Dust Bunnies and Dry Holes (Drip Port) January 28, 1999

<THE DRIP PORTFOLIO>
Dust Bunnies and Dry Holes
...and some oil and gas accounting fun

by Brian Graney ([email protected])

ALEXANDRIA, VA (Jan. 28, 1999) -- Before we get started on the individual company-by-company analysis of our final list of oil and gas companies, we need to do a little Drip Port housekeeping. I hate cleaning up as much as the next red-blooded, steak-eating, TV-watching American, but sometimes you've just got to do what needs to be done, even if you are like most us and don't particularly mind a bit of untidiness in your everyday life.

Jeff is an exception to this general rule, mind you. Besides his well-documented disdain for cars, he is also inexplicably terrified of dirt. His beloved French maid outfit and feather duster are still sitting beside his empty desk here at Fool HQ, patiently awaiting his return from the Old Country.

We've tried to pay special attention to neatness during the first part of our oil and gas industry study. For those Drippers following along at home, we realize that our individual research and thoughts about the sector may very well form the starting point for your own research in this industry. (Of course, we don't want anyone blindly taking our conclusions as gospel or absolute truths. We're Fools, after all.) But it appears that a few folks on the Drip Companies message board have been poking around behind the couches and have found a dust bunny that we missed during our initial sweep of the industry. Time to get the Drip Port vacuum out of the closet and get rid of this unsightly nuisance.

Vrrrooommm...... Suuuccckkkk!!!!!

Recently, a few questions have been posted regarding the accounting policies used by oil and gas exploration and production companies. Specifically, Fools have wondered about the differences between the full-cost (FC) and successful-efforts (SE) methods of accounting for oil and gas acquisition and exploration costs. During our examination of the upstream end of the business, we somehow overlooked this point. This isn't especially surprising, since Jeff and I tend to avoid everything remotely related to the subject of accounting like three month-old milk.

Still, we want to begin the analysis of our companies knowing as much information about their business practices as practically possible. So, let's get out our green accountant eye-shades and take a look at this question. First of all, these two concepts relate only to acquisition and exploration expenses, not production, refining, marketing, and transportation costs. So, the issue is not relevant to the likes of Ashland, Baker Hughes, Pennzoil-Quaker State, Ultramar Diamond Shamrock, or Sunoco. That's almost half of our list right there. Of the remaining companies, all but one use the SE method. Our lone independent E&P company, Apache, uses the FC model.

What's the difference? Under FC, all costs related to acquisition and exploration activities are considered a cost of discovering reserves. As such, they are capitalized in one cost center, which is an accounting designation for the country in which the costs were incurred. This includes everything under the umbrella, from the actual costs of building a well to the salaries and benefits of the workers that are involved in this end of the business. All of these costs are capitalized and amortized against the reserves produced within the cost center according to an approved schedule.

How much can be capitalized, you ask? As Apache states in its most recent 10-K, "capitalized costs of oil and gas properties may not exceed the present value of estimated future net revenues from proved reserves, discounted at 10 percent, plus the lower of cost or fair market value of unproved properties, as adjusted for related tax effects and deferred income taxes." These accounting policies are kids' stuff, huh?

On the other end of the accounting spectrum, all of our integrated firms use the SE method. In this case, some costs are capitalized and other costs are expensed when they are incurred. According to the Fool's in-house copy of the 1998 Miller GAAP Guide, here's what is likely to be expensed: "geological and geophysical costs, the costs of carrying and retaining undeveloped properties, and the costs of drilling exploratory wells that do not find proved reserves."

That last item is the kicker. Unproducing exploratory "dry holes" are expensed under SE but are capitalized under FC. This makes FC accounting less conservative than accounting for dry holes under SE. But it can also make a difference for an independent E&P such as Apache, which participated in drilling a total of 123 exploratory wells in 1997, 66 of which ended up being dry holes. In short, not expensing those dry holes every reporting period can help "smooth out" Apache's overall expenses and earnings.

(To clear up any confusion, a developmental well is drilled in an area with proved reserves, while an exploratory well is closer to a shot in the dark in an area with unproved reserves. Other kinds of wells for accounting purposes include service wells, stratigraphic test wells, and all's-well-that-ends-wells.)

We'll have more thoughts on what these policies mean for Apache when we take a closer look at the company next week. While the FC accounting policy alone won't deter us from including Apache in our study, we would like to do some more research on the subject over the next few days. That way, we can figure out how we should factor this detail into our overall valuation (and evaluation) of the company.

Until then, check out how Drip Port holdings Intel and Campbell Soup fared under the Fool's investor relations microscope in our recent Shareowner Rights survey. It makes for some interesting reading.

Fool on!

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