Reducing Costs in an Oil and Gas Company: Depreciations, Depletion and Amortization

Oil and gas companies look for ways to cut costs on each Barrel of Oil Equivalent (BOE) produced in order to become more profitable. Even pennies pre BOE add up. If a 100K BOED company can reduce costs per BOE by $.10, this would add up to $3.65M per year.

There are only a few areas that oil and gas companies can reduce their costs. They typically include:

1. Operating Costs: includes numerous different items such as power, well servicing and others
2. General and Administrative: office expenses such as wages, benefits and others
3. Marketing and Transportation: costs associated with moving oil and gas
4. Interest: money paid on loans
5. Royalties: money owed to either the government or a freehold land owner for payment on the right to remove product. This can also be revenue depending on how your contracts are written.
6. Depreciation, Depletion and Amortization (DD&A): The allocation of costs over the useful life of an asset.

Most of these costs have subcategories of costs, but we won't do into a bunch of deal here. In later posts, I will talk about some of the sub categories.

By far, on average, the largest cost that an oil and gas company incurs are the DD&A costs. These costs are quit often associated with expenses that an oil and gas company undertakes while adding reserves, although it can include facilities, pipelines, and other costs.

On TSX listed Junior Oil and Gas Companies with production in the Western Basin, the average cost per BOE is $50.20. The following breaks our the costs by line item (with the exclusion of interest costs) and the percent of the total BOE costs.

Operating expenses: $12.60/BOE or 25%

G&A expenses: $5.23/BOE or 10%

DD&A costs: $27.09/BOE or 54%

Royalties: $5.28 or 11%

As can be seen, DD&A costs are by far the largest single expense that the average oil and gas company has.

So how do you reduce the DD&A costs for an oil and gas company? I somewhat answered this in my post Analysis of Q3 Results for Junior Oil and Gas Companies on the TSX: Part One, but it probably should be repeated.

DD&A costs are typically costs that are associated with adding reserves (and other assets such as pipelines, facilities and such) to an oil and gas company. One of the easiest ways that reducing DD&A costs can be accomplished is by buying existing reserves for less than the companies current DD&A costs/BOE. Since the average DD&A cost is $27.09/BOE and the average Reserve life Index is 10.4 years, then the cost to replace one Barrel of Oil Equivalent per Day (BOED) is $102,833. All you have to do is find a way to purchase pre-existing production for less then that (give it has 10.4 years as a RLI) and you will reduce your DD&A costs. This is marginalizing the acquisition process, but it is for illustrative purposes.

Another way to reduce DD&A costs is to identify reserves that are missing on the reserves report, which Argentis Group can help with with a service we offer. With this service, a company can add reserves for as little as $.05 per BOE as opposed to the industry average of $16 per BOE for Find and Develop (F&D) costs for oil and gas.

Another way of looking at how to reduce the DD&A costs (including F&D costs) would be as follows:

If the average oil and gas company has a daily production of 2690 BOE and has a reserves life index of 10.4 years, then the DD&A costs associated with this company would be $276,622,492. This is derived by 2690 BOED X 10.4 years X 365 Days X $27.09 DD&A costs. By adding 9% reserves that a company does not know about, then your overall DD&A costs for the company have now shrunk on a BOE basis (assume that the cost to add the additional 9% is not included, and this cost is minimal). The new DD&A costs per BOE are $24.85. For the average Oil and Gas company, this would be a reduction of $602,183 per quarter (or $2.4M per year) on DD&A costs, which is amazing.

There is a potential double effect on a DD&A reduction, the company can take the money that was going to be spent on reserves replacement and now use it to pay down interest, which will reduce the costs per BOE.

One other point that is overlooked here, for every BOE a company finds that they didn't know about, this would add net asset value (NAV) to the company. Typical NAV per BOE is $12. So in the example above, the additional NAV would be $11M. Could you imagine a company leaving that much money on the table if there were to sell? Believe it or not, leaving money on the table happens all the time.

Anyway, long story short, if oil and gas companies were to identify missed reserves first (low hanging fruit) instead of drilling for reserves, they might be able to uncover reserves for a significantly lower price. Since the industry average is $16/BOE to find and develop reserves worth $12/BOE in NAV, it would make sense to look at a process that can identify reserves for less than a dollar a BOE (which Argentis Group can provide through a service we offer).

These opinions are mine and may not reflect your view. If you would like to contact me, then please feel free to do so at info@argentis-group.com. ArgentisGroup assists oil and gas companies with operational audits to identify areas to reduce costs, increase revenues and increase the overall asset value of an oil and gas company.

Analysis of Q3 Results for Junior Oil and Gas Companies on the TSX: Part One

As Q3 numbers have now been released, I will now analyze of the Q3 results for Junior and Intermediate Oil and Gas companies that are TSX listed and producing predominantly in the Western Canadian Basin.

In this post I will focus on the Junior Oil and Gas companies, which means companies with production between 500 and 10,000 barrels of oil equivalent per day (BOED). Most of this information comes from the Brian Mills Iradesso Quarterly Report. You can find access to this report here. This is an excellent free report that provides comparisons on key metrics of oil and gas companies.

