Oil & Gas

Accounting
Principles & Issues
KABIR TAHIR

BAYERO UNIVERSITY, KANO

FACULTY OF SOCIAL AND MANAGEMENT SCIENCES
DEPARTMENT OF ACCOUNTING
2nd July, 2012
COURSE: ACC 8211 (Oil and Gas Accounting)
CLASS: M.Sc. Accounting
SESSION/SEMESTER: 2011/2012 Session First Semester
LECTURER: Kabir Tahir Hamid, PhD
CONSULTATION: Strictly by Appointment
OFFICE: A8, Department of Accounting, Aminu Alhassan Dantata School of Business,
New Campus, Bayero University, Kano.
A.COURSE DESCRIPTION

This course is designed to introduce students to the fundamentals of oil and gas
accounting, different accounting principles and procedures prevalent in the petroleum
industry and accounting framework of the Nigerian petroleum industry.
B. COURSE OBJECTIVES
i)
To develop an understanding of the nature and historical development of oil and

gas accounting.
To develop an understanding of the basic characteristics and differences
between the downstream and the upstream sectors and their activities.
iii)
To develop an understanding of accounting for exploration, ditching, and
development costs.
iv)
To develop an understanding of petroleum products pricing, accounting
standards and financial statement disclosures in the oil and gas industry.
C. COURSE CONTENTS
1. History and Nature of Oil and Gas Operations
1.1 Definition of Petroleum
1.2 Origin of Petroleum, Its Industry Characteristic and Activities
1.3 The History of the Nigerian Oil and Gas Industry
1.4 The Nature of Petroleum Assets and the Process of Acquiring It
1.5 Accounting Dilemmas in Oil and Gas Accounting
1.6 The Upstream and the Downstream Sectors of the Nigerian Oil industry
1.7 NNPC and DPR and Their Roles
1.8 PPPRA and the Proposed Petroleum Industry Bill (PIB) 2011
2. Oil Prospecting and Reserves Valuation
2.1 Steps in Prospecting for Oil and Gas
2.2 Types of Oil and Gas Wells
2.3 Estimation and Valuation of Oil and Gas Reserves
2.4 Classification of Reserves
2.5 Oil and Gas Reserves Estimation
ii)

3. Arrangements, Agreements and Contracts in the Nigerian Petroleum Industry

3.1 Types of Operating Contracts in the Petroleum Industry
3.2 Contract Arrangements in the Nigerian Petroleum Industry and their Operations
3.3 Financial and Fiscal Monitoring Mechanisms of Agreements in the Petroleum Industry
4. Accounting Principles and Standards in the Oil and Gas Industry
4.1 Application of GAAPs in the Oil and Gas Industry
4.2 Classification of Costs in the Oil and Gas Industry
4.3 Methods of Accounting in the Oil and Gas Industry
4.4 Accounting Standards in the Oil and Gas Industry
5. Procedures in Oil and Gas Accounting
5.1 Basic Accounting Transactions
5.2 Depreciation, Depletion and Amortization (DD & A)
5.3 Accounting for Oil and Gas Exploration and Acquisition Costs
5.4 Accounting for Oil and Gas Development and Production Costs
5.5 Accounting for Crude Oil Refining, Petrochemical and Liquefied Natural Gas
5.6 Petroleum Products Pricing and Marketing
5.7 Typical Oil and Gas Financial Statements and Oil and Gas Accounting Disclosure
D. RECOMMENDED TEXT BOOKS
i) Fundamentals of Oil and Gas Accounting by Gallun, R. A., Wright J. C., Nichols, L. M.
and Stevenson. J. W.
ii) Financial Accounting and Reporting by Oil and Gas Producing Companies by FASB
iii) Accounting for Oil and Gas Exploration, Development, Production and
Decommissioning Activities by SORP
v) International Petroleum Accounting by Wright, C. J. and Gallun, R.A.
vi) Financial Reporting in the Oil arid Gas Industry by Pricewaterhousecoopers
vii) Petroleum Accounting, Principles, Procedures and Issues by Gallun, R. A. and Wright
viii) Fundamentals of Petroleum by Kate. V.D.
ix) Petroleum Accounting: Principles, Procedures & Issues by Jennings, D. R., Feiten, J. B. and
Brock, H. R.

