How Oil Companies Record Oil Reserves on Their Balance Sheets

How Do Oil Companies Record Oil Reserves?

Oil reserves are estimated quantities of crude oil that have a high degree of certainty, usually 90%, of existence and exploitability. In other words, they are estimated quantities of crude that oil companies believe exist in a particular location and can be exploited.

According to the Securities Exchange and Commission (SEC), oil companies are required to report these reserves to investors through supplemental information to the financial statements. It is important to note oil still in the ground is not considered an asset until it is extracted and produced. Once the oil is produced, oil companies generally list what isn't sold as products and merchandise inventory.

Understanding How Oil Reserves Are Recorded

The quantity of oil reserves that have a high degree of probability of being recovered is called proved reserves. Companies list their proved reserves in the supplemental section of their financial statements. Proved reserves are typically broken down into two categories called developed and undeveloped.

Developed reserves are the reserves that are in the pipeline and can be reasonably expected to be recovered from existing wells. Undeveloped reserves typically include reserves expected from new wells as well as expanding and deepening existing wells.

Oil companies can value their reserves by finding their net present value less extraction costs–also known in the industry as "lifting costs." There are two accounting methods for recording the costs associated with the exploration of oil. Companies can choose between the successful-efforts (SE) method or full cost (FC) method. The choice of which method is important because it can determine whether the costs are treated as expenses or if they can be capitalized.

Capitalized costs are costs that are not expensed when they are incurred. Instead, the costs are spread out over time, allowing the company to earn revenue from the asset. Capitalizing costs helps companies since they don't have to realize the full expense in year one.

Successful Efforts Method

The successful efforts accounting method is a rather conservative method for allowing capitalization of exploration costs. The cost of drilling an oil well can't be capitalized unless the well is successful. If the well is unsuccessful–called a dry hole–the cost must be charged as an expense against revenue for that period. Proponents of the successful method suggest that oil companies should only be allowed to capitalize the cost of exploration for wells that are producing oil.

Full Cost Method

However, there are others in the oil industry that believe that the process of exploration–regardless of the level of success–is all part of the exploration of oil and should be capitalized.

Under the full cost method, oil companies can capitalize all of the operating expenses involved in searching for and producing new oil reserves. In other words, the purchase of land, exploration, drilling, and any development costs are capitalized. The costs are totaled and grouped into cost pools–full cost pools (FCP)–for each country.

For example, if the company has 2 million barrels of oil reserves and an FCP of $50 million, each barrel, in theory, costs $25. As barrels are produced, $25 is charged against the FCP. If 500,000 barrels are produced, reserves are decreased to 1.5 million, and the FCP decreases to $37.5 million.

Tracking the Actual Costs of Crude

Under this method, the company must prove that its reserves carry a value that exceeds the FCP value. If it doesn't, the value of the reserves must be written down according to the "ceiling test write-down." Under successful efforts, each cost center, or group of assets, is tracked separately so that actual costs are measured. In this way, one cost center may turn a profit while another may generate a loss. 

Only if the cost is capitalized is that cost considered an asset that is depreciated over time. It is important to note that before the companies can list oil reserves through supplemental information to the financial statements, the SEC requires them to prove their claims and file appropriate documents.

For oil and gas companies, oil reserves are considered a depleting asset, in that the more reserves they extract, the less product they will have available to sell in the future. Reserves are generally the most valuable asset an oil company holds; proved estimates are included in the report to investors, but not typically valued. 

Real World Example of How Oil Reserves are Recorded

Below is the annual summary of oil reserves for Exxon Mobil Corporation (XOM) for 2018 as reported in the company's 10K report. The proved reserves are broken down based on developed and undeveloped.

• Exxon's total developed oil reserves was 5.1 billion barrels for 2018.
• The total undeveloped proved reserves equaled 4.1 billion barrels for the period.
• Exxon's total proved reserves for the year was 9.26 billion barrels–located at the bottom and highlighted in orange.

This question was answered by Chizoba Morah.