Challenges of oil and gas exploration activities facing the Arctic region

The upstream sector of the oil and gas industry has unique features that are being faced by the players in the industry; more so, in the Arctic region which has peculiar environmental challenges, thus posing some reporting challenges to the accounting profession.

The aim of this essay is to discuss the unique challenges of oil and gas exploration activities facing the Arctic region together with the accounting and reporting challenges arising in order to suggest possible solution(s).

Irrespective of the strategies being used by Shell, its desire to successfully explore oil and gas in the Arctic was frustrated. This was probably because of the large ice deposits in the Arctic and as a result of the kulluk ship that went aground while transferring equipment to a warmer environment. More so, shell met the challenges of regularly meeting all the Environmental Protection Agency air permits requirements of the U.S. and in moving the Kulluk drilling rig out of Alaska after the drilling season ended. However, in 2013, shell paused exploration drilling activity in Alaska’s Beaufort and Chukchi seas to prepare equipment and plans for a resumption of activity (Shell Consolidated Financial Statements 2013, page 56).

Also, due to the peculiarity of the Arctic region, Shell and other oil company’s executives like Lukoil, the vice president of Russia’s second largest oil major said that the risks of drilling the Arctic is too much for an investment. Also, Total S.A., the fifth largest oil and Gas Company in the world recognised the fact that accident in the Arctic would be so disastrous. As a result of the risks, so many oil companies like Statoil proposed to leave the Arctic; after seeing shell’s mistakes. (Foster, 2014)

Furthermore, though Royal Dutch Shell was expected to drill its first oil over a decade ago in the Arctic, some problem of equipment and materials delayed them from meeting that target. However, the company was able to extract 400,000 barrels of oil daily. The company had spent a total of us$4.5 billion and seven years preparing to drill there, moreover, it would still take up to a decade to build the infrastructure needed to bring the market (Gale, Sarah Fister 2012)

Also, immediate threat of an oil spill was one of the challenges identified by Greenpeace. It claimed the lack of appropriate risk mitigation by oil companies against an accident of this kind. The unforeseen threat to the Arctic ecosystem posed by climate change and the fossil fuel industry's contribution to carbon emissions is the supporting inspiration for Greenpeace's actions. Diminishing Arctic sea ice poses a direct threat to the Arctic's biodiversity and eventually to the planet, says Greenpeace. Greenpeace elucidated that as climate change melts the Arctic ice, oil companies are moving in to extract more of the fossil fuels that caused the melt in the first place. But above the Arctic Circle, freezing temperatures, a narrow drilling window and a remote location mean that an oil spill would be very difficult to deal with. Greenpeace is working to halt climate change and to stop this new oil rush at the top of the world” (Karl Mathiesen, 2013)

Hence, a number of situations frequently occur in drilling and development activities that give rise to more complicated accounting questions. Though some of the world’s largest listed companies are in the oil and gas and mining sectors, IFRS do not address some of the key accounting challenges being faced by companies, unlike many other GAAPs. Financial statements need to provide more information about the nature and extent of the risks of extractive activity than is currently required (IASB discussion paper) DP/2010/1.

A greater portion of these problems result from the distinction between exploratory wells and development wells. Others arise because of a halt or delay in drilling activities. These situations do not create accounting problems for companies using the full cost method because all drilling and development costs are capitalized under that approach. Although different companies using the successful efforts method follow different procedures in accounting for many of these situations. Reg. S-X Rule 4-10 classifies costs incurred in oil and gas producing activities into four categories: property acquisition costs, exploration costs, development costs, and production costs. (Brady, J., Chang, C., Jennings, D.R. and Shappard, R., 2011)

However, Shell being one of the major Oil and Gas Company in the world uses the successful effort method of accounting. (Shell Consolidated Financial Statements 2013). The successful efforts method of accounting for oil and gas exploration and development activities writes off exploration activities that is general or relates to unsuccessful drilling operations. Only costs that directly relates to the location and development of specific commercial oil and gas reserves are capitalised and are depreciated over the lives of these reserves. The success or failure of each exploration effort is judged on a well-by-well basis as each potentially hydrocarbon bearing is identified and tested (Brady, J., Chang, C., Jennings, D.R. and Shappard, R., 2011).

On the other side, The full cost method of accounting for oil and gas exploration and development activities capitalises all exploration and development cost whether successful or not. Costs are accumulated in cost centres known as cost pools’ and the cost in each cost pool are written off against income arising from production of the reserves attributable to that pool.

