1.1
The Oil & Gas Sector & The Macro-economic Factors
o commodity prices, currency fluctuations, interest rate risk
and political developments and environmental risk.
Introduction
The objective of Oil & Gas operations is to:
 find
 extract
 refine and
 sell
o oil and gas,
o refined products
o and related products.
QUESTION
What area of operation are you involved in and what
are the major features of your activity ?
Major Features of the Oil & Gas sector
 the substantial capital
investment
 long lead times from exploration
to sale
 the production often needs to be
transported significant distances
through pipelines (often across
borders, which involves political
risk) and tankers (who may face pirates). Gas volumes are
increasingly liquefied, transported by special carriers and the
turned back into gas on arrival at its destination. Gas remains
challenging to transport; thus many producers and utilities look for
long-term contracts to support the infrastructure required to
develop a major field, particularly off-shore.
 the risks
o Exploration is costly yet not always certain to produce results
o Environmental conditions are hazardous for those involved
and the environment with large penalties for damaged
caused (ask BP)
o Business - competition etc
o Financial – CAPEX (NPV) is difficult to assess given the
uncertainty, technical feasibility, capital involved and long
lead times not to mention the ever-changing macroeconomic factors (discussed below)
As a result exploration, development and production often take place in
joint ventures or joint activities to share the substantial capital costs.
Considered on Day 4
QUESTION
What are the macro-economic factors ?
The Macroeconomic Factors
The industry is exposed significantly to macroeconomic factors such as:
 Commodity Prices
 Growth/Recession - Demand
 Currency Fluctuations
 Interest Rate Risk
 Inflation
QUESTION
What are the current prices/rates and how exposed
and your companies to these risks ?
Commodity Prices
View
www.ft.com/commodities
Brent Crude Oil
Compare to
Time period
Brent Crude Oil
1 Year
Commodity performance
View
Brent Crude Oil
Compare to
Time period
FTSE 100
5 days
Data delayed by at least 20 minutes.
QUESTION
How are you impacted by Price Changes and what is
your Break Even Price ?
Break Even Oil Price
We can consider Break Even in 2 ways:
 The Oil/Sale price required per barrel to cover Total Costs and
 The Oil/Sale price per barrel required to balance the Fiscal Budget
of the country
The Oil/Sale price per barrel required to cover Total Costs
We will examine this in more detail throughout the course as we
examine costs but basically it is:
Contribution per barrel =
Break-even point (units) =
Sales
less Variable Costs
Contribution
Total Fixed Costs
Contribution per unit
Margin of Safety =
Forecast Sales
Break-Even Point
Margin of Safety
2,000 units
1,000 units
1,000 units
100%
50%
50%
The Oil/Sale price per barrel required to balance the Fiscal Budget
of the country
Analysts at Carnegie Investment Bank recently put together this chart,
based on Brent crude oil prices, which illustrates the breakeven price
needed for some of the world’s largest oil producers. Combined, these
countries are expected to produce 30% of the world’s oil in 2011,
The Middle East
According to Carnegie many countries in the Middle East have used oil
profits to ease “Arab Spring” tensions by financing public programs.
However, Carnegie notes that the fiscal budgets of many oil-exporting
countries were rising prior to the citizen revolution. For example,
Government spending increases since 2008:
Qatar
up 59%
Saudi Arabia:
up 54%
Bahrain:
up 53%
UAE:
up 48%
Increases have been due to:
 a lack of non-oil revenues (Saudi Arabia generates 80% of its
government revenue from the petroleum sector)
 rapid population growth
 generous welfare systems
 investment in infrastructure
Carnegie says the result is:
“OPEC countries have stronger incentives to defend higher oil
prices, i.e. any drop in the oil price could mean lower OPEC
production in order to try to secure higher oil prices.” It also
means these countries are “less likely to invest in building
additional production capacity.
This only adds to our argument that we could see oil prices
continue at their current levels despite a weaker global
economy and softening demand for oil.”
Growth/Recession - Demand
Whilst G7 show little/no sign of growth BRIC are growing
 These are new markets for companies
 But they have proved politically/economically unstable hence they
are risky markets
 They also involve Exchange Rate Risk
QUESTION
Which are your major markets and what risks do
they involve?
Currency Fluctuations
ACTIVITY
If Today a barrel of oil costs $100 and the
exchange rate is £1 = $1.50 calculate the impact of
the following possible future scenarios:
e.g. Today
IF Future 1:
IF Future 2:
IF Future 3:
IF Future 4:
Oil Price per barrel
$100
$120
$120
$ 80
$ 80
£/$ Exchange Rate
£1 = $1.50
£1 = $1.00
£1 = $2.00
£1 = $1.00
£1 = $2.00
Answer
Oil Price per barrel
Today
$100
Future 1: $120
£/$ Exchange Rate
£1 = $1.50
£1 = $1.00
£ Equivalent Cost
£ 66.67
£120.00
The increased cost of oil and the depreciation of the £/appreciation of
the $ v £ have both increased the £ equivalent cost.
