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.