There are 54 companies that fit the Junior classification and they have production between 517 BOED and 9,907 BOED.

Here are the averages:

Productions: 2,690 BOED

% Gas: 66%

Market Cap per BOED: $63,446

Netback: $9.99/BOE

Operating Expense: $12.60/BOE

General and Administrative Expense: $5.23/BOE

Depletion, Depreciation and Amortization Expense: $27.09/BOE

Royalty Expense: $5.02/BOE

Op Ex + G&A + DD&A + Royalty Expenses: $49.95/BOE

Sell Price: $34.66/BOE

The main point to look at here is that the expenses are higher than the sell price (or revenue per BOE) by $15.29/BOE. Not a great place to be in. In my opinion, the junior oil and gas companies have to look at ways to reduce the costs that they can, such as Operating expenses, G&A costs and DD&A costs. I have excluded interest costs in this analysis.

Since the biggest costs are DD&A costs, oil and gas companies should find ways to reduce these costs per BOE. DD&A costs are costs that are associated with adding reserves to an oil and gas company. One of the easiest ways that reducing DD&A costs can be accomplished is by buying existing reserves for less than the companies current DD&A costs/BOE. Since the average DD&A cost is $27.09/BOE and the average Reserve life Index is 10.4 years, then the cost to replace one Barrel of Oil Equivalent per Day (BOED) is $102,833. All you have to do is find a way to purchase pre-existing production for less then that (give it has 10.4 years as a RLI) and you will reduce your DD&A costs. This is marginalizing the acquisition process, but it is for illustrative purposes.

Another way to reduce DD&A costs is to identify reserves that are missing on the reserves report, which Argentis Group can help with with a service we offer. With this service, a company can add reserves for as little as $.05 per BOE as opposed to the industry average of $16 per BOE for Find and Develop (F&D) costs for oil and gas.

Another way of looking at how to reduce the DD&A costs would be as follows:

If the average oil and gas company has a daily production of 2690 BOE and has a reserves life index of 10.4 years, then the DD&A costs associated with this company would be $276,622,492. This is derived by 2690 BOED X 10.4 years X 365 Days X $27.09 DD&A costs. By adding 9% reserves that a company does not know about, then your overall DD&A costs for the company have now shrunk on a BOE basis (assume that the cost to add the additional 9% is not included, and this cost is minimal). The new DD&A costs per BOE are $24.85. For the average Oil and Gas company, this would be a reduction of $602,183 per quarter (or $2.4M per year) on DD&A costs, which is amazing.

So the above example is one way to help reduce the costs per BOE. There are others expense reduction strategies that can be look at to reduce the overall costs per BOE. All you have to do is find some more (email me and I can work with you).

These opinions are mine and may not reflect your view. If you would like to contact me, then please feel free to do so at info@argentis-group.com. Argentis Group assists oil and gas companies with operational audits to identify areas to reduce costs, increase revenues and increase the overall asset value of an oil and gas company.

Question 10 - How will your auditors ensure your Cash Generating Unit’s will be authenticated?

This is the tenth and final question in the list of ten questions to ask your auditor if you are a Canadian based oil and gas company. The original post can be found here.

How will your auditors ensure your Cash Generating Unit’s will be authenticated?

Believe it or not, there are companies that do not know that they own an oil or gas well(s). This is due to numerous reasons, but suffice to say, without going into detail, it is true.

If you can't authenticate that you own a well, then how would you be able to ensure that your cash generating units are authenticated.

These opinions are mine and may not reflect your view. If you would like to contact me, then please feel free to do so at info@argentis-group.com. Argentis Group assists oil and gas companies with operational audits to identify areas to reduce costs, increase revenues and increase the overall asset value of an oil and gas company.

Question 9 - How can your auditors potentially make your IFRS conversion pay for itself and add asset value to your company?

This is the ninth question in the list of ten questions to ask your auditor if you are a Canadian based oil and gas company. The original post can be found here.

How can your auditors potentially make your IFRS conversion pay for itself and add asset value to your company?

Most companies look at the transition to IFRS as cost that they have to incur, but there is a potential to increase the value of your oil and gas company, reduce capital expenditures and identify missed revenues that will help pay for the conversation.

For example, Argentis Group has a process that we run in oil and gas companies to identify missed reserves and missed revenue. On average we identify 9% missed on reserves. For the average junior oil and gas company this would be equal to identifying 919,011 barrels of oil equivalent (BOE). This number was derived from using the average barrel of oil equivalent per day (BOED) of Junior oil and gas companies listed on the TSX with production in the Western Canadian Basin, which is 2,690 and multiplying it by the average reserve life index of junior companies of 10.4 year. (2,690 BOED X 10.4 years x 365 days). The average Find and Develop (F&D) cost per BOE in the Western Canadian Basin is $16. So at $16/BOE in F&D costs times 919,011 BOE would be equal to $14,704,176 in find and develop costs.

So by identifying 9% missed reserves, a company has the potential to free up $14.7M in capital that would normally be associated with reserves replacement.