This is Good for Sellers, Bad for Buyers subject to:
 Elasticity of Demand and Volume changes
 Competitor Action
Future 2: $120
£1 = $2.00
£ 60.00
The increased cost of oil has been offset by the appreciation of the
£/depreciation of the $ v £.
Future 3: $ 80
£1 = $1.00
£ 80.00
The reduced cost of oil has been lost due to the depreciation of the
£/appreciation of the $ v £
Future 4: $ 80
£1 = $2.00
£ 40.00
The decreased cost of oil and the depreciation of the £/appreciation of
the $ v £ have both reduced the £ equivalent cost
QUESTION
What should UK Oil Companies do and what do your
company do to overcome Exchange Rate and Oil Price
Risk ?
Managing Exchange Rate and Oil Price Risk
Adjusting Exploration & Production
In the short run:
 Exploration & Production companies may adjust capital budgets
and production with the fluctuations in commodity prices
 In the good times they increase production as it will lower the
Break Even Point per Barrel, e.g. Canada.
However, over the past 10 years:
 the number of rigs demanded has shown a steady increase,
despite the volatility of commodity prices, as E&P companies have
needed to drill more wells to maintain flat production rates, (mature
fields) .
Adjust Day Rates
i.e. how much the driller gets paid per day
e.g. land drilling in the U.S. (which affects share price)
This typically see the most dramatic fluctuations due to the spot price of
the commodities.
This results in:
 volatility in margins and
 the drillers' willingness to improve those margins and maintain high
utilization rates by decreasing new builds and stacking existing
rigs.
Hedge
The Use of Derivatives in the Oil& Gas Sector to manage the
commodity, currency and interest-rate risks etc
Interest Rate Risk
UK Base Rate
Year
Month
Base Rate %
Change
2009
05 March
0.50
-0.50
05 February
1.00
-0.50
08 January
1.50
-0.50
04 December
2.00
-1.00
06 November
3.00
-1.50
08 October
4.50
-0.50
10th April
5.00
-0.25
7th February
5.25
-0.25
6th December
5.50
-0.25
5th July
5.75
+0.25
10th May
5.50
+0.25
11th January
5.25
+0.25
2008
2007
QUESTION
What are the Interest Rates in your country and given
the significant capital required in the sector what risks
do you face if you borrow on a Floating Rate ?
Inflation
Inflation Soars Above 5% To Three-Year
High
The cost of living in Britain has jumped by the biggest amount in three years, figures have
showed, as the CPI rate of inflation soared above forecasts to 5.2%.
Hefty rises in gas and electricity bills last month drove the inflation increase, the Office for
National Statistics said.
The CPI rate of 5.2% now equals the high reached in September 2008, and was a large jump
from August's rate of 4.5%.
Meanwhile, annual RPI inflation, which also includes housing costs, reached 5.6% last month
- the highest it has been since June 1991.
It adds further pressure to Britons' living standards, as wage rises fail to keep pace with
higher basic living costs.
However, it is better news for those on state benefits, as September's CPI rate is used to
determine next April's rise in payments.
Next year's benefit rates are not formally unveiled until later this year, but the basic single
state pension is set to increase by £5.31 to £107.46 a week, while the joint state pension will
increase by £8.49 to £171.84.
Jobseeker's allowance is set to increase by £3.51 to £71.01 a week based on the 5.2% rise.
Although the CPI rate has now never been higher since the measure began in 1997, it was
expected by the Bank of England.
It had forecast inflation to rise to 5% this year, before falling back below its target of 2% next
year.
As he gives a keynote speech in Liverpool tonight, the bank's governor Sir Mervyn King is
expected to defend the BoE's decision to leave the interest rate at 0.5% and pump more cash
into the economy at a time when inflation is so high.
1.2
Costs in Acquisition, Exploration, Development and
Production of new oil or natural gas reserves
 Acquisition
o costs are incurred in the course of acquiring the rights to
explore, develop and produce oil or natural gas.
 Exploration & Evaluation
o the collection and analysis of geophysical and seismic
data involved in the initial examination and
o drilling a well
 Development
 Production
ACTIVITY
Make a list of the major costs incurred at each
stage
Acquisition Costs
Acquisition costs are incurred in the course of acquiring the rights to
explore, develop and produce oil or natural gas.
They include:
 expenses relating to either purchase or lease the right to extract
the oil and gas from a property not owned by the company
 lease bonus payments paid to the property owner
 associated legal expenses, and title search, broker and recording
costs.
