Replies to This Discussion

Permalink Reply by Mac Davis on September 5, 2009 at 14:29

I believe neither of these accounting methods are relevant to payments to a mineral owner.

An unleased mineral owner will be paid based on gas sales minus drilling costs for the wells in his unit, minus certain expenses and management fees. Lots of the items in SE and FC accounting will not be appropriate for UMO payment calculations. For instance, leasing costs are not allowed for UMO calculations, only actual drilling costs.

A leased mineral owner will be paid based on gas sales, unit size, leased acreage, and royalty percent.

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Permalink Reply by sesport on September 5, 2009 at 16:42

Mac - Thanks, that's why I'm asking & digging around. I read where these are methods used for reporting (say to SEC), but wasn't sure if/how it applies to deducts, costs, expenses applied to revenues paid mineral owners.

Why would there be differences in accounting & reporting methods to mineral owners and SEC? At some point I would think that the books have to align and I would think that alignment would be more easily accomplished with similar calculation methods. I suppose this is more useful for investment purposes??? Like I said, I've just started to scratch the surface in this area.

Thanks again - :0)

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Permalink Reply by Mac Davis on September 5, 2009 at 19:39

There's not necessarily anything sneaky and underhanded about this.

IANALOA (I Am Not A Lawyer Or Accountant.) Consider this to be somewhat oversimplified.

Do you understand the difference between "Capital" and "Operating Expense?" For instance, if a company buys a $150,000 truck, it can't deduct the entire $150,000 immediately from its taxes. The truck is considered to be a "Capital" asset that has a current value. You might assume that at the end of 1 year, the truck would still be worth $120,000 and you'd only be able to deduct $30,000 from the first year's taxes. You would eventually be able to deduct all $150,000 from your taxes, but it might be over a 5 year period.

(That's WAY oversimplified, but you get the idea, I hope.)

Now, suppose you buy and burn $150,000 worth of diesel fuel this year to run your fleet of trucks. You can immediately deduct the $150,000 from your taxes because the $150,000 is gone. You don't have a residual value to the fuel you used.

(Once again, way oversimplified.)

As I read it, this FC vs SE accounting question has to do with whether the O&G company capitalizes certain expenses or treats them as operating expenses, based on whether it's a successful or unsuccessful well. It affects when the expenses are reported to the stockholders, balance sheets, and tax man.

(oversimplified.)

When calculating UMO payments, all expenses for drilling the well are applied at the start. They are applied to the UMO's share of profits before the UMO gets any payment at all, not spread out over a number of years. In essence, all costs are "operating expenses" when applied to UMO payments. The producing company gets repaid for the well before the UMO gets a cent.

In practice, there may be some "capital" vs. "expense" questions in determining what the costs are, but I think that well costs would all be lumped up front in determining a UMO payment, not depreciated and applied over the life of the well. There would be some legitimate "operating expenses" that would be deducted over the life of the well.

(Or am I all wet, and they do depreciate some drilling costs over the life of the well?)

There is some potential for hanky-panky here. For instance, suppose the production company buys a new drilling rig for $50 million and charges it all to the first well it drills, and then continues to use that drilling rig "free" for the next 20 years. This example is such a clear case of fraud that they probably wouldn't try it, but there are some tricks to unfairly move expenses to "UMO heavy" units.

I'm not sure the "SE vs. FC" question really has a lot of bearing on UMO or leased MO payments.

To explain it at a simpler level, the SE vs. FC question has a bearing on when and how the costs show up on the books, but the costs all eventually show up.

Leased mineral owners don't get drilling expenses deducted, so capital vs. operating expense doesn't matter.

Corrections from someone with a better grasp of accounting are welcome.

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Permalink Reply by sesport on September 6, 2009 at 12:28

Thanks, IANALOA ... I mean Mac. lol Okay, I'm getting the picture. Now, I'm compelled to ask another question. How are costs accounted for if operations are UN successful? Maybe that's a moot point, highly unlikely to happen given the technology used?

:0)

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Permalink Reply by Henry on September 6, 2009 at 13:15

Sesport,
Wells can be very much UN successful. We've seen blow-outs, tubing stuck in the hole, cracked casings, etc. When that happens, the cost of the well goes up, and if you are an UMO, you will have to wait until that very-expensive well is paid off, before you collect. That's the risk of going unleased. If all goes well, it's great. If the well has problems, you just wait longer and longer to start collecting.

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Permalink Reply by sesport on September 6, 2009 at 13:36

Thanks Henry. Any idea how costs are accounted for UNsuccessful wells that never produce & generate revenue? ( I don't know if I'm being clear, or using the correct terminology. Please bear, but don't bare, with me. lol)

:0)

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Permalink Reply by Mac Davis on September 6, 2009 at 14:35

If there's no production on your unit (usually a 1 square mile section), you don't get any royalty payments or UMO payments.

However, what happens if there is 1 dry well in your unit, and a successful well? A Leased MO would get paid on the successful well, with no regard for the unsuccessful well. Would the production have to pay off on BOTH wells before the UMO gets paid? I seem to recall hearing that UMO payments were by well, not by unit, but I could be wrong.

i.e. Do the costs for a dry hole get deducted from the UMO's payments for another well on the same unit?

Either way, I think all applicable drilling costs are immediate for UMO payments. Drilling costs are not spread out over a period of years. Capital vs. operating expense is not relevant for UMO payments, only for taxes, reports to the SEC and stockholders.

(BTW, is there a common term for a leased mineral owner similar to "UMO"?)

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Permalink Reply by sesport on September 6, 2009 at 17:25

Okay, thanks again. And I wasn't necessarily being suspicious, just curious. I found myself reading in some unfamiliar territory and just needed a compass. :0)

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Permalink Reply by Mac Davis on September 8, 2009 at 11:21

You should always be suspicious.

In this case, I don't think either of these accounting methods matter to mineral interests, only to stockholders and the tax man. (Unless fraudulent accounting methods are used, which probably DOES happen occasionally.)

Actually there's one case where it might matter. If you're unleased and "participating(?)", the accounting might matter. (Is participating the correct term for a mineral interest owner who opts to be a "partner?") You're probably not a participating mineral interest owner unless you took some very deliberate steps and hopefully, you understand tax, O&G, and other accounting already.

PARTICIPATING mineral interest owners are in a very different legal situation and should really understand the ins and outs of the system much better than the rest of us.

Once again, in theory, the expenses all come out in the wash. Capital vs. operating expense just changes when it shows up on the balance sheet, not the amount. (With the exception of some tax consequences, etc.)

Permalink Reply by Henry on September 7, 2009 at 3:35

Mac,
I think Caliente has written about the issue of whether payout is by well or by unit. You can read her extensive writings on this site. Her answer is that the payout is by well. I.e., if the first well is has problems, none of the costs associated with those problems may be transferred to the second well.

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Permalink Reply by sesport on September 7, 2009 at 5:31

Henry - So, what becomes of the costs of an UNsuccessful well? Does the company, and investors and/or shareholders, just eat them?

:0)

Permalink Reply by Henry on September 7, 2009 at 11:33

Sesport,
If the well is UNsuccessful, the company eats the cost, whether the land is leased or not. The landowner is not out anything, regardless of whether he is leased or unleased. However, if too many acres in a section are unleased, the company will not drill. While no one knows for sure what the real number is, I'll guess that if over 15% of the section is unleased, it won't be drilled.

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