawn wagons to railroad spurs or river barge docks.
At the railroad spurs, the oil was emptied into large wooden tanks that
were placed on flatbed railroad cars. The quantity of oil that could be
moved by this method was limited. However, the industry's attempts to
construct pipelines were delayed by the unions whose members would
face unemployment and by railroad and shipping companies who would
suffer from the loss of business by the change in method of transportation.
Nevertheless, pipelines did come into existence in the 1860s; the first line
was made of wood and was less than a thousand feet long.
Growth in the physical production of petroleum corresponded with
growth in the size and investment of corporations engaged in producing
and refining petroleum. One of the companies involved in the petroleum
industry was partially owned by John D. Rockefeller; in 1865 he acquired
the entire interest in the company. In 1870 Rockefeller merged his firm
with four other companies to form the Standard Oil Company. His original
goal was to become paramount in the refining, transporting, and marketing
of petroleum; but shortly after the merger, he also moved into the area of
oil production.6
Rockefeller's plan for dominance succeeded, and during the 1880s
Standard controlled approximately 90 percent of the refining industry in
the country and dominated the global petroleum industry. Standard's
control of refineries as well as its ownership of railroads, pipelines, and
marketing outlets forced most petroleum customers in the United States to
purchase their products from the company.7
Standard's dominance did not escape federal and state antitrust
regulators. After the discovery of the prolific Spindletop field near
Beaumont, Texas, in 1901, the Texas legislature passed laws preventing
Standard's involvement in Spindletop. As a result, other companies were
formed, and some evolved into vertically integrated companies, such as
Texaco, organized in 1901. In addition to state antitrust laws, federal
legislation had a great impact on Standard Oil Company and led to its
break-up in 1911-1915 into several companies that today have a combined
market value exceeding $200 billion. They include:

♦ Standard Oil of New Jersey (i.e., Exxon) and Standard Oil of New
York (i.e., Mobil) that merged in 1999 to form ExxonMobil, the
largest U.S. petroleum company and a world giant;
♦ Standard Oil of California (now Chevron, the second largest U.S.
petroleum company);
♦ Standard Oil of Indiana (subsequently renamed Amoco) and
Standard Oil of Ohio, both now a part of BP Amoco, following
merger with or acquisition by British Petroleum to create a world
giant rivaling ExxonMobil;
♦ Continental Oil (now Conoco, eighth largest U.S. oil company).8
After the breakup of the Standard Oil Company, Europe's Royal
Dutch/Shell Group succeeded Standard Oil as the world's largest oil
company. The group was an unusual amalgamation that was owned 60
percent by the Netherlands’s Royal Dutch Company and 40 percent by
England's Shell Transport and Trading Company. Royal Dutch had made
its fortunes in oil production in the Dutch East Indies, now Indonesia.
Shell had prospered in global oil trading and transportation before
expanding into production and refining.