E. METHODOLOGY
Discussion papers, covering the theoretical aspects of each topic, would be prepared and
presented in the class, to be followed by discussion exercises. Some of the exercises would
be attempted in the class, while the rest would be left to the students to practice on their own.
F. GRADING FORMULA
Continuous Assessment
40%
Semesters Examination
60%
Aggregate
100%
The continuous assessment marks are to be absorbed through snap test (s) to be given
without notice, scheduled test(s) and/or assignment(s).

1.0 HISTORY AND NATURE OF OIL AND GAS OPERATIONS

1.1 Definition of Petroleum
The term petroleum is said to have been derived from two Latin words, Petra, meaning rock, and
Oleum, meaning oil. Eventually, the term petroleum came to refer to both crude oil and natural gas.
More broadly defined, Petroleum (i.e. crude oil and natural gas) refers to mixture of hydrocarbons
that are molecular in nature, in various shapes and sizes of hydrogen and carbon atoms, found in
small connected pore spaces of some underground rock formations. While crude oil refers to
hydrocarbon mixture produced from underground reservoirs that are liquid at the normal
atmospheric pressure and temperature, natural gas refers to hydrocarbon mixtures produced from
underground reservoirs that are not liquid but gaseous at the normal atmospheric pressure and
temperature. Hydrocarbons are compounds containing only the elements hydrogen and carbon,
which may exist as solids, liquids or gases.

1.2 The Origin of Petroleum, Its Industry Characteristics and Activities

1.2.1 The Origin of Petroleum
Geologists and Geophysicists dealing with the earth crust propound that rock formations within the
earths crust consist of igneous, metamorphic and sedimentary rocks. While, igneous rocks are rocks
that are formed as a result of cooling and solidification of molten magma, sedimentary rocks, such as
sandstone, developed as a direct result of erosion, transport and deposition of pre-existing igneous
rock, along with remains of plants and animals. Eroded particles of igneous rocks are carried to low
areas and are deposited into sedimentary layers through the action of wind and water. Metamorphic
rocks develop when igneous or sedimentary rocks are subjected to heat and pressure resulting from
the weight of overlying rocks stresses, thus converted into metamorphic slates and quartzite. Nearly
all significant oil and gas reservoirs in the World today are found in sedimentary rocks, as the
accumulation of oil or gas in igneous or metamorphic rocks is very rare; however petroleum can be
reservoired in these types of rock under certain albeit rare conditions. The extreme heat and pressure
associated with these types of rocks drives off or burns any organic material or hydrocarbons.
It can therefore be said that, out of the three types of rocks explained above (namely, igneous,
sedimentary and metamorphic rocks) only sedimentary rocks form the source in which hydrocarbons
reservoirs are found. Even in the sedimentary rocks, hydrocarbons are possibly found in only
sandstone (shale) and not limestone and dolomite. In other words, sandstones are the source rock in
which oil and gas is formed and accumulated, while limestone and dolomite evolve through
chemical processes. However, it is important to note that the various rock formations, as well as, the
various changes in the earth's crust do not, by themselves, explain the evolution of oil and gas.
The earth is made up of a core over 4,000 miles in diameter surrounded by the earth's mantle, which
is approximately 2,000 miles thick. The earth's surface is underlain by the lithosphere, a relatively
thin layer, some 125 miles in thickness, that is composed of the crust and upper mantle. Commercial
oil and gas are found only in the crust of the earth.
Explanations propounded on the origin of petroleum have their bases in geology and geophysics.
Geology is the science that studies the planet earth, the materials it is made up of, the processes that
act on these materials, the products formed, and the history of the planet and its life forms since its
origin. Most geological studies are focused on aspects of the earth's crust because it is directly