In addition to this, by identifying these missed reserves, a company will now be able to increase net asset value (NAV) by up to $11M. This is calculated by using the same 919,011 BOE and multiplying this by $12/BOE for NAV. $12 is the average NAV per BOE in the Western Canadian Basin.

In addition to increasing NAV and offsetting capital costs associated with reserves replacement, Oil and gas companies should also look for missed royalties or missed working interests. These revenues can also add up to potentially offset IFRS costs.

Argentis Group can help your company in providing a way to pay for your IFRS conversion all while increasing the value at the same time.

These opinions are mine and may not reflect your view. If you would like to contact me, then please feel free to do so at info@argentis-group.com. Argentis Group assists oil and gas companies with operational audits to identify areas to reduce costs, increase revenues and increase the overall asset value of an oil and gas company.

Question 8 - Do your auditors authenticate well counts for Annual Information Form’s?

This is the eighth question in the list of ten questions to ask your auditor if you are a Canadian based oil and gas company. The original post can be found here.

Do your auditors authenticate well counts for Annual Information Form’s?

A quick definition on the Annual Information Form (AIF):

A source of additional investor information not included in a company’s prospectus or annual financial statements. Required by law and must be given to you free of charge if you request it. From http://www.getsmarteraboutmoney.ca/tools_and_calculators/glossary/definition/Pages/annual-information-form-aif.aspx

Although the Annual Information Form does not have the same impact as a quarterlies and annual financial statements, they are important as this is were a publicly listed oil and gas company show what their reserves are and how many wells they own (among other pieces of information).

We have seen in one instance, where a company had 222 gross wells but only listed 57 in their AIF. In another example, a company that we worked with were out by 16% on their net well count. A couple of mighty big discrepancy. If your auditor can not identify how many wells you own our if they can not assist you with this process, then chances are, as an oil and gas company, you might be incorrectly stating reserves and hence, either overstating or understating your asset value. This has an impact on the depletion, depreciation and amortization (DD&A) costs, which would make them lower.

These opinions are mine and may not reflect your view. If you would like to contact me, then please feel free to do so at info@argentis-group.com. Argentis Group assists oil and gas companies with operational audits to identify areas to reduce costs, increase revenues and increase the overall asset value of an oil and gas company.

Question 7 - How do your auditors tie up reserves to cash generating units?

This is the seventh question in the list of ten questions to ask your auditor if you are a Canadian based oil and gas company. The original post can be found here.

How do your auditors tie up reserves to cash generating units?

This is important as companies move forward with IFRS. As an oil and gas company, you have to be able to identify where your revenue is coming from at a cash generating unit. Since an oil and gas companies future revenues come from their reserves, if you can not tie reserves to cash generating units, then how do you authenticate revenue?

These opinions are mine and may not reflect your view. If you would like to contact me, then please feel free to do so at info@argentis-group.com. Argentis Group assists oil and gas companies with operational audits to identify areas to reduce costs, increase revenues and increase the overall asset value of an oil and gas company. If you would like to find out how to tie up reserves to a cash generating unit, then please contact us.

Question 6 - How do your auditors authenticate your Asset Retirement Obligation’s and Offset well liabilities?

This is the sixth question in the list of ten questions to ask your auditor if you are a Canadian based oil and gas company. The original post can be found here.

The question is:

How do your auditors authenticate your Asset Retirement Obligation’s (ARO) and Offset well liabilities?

Let's say an oil and gas company will set aside $50K per well for your asset retirement obligations. For and average Junior Oil and Gas company with production being 2,690 Barrerl of Oil Equivalent per Day (BOED) and the average well producing 30 BOED, then they would have an asset retirement obligation of $4.5M. This is a significant amount. We have seen on different occasions where companies are carrying ARO's on royalty wells (where you shouldn't be). We have also seen where wells that were divested were still being carried as well as ARO's being applied to multiple events on the same well.

As of Offset well liabilities, this is extremely tough to identify. When a company has a lease agreement with a freehold land owner, there is typically a clause in the agreement that states that if a well is drilled within a section or quarter section basis (depending on oil or gas) on the adjoining section/quarter section, this would trigger a drill, drop or compensate mechanism. The leesee has to either drill a well, compensate for drainage or drop the lease. The legality behind this takes too long to go into, but if you want to find out more, I would suggest going to the Freehold Owners Association at www.fhoa.ca. Since an oil an gas company has to look at each freehold lease that they representing for the freehold land owner, it is a very long task to identify any offset well obligations. As an example, say an oil well is drilled on an adjoining quarter section and triggers a potential compensatory royalty. The average oil well produces 40 barrels of oil per day. Say the royalty rate for the freehold land owner is 5% and the average price is $80/barrel. This would mean that the oil and gas company would potentially have to pay the freehold land owner $160/day or $58,400 per year. This is a liability that is carried on the books that is often left un-actioned.

In both cases, more than likely your auditors are not identifying additional ARO's or offset well liabilities, which have impacts on the overall financials of an oil and gas company.

These opinions are mine and may not reflect your view. If you would like to contact me, then please feel free to do so at info@argentis-group.com. Argentis Group assists oil and gas companies with operational audits to identify areas to reduce costs, increase revenues and increase the overall asset value of an oil and gas company.