A:

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/produced. Once the oil is produced, oil companies generally list what isn't sold as products and merchandise inventory.

Oil companies can value their reserves by finding their net present value less extraction costs (also known in the industry as "lifting costs"). Depending on which of the two methods of accounting for exploration, full cost versus successful efforts, certain costs of finding reserves are capitalized.

Under full cost accounting, the company lumps all costs associated with developing its asset base, including dry holes, into a Full Cost Pool (FCP). If the company has 2 million barrels of oil reserves and a 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 drops 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. (See also: Oil And Gas Industry Primer.)

This question was answered by Chizoba Morah.

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