observable and is the source of energy and minerals for today's modern industrial societies. On the
other hand, geophysics is the science that studies the earth by quantitative physical methods.
Over the last two centuries, two theoriesthe inorganic theory and the organic theoryhave been
advanced to explain the formation of oil and gas. Although no one theory has achieved universal
acceptance, most scientists and professionals believe in the organic origin of petroleum. The
inorganic theory recognizes that hydrogen and carbon are present in natural form below the surface
of the earth (diamonds, for example, indicate the presence of carbon in the earth's mantle). Different
related theories explain the combination of the two elements into hydrocarbons. These include the
alkali theory, carbide theory, volcanic emanation theory, hydrogeneration theory, and the high
temperature intrusion theory. Except for the intrusion theory, most of the inorganic theories have
been largely discounted. The intrusion theory argues that high temperatures applied to carbonate
rocks can produce methane gas and/or carbon dioxide. This theory applies only to gas, not to the
heavier hydrocarbons (oil).
Based on abundant direct and indirect evidence, most scientists accept the organic theory of
evolution of oil and gas. According to geological research, the earth was barren of vegetation and
animal life for roughly one half of an estimated five billion years of the earth's existence.
Approximately 600 million years ago, an abundance of life in various forms began in the earth's
oceans. This development marks the beginning of the Cambrian period in the Paleozoic era. Nearly
200 million years later (in the Devonian period), vegetation and animal life had spread to the
landmasses. The Paleozoic (roughly 350 million years), Mesozoic (roughly 150 million years), and
Cenozoic (roughly 1000 million years), eras have been labeled as successive and definitive
geological time periods by geologists, which brings us up to the present. These time periods are
shown in Table 1.
Table 1: Geologic Time Period

Era
Cenozoic
"Modern Life"
Mesozoic
"Middle Life"

Paleozoic
"Ancient Life"

Period
Quaternary
Tertiary
Cretaceous
Jurassic
Triassic
Permian
Carboniferous
Devonian
Silurian
Ordovician
Cambrian

Approx.
Duration in
million yrs.
3
63
71
54
35
55
65
50
35
70
70

Indicative New
Life Forms
Large Mammals
Large Dinosaurs

Early Reptiles,
Amphibians and
Fish
Bacteria, Algae
and Jellyfish

Crypotozoic or Precambrian

4,000

Approximate age of the earth

4,600,000,000 years

The basic premise is that oil and gas are formed from chemical changes taking place in plant and
animal remains. Through the process of erosion and transportation, sediments are carried from the
land down the rivers and, together with some forms of marine life, settle into the ocean floor. Most
hydrocarbons are believed to be derived from tremendous volumes of plankton, algae, and bacteria
5