Though the full cost method gained fame as a result of the desire for creative accounting among small and medium sized exploration companies (Van Riper, 1994). The founder of Mesa Petroleum, T. Boone Pickens, indicated that the full cost method had assisted his company to grow its assets from US$4 million to US$600 million in 12 years, and to increase revenues from US$1.5 million to US$100 million over that period (Van Riper, 1994). Examples of the economic consequences of a change in costing method include Conquest, a petroleum company based in North America, which reported in 1985 as a full cost company, posting a $3.7 million profit, but later restated its results under successful efforts accounting and recorded a $17.1 million loss (Editorial, 1986). Premier Oil, an oil producer based in the UK, also switched accounting methods from full cost to successful efforts in 2004, resulting in a downward restatement of profits from $44 million to $22 million (Neveling, 2005).

From the above information, it may be deduced that the full cost method of accounting for oil and gas exploration has the potential of increasing a company’s profit because not all expenses are recognised in the income statement as at when they are incurred, thus, making the profit margin to soar higher; whereas, companies using the successful effort method usually report lower profit because unsuccessful costs are expensed immediately in the account, thus reducing the profit margin. Hence, the profits reported by Shell may be less when compared to the profit of a counterpart using the Full Cost Method. For this reason, they may decide to change from the current method to Full cost Method in order to show better profits. However since Shell operates in the U.S, they will require approval from SEC to enforce such changes. This may not be easy in times of stiff controls and penalty.

If Shell decides to continue with the project it will capitalise its exploration drilling costs awaiting the outcome of reserve in commercial quantity. Though exploratory cost of drilling are added to property, plant and equipment pending the determination of proved reserve.( Shell Consolidated Financial Statements 2013). Also, If Shell decides to continue, there may be the problem of quantifying risk and uncertainty. Provisions for special happenings (restructuring, environmental clean-up, settlement of a lawsuit) are measured at the utmost probable sum considering the risks and uncertainties that surround the fundamental events. [IAS 37.40] and [IAS 37.42]. However, the risk and uncertainty that surrounds this project may not be adequately quantified in monetary terms.

On the other hand, if shell makes a decision stating the discovery of oil in commercial quantity, the accounting implication will be a reversal from capitalisation to the recognition of unsuccessful exploration cost in the income statement. Because, exploration expenses over 12 months capitalised with regard to exploration well are written off except (a) proved reserves are booked, (b) (i) commercial quantities of reserves are found plus (ii) further exploration and evaluation activity is envisaged so much so that either additional drilling and exploratory wells is strongly scheduled in the nearest future or other activities are embarked upon to adequately progress the reserve assessment (Shell Consolidated Financial Statements 2013 page 107)

From the above statement, it could be deduced that the over $5 billion shell had spent in the arctic oil and gas exploration activities may have also been expensed, notwithstanding the fact that shell has indicated its willingness to go back to the arctic pending the outcome of the ongoing issues at hand. (Shell Consolidated Financial Statements 2013, page 27). Arguably, the implication for this 12 month condition for determination of proved reserves is that profit in the income statement may be eroded.

In conclusion, it may be drawn that due to the peculiarity of the Arctic region and legal tussles, the natural resources found there may not be fully explored. Also, difficulties in classifying exploration expenses were identified between successful effort and full cost, of which I suggest that the SE should be used because it gives a better picture of the Shell’s financial position. .

Provisions for one-off events (restructuring, environmental clean-up, settlement of a lawsuit) are measured at the most likely amount. [IAS 37.40]

Provisions for one-off events (restructuring, environmental clean-up, settlement of a lawsuit) are measured at the most likely amount. [IAS 37.40] Provisions for one-off events (restructuring, environmental clean-up, settlement of a lawsuit) are measured at the most likely amount. [IAS 37.40]

Provisions for one-off events (restructuring, environmental clean-up, settlement of a lawsuit) are measured at the most likely amount. [IAS 37.40]

REFERENCES:

Foster, J. M. (2014), Shell Suspends 2014 Offshore Drilling Plans In Arctic. Accessed from: http://thinkprogress.org/climate/2014/01/30/3225831/shell-arctic-drilling-2014/

on October, 2014.

Karl Mathiesen, Wednesday (2 October 2013 18.48 BST)THE ECO AUDIT. theguardian.com

http://www.oiac.co.uk/resources/SORP.pdf

http://www.pwc.com/id/en/publications/assets/financial_reporting_in_the_oil_and_gasindustryfinal.pdf

Shell Consolidated Financial Statements 2013.

IAS 37

Exploration costs: See Note 2 to the “Consolidated Financial Statements” page 34.

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