Exploration & Evaluation Costs
Costs relating to:
 the collection and analysis of geophysical and seismic data
involved in the initial examination of a targeted area and later used
in the decision of whether to drill at that location.
Drilling Costs
 Intangible Costs - those incurred to make the site ready prior to the
installation of the drilling equipment
 Tangible Drilling Costs - those incurred to install and operate that
equipment.
IFRS 6: Exploration for and Evaluation of Mineral Assets
Defines it as:


Exploration for and evaluation of mineral resources mean the search for
mineral resources, including minerals, oil, natural gas and similar nonregenerative resources after the entity has obtained legal rights to explore in a
specific area, as well as the determination of the technical feasibility and
commercial viability of extracting the mineral resource. [IFRS 6.Appendix A]
Exploration and evaluation expenditures are expenditures incurred in
connection with the exploration and evaluation of mineral resources before
the technical feasibility and commercial viability of extracting a mineral
resource is demonstrable. [IFRS 6.Appendix A]
Development Costs
Preparation of discovered reserves for production such as:
 those incurred in the construction or improvement of roads to
access the well site
 additional drilling or well completion work
 installing other needed infrastructure to extract (e.g., pumps),
gather (pipelines) and store (tanks) the oil or natural gas from the
reserves.
Production Costs
The costs incurred in extracting oil or natural gas from the reserves are
considered production costs.
Typical of these costs are:
 wages for workers and
 electricity for operating well pumps.
1.3
Accounting Approaches
o the "Successful Efforts" (SE) Method or the "Full Cost" (FC)
Method
Companies involved in the Exploration and Development of crude oil
and natural gas have the option of choosing between two accounting
approaches:
 The "Successful Efforts" (SE) Method – favoured by the
Financial Accounting Standards Board (FASB), (SFAS) 19
 The "Full Cost" (FC) Method – favoured by the Securities and
Exchange Commission (SEC).
These differ in:
 the treatment of specific operating expenses
As a result the accounting method affects:
o Net Income
o The Balance Sheet
o Cash Flow
The Successful Efforts (SE) Method
Capitalise only those expenses associated with successfully
locating new oil and natural gas reserves.
Expense
the associated operating costs of unsuccessful (or
"dry hole") are immediately charged against
revenues for that period.
Full Cost (FC) Method
Capitalise all operating expenses relating to locating new oil
and gas reserves - regardless of the outcome and
then written off over the course of a full operating
cycle.
Let us examine this further with reference to:
 Acquisition
 Exploration & Evaluation
 Development
 Production
Acquisition Costs
SE & FC - acquisition costs are capitalized.
Exploration Costs
SE Method:
 All intangible costs will be charged to the Income Statement as
part of that period's operating expenses for a company.
 All tangible drilling costs associated with the successful
discovery of new reserves will be capitalized
 All tangible drilling costs incurred in an unsuccessful effort are
added to operating expenses for that period.
Full Cost
 All exploration costs - including both tangible and intangible
drilling costs - are capitalized by being added to the balance
sheet as part of long-term assets.
This is because like the lathes, presses and other machinery used by a
manufacturing concern, oil and natural gas reserves are considered
productive assets for an oil and gas company; Generally Accepted
Accounting Principles (GAAP) require that the costs to acquire those
assets be charged against revenues as the assets are used.
Development Costs
SE & FC - allow for the capitalization of all development costs.
Production Costs
SE & FC - Production costs are considered part of periodic
operating expenses and are charged directly to the income
statement
In Summary:
 Acquisition – capitalise
 Exploration
o SE capitalise successful ONLY;
o FC capitalise ALL
 Development - capitalise
 Production - expense
1.4
An Introduction/Overview of IFRS in relation to the Oil &
Gas Sector, with particular reference to:
o IFRS 1:
o IFRS 6:
o
o
o
o
o
IFRS 10:
IFRs 11:
IAS 16:
IAS 36:
IAS 37:
o IAS 38:
o IAS 39
First-time Adoption of International Financial
Reporting Standards
Exploration for and Evaluation of Mineral
Assets
Consolidated Financial Statements
Joint Arrangements
Property, Plant and Equipment
Impairment of Assets
Provisions, Contingent Liabilities and
Contingent Assets
Intangible Assets
Financial Instruments: Recognition and
Measurement – Superseded by IFRS 9
effective 2013
Introduction
In late August 2008, the Securities and Exchange Commission (SEC)
announced that it would issue a proposed IFRS roadmap” that would
include a timetable and appropriate milestones for mandatory transition
to IFRS starting for the years ending on or after December 15th, 2014.
QUESTION
Where are your company on the Roadmap for
conversion/introduction of IFRS ?
ACTIVITY
In groups select one of the above IFRS and present
an outline of the major features and how impact on
your company.
Note: You are expected to make use of information
available on-line:
 www.ifrs.org
 www.iasplus.com