common in ocean basins and lakes, and other marine lives that lived millions years ago in low land
areas, usually in the oceans. The theory posits that the remains of plants and animals were deposited
along with the eroded particles of igneous rocks, which have been weathered through physical and
chemical reactions. The weight and pressure of layer upon layer of the eroded particles of the
igneous rocks resulted in the formation of sedimentary rocks, and some chemical and bacterial
processes turned the organic substances in the sedimentary rock into oil and gas. The sedimentation
process can be observed even within an individual's lifetime. For example, the delta area at the
mouth of a large river is formed by sedimentation. Layer after layer of silt, mud, particles of sand,
and plant and animal life are deposited on the ocean floor, with a great portion of the plant and
animal life coming from the ocean itself. Anaerobic bacteria in the sediment aid in breaking up the
organic material and releasing oxygen, nitrogen, phosphorus, and sulfur from the organic material,
leaving the balance with a much higher percentage content of hydrogen and carbon and, thus, a more
petroleum-like composition.
After formation, oil and gas move upward through the layers of the sedimentary rock due to pressure
and the natural tendency of oil to rise through water. The petroleum migrates upwards towards the
earth surface through the porous rock formations until it becomes trapped by an impervious layer of
rocks. When this occurs, the oil remains there and forms a petroleum reservoir. A reservoir is a rock
formation with adequate porosity and permeability to allow oil and gas to migrate to a well bore at a
rate sufficient as to be economically producible (most geologists believe the earth initially formed
from molten rock, or magma, and cooled into solid igneous rocks. During the cooling and
contraction processes, some rock solidified beneath the surface). The impervious layer formed a seal
which prevent hydrocarbons from leaking to the surface. If the seal is inadequate, little quantity of
the hydrocarbon escapes to the surface. This is known as oil seeps. Seeps at the surface are often
used as indicator of potential hydrocarbon reservoirs in the subsurface.
In some instances, oil and gas migrate directly to the reservoir area. More often, however,
movements in the earth's crust caused additional shifting, folding, bends, and fissures, and a
secondary migration of the oil and gas took place through porous layers until another impermeable
seal was reached. This may occur when an area is subjected to new tectonic forces, earth quakes,
tsunami, etc. To search for new oil and gas fields, therefore, geologists and geophysicists devote
their efforts to understanding the distribution of rocks that could be sources, seals, and reservoirs in
an attempt to develop locations for potential traps within petroleum systems. While it can be seen
that oil and gas are formed through the sedimentary process, this does not necessarily mean that the
oil and gas have remained in the source beds or places of origin. Hydrocarbons are known to have
been preserved for hundreds of millions of years and the process of hydrocarbon formation is
undoubtedly continuing, but much more slowly than is the rate of consumption of hydrocarbons.
Generally, marine and lacustrine source rocks generate oil whereas coal source rocks commonly
generate natural gas.
The impervious rock that prevents further movement of the oil and gas is known as trap. There are
four broad classifications of traps, namely:
(1) structural strap
(2) truncation trap
(3) stratigraphic trap, and
(4) a combination trap.
Structural trap is a result of upheavals of the earth and may take the form of an anticline, fault or
dome. Anticlines are the most significant reservoirs of hydrocarbons and are estimated to contain

around 80 per cent of the worlds oil. However, in order for an oil and gas reservoir to have been
formed, four necessary conditions must have been met. These conditions are:
(1) there must have been a source of oil and gas, i.e. the remains of plants and animals;
(2) heat and pressure resulting in the transformation of the organic substances of the remains of
plants and animals into oil and gas;
(3) Porous and permeable sedimentary rock formations through which the oil and gas was able to
migrate upwards after formation.
Porosity is the measure of the pore openings in a rock in which petroleum can collect; none of
the sedimentary rocks are completely solid. The greater the porosity, the more petroleum the
rock can hold, and the closer the rock is to the surface, the more the porosity. It is within the
pore spaces that the oil and gas initially accumulated, together with some water called connate
water. The pore spaces may constitute up to 30 percent of the volume of the reservoir rocks
that are relatively close to the surface. As depths increase, the porosity of the formation tends
to decrease as the result of compaction from the weight of the overlying layers of sediment.
Permeability, on the other hand, measures the relative ease with which the oil and gas can flow
through the rocks and is expressed in millidarcies. The flow of oil and gas through a reservoir
takes place in microscopic channels between pore spaces. In some cases fractures are also
present that provide greater permeability. If there is high permeability, oil and gas can move
through the formation with relative ease. Low permeability will decrease or even block the
movement of fluids through the formation. Though, permeability may be improved through
fracturing (i.e. introduction of a mixture of sand and water or oil into the formation under high
pressure to clean the channels between the pores) and acidizing (i.e. introduction of
hydrochloric acid into the formation to enlarge and clean the channels between the pores),
porosity is difficult, if it impossible to be improved.
There are two types of producing reservoirs, namely (1) oil reservoir and (2) gas reservoir.
While the components of oil reservoir are crude oil, basic sediment, water and associated gas,
the components of gas reservoir are non-associated gas, condensates and natural gas. To be
commercially viable therefore, a petroleum reservoir must have adequate porosity and
permeability and must have a sufficient physical area of rock that contains hydrocarbons. In
other words, the reservoir must contain high quantity of oil and gas, so that when produced and
sold, cover the cost of production (including payment of royalties to the government) and leave
some profit margin for the producing company and tax revenue to the government. Condensate
are hydrocarbons that are in a gaseous state at reserviour conditions but condense into liquids
as they travel up the wellbore and reach surface conditions.
(4) an impervious rock formations that a prevents the oil and gas from further migration, thereby
enabling the oil to collect.

Evidence Supporting the Organic Theory of Oil and Gas Formation

The following are the evidence supporting the organic theory of the origin of oil and gas:
1. sedimentary beds are rich in organic matter;
2. some of the chemical components of oil are the same as those found in plants and animals;
3. the chemical composition of oils and gases derived from so called source rocks match the
observed composition of oils and gases in nearby reservoirs; and
4. the recent discovery of bio-fuel (a fuel that is derived from biomass-recently living
organisms or their metabolic byproducts-from sources such as farming, forestry, and

biodegradable industrial and municipal waste) support the proposition that hydrocarbon
itself is most likely to have been originated from the remain of plants and animals.
1.2.2 Characteristics of the Petroleum Industry
Although the primary purpose of this course is to deal with the accounting principles and practices in
the oil and gas industry, it is considered that the appreciation of operational aspects of the industry is
important for a better understanding of accounting practices in the industry. Basically, the objective
of the oil and gas industry is to exploit and recover hydrocarbons (crude oil and gas) in its natural
form from large sub-surface reservoirs, subject it to changes through chemical and physical
processes in a refinery, gas plant or petrochemical plant in order to obtain products such as gasoline,
diesel, kerosene, jet fuel, lubricants, asphalt, bitumen, petrochemicals and treated natural gas.

It is important to add that although Exploration and Production (E&P) procedures and processes are
more important to geologists and geophysicists, the knowledge of the procedures and steps involved
in locating and acquiring mineral interest, drilling and completion oil and gas wells and producing,
processing and selling petroleum products is necessary in order to understand their accounting
implications. Hence, it is important that accounting students and accounting practitioners become
familiar with the process.

Oil and Gas industry is one of the vital industries in the world, largely because of its strategic role in
every economy and the world, at large. The distinctive features that characterized the industry are
derived from the nature of crude oil, its operations and commercial arrangements. Some of these
characteristics of the oil and gas industry may include the following:
1. High Level of Risk and Uncertainty: The level of risk in oil and gas operations can be both
substantial in amount and wide in scope, and locating new well sites even in already
established field is surrounded with high level of uncertainties. Exploration operations are
risky because oil is hidden underground and the only conclusive evidence of its presence in
any form, quantity and quality is drilling. There is therefore a geological risk of drilling and
hitting a dry hole. In addition, there are market risk (the risk of not finding an outlet for
production at a satisfactory price), sovereign/political risk (the risks of nationalization of
operations, currency devaluation, licensing and exploration agreements), partner risk (the risk
of partner default, distrust, unwillingness, inability or delay in paying due shares of cost of
exploration and development), youth militancy risk (the risk of kidnapping of personnel and
vandalisation of equipments by militant youths) and tax risk (the risk of unexpected change
in tax provisions) . Consequently, the risk of loss of capital is very high.
2. Dominance of the World Economy: The second feature of oil and gas industry is its
dominance of the world economy, in terms of financial figures, unlimited potentials as raw
material, global economy development and international politics and touches the lives of
people in any more ways, anywhere on earth. Exxon Mobil, Saudi Aramco, Chevron and
Shell B.P. are one of the largest companies in the World today in terms of financial figures
and profitability.
3. Long Lead-Time between Investment and Returns: Even in normal circumstances,
upstream activities can take several years, thereby complicating the risk further in oil and gas
operations. The operations are highly capital intensive, requiring large amounts of capital

investment up-front. The lead-time therefore stretches the capital outlay and brought about
long gestation period between investment and return from the investment.
4. Significant Regulation by Government Authorities: The petroleum industry, in any part of
the world is subject to involvement, participation, intervention and regulation by various
governments and its agencies. This is as a result of the indispensability of oil, its depletable
nature and its influence in international politics.
5. Technical and Operational Complexity: Finding oil has proved to be a difficult task and
therefore demands the best technology possible. This results from the complexity of
operations, especially in the offshore terrain.
6. Specialized Accounting Rules for Reporting and Complex Tax Rules: There are
fundamental dissimilarity between financial/tax accounting in the oil and gas industry and
other industries. This arises from the nature of oil and gas industry, its highly technical
operations and specialized activities.
7. Lack of Correlation between Investment and the Value of Reserves: The amount
invested in oil and gas operations usually does not bear any relationship with the value of oil
and gas reserve, as a result of the inherent difficulties in estimating the value of reserves and
the need for up-front large investments in petroleum exploration and production.
Although, these characteristics are most evident in Exploration and Production (E&P) functions of
the oil and gas industry, they are found in other segments of the industry in varying degrees.
1.2.3 Activities/Segments in the Nigerian Oil and Gas Industry
Nigerian oil and gas companies may be involved in four different types of functions or segments,
namely Exploration and Production (E&P), storage and transportation, refining and hydro
processing, and distribution and marketing. A company may decide to operate in any of the four
segments or a combination thereof. The four segments are briefly explained below:
1. Exploration and Production (E&P): Exploration is the search for oil with a view to
discovering oil-in-place, while production is the removal of oil from the ground and surface
treatment. In this segment, companies explore from underground reservoirs of oil and gas
and produce the discovered oil and gas using drilled wells, through which the reservoir oil,
gas and water are brought to the surface and separated. Companies that are involved in E&P
are only to explore and produced the discovered oil and gas and sell it depending on the
nature and conditions of the contract, i.e. concession, joint venture or production sharing
contracts. This segment is an upstream activity.
2. Storage and Transportation: This segment encompasses the storing and moving of
petroleum from the production field to crude oil refineries and gas processing plants. Once
crude oil and gas produced and treated, it is stored in tanks and later transported to refineries
and gas processing plants by road tankers, railway tankers, sea oil tankers, and pipelines.
3. Refining and Hydro Processing: Refining is the treatment of crude oil in order to form
finished products and may extend to the production of petrochemicals. This segment
required plants to be put in place for the separation and processing of hydrocarbon fluids and
gases into various marketable products such as gasoline, diesel, kerosene, jet fuel, lubricants,
asphalt, bitumen, petrochemicals and treated natural gas.
Crude oil refining involves the breaking down of hydrocarbon mixture into useful products,
through distillations, cracking, reforming and extraction process. The factors that determine
the refinery configuration are:

(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)

the domestic, regional or global economy;

availability of crude oil;
price of crude oil per barrel;
quantity of product to be developed and present technology;
regulations (i.e. government and OPEC regulations);
market trends;
environmental issues, competition; and
degree of integration.

Petrochemical is a substance produced commercially from the feedstock derived from oil and
gas. The functions of petrochemical plants, therefore, is to turn outputs of the refining
process either in form of crude oil fractions or their cracked or processed derivatives into
feedstock that will ultimately be used in the manufacture of a number of other products, e.g.
plastics, detergents, nitrogen fertilizers, etc.
The gas mixtures consist largely of methane (the smallest natural hydrocarbon molecule
consisting of one carbon atom and four hydrogen atoms). Natural gas usually contains some
of the next smallest hydrocarbon molecules commonly found in nature:
Ethane (two carbon, six hydrogen atoms, abbreviated C2H6),
Propane (C3H8),
Butane (C4H10), and
Natural gasolines (C5H12 to C10H22).
These four types of hydrocarbons are collectively called natural gas liquids (abbreviated
NGL) which are valuable feedstock for the petrochemical industry. When removed from the
natural gas mixture, these larger, heavier molecules become liquid under various
combinations of increased pressure and lower temperature. Liquefied petroleum gas
(abbreviated LPG) usually refers to an NGL mix of primarily propane and butane typically
stored in a liquid state under pressure. LPG (alias bottled gas) is the fuel in those pressurized
tanks used in portable "gas" barbeque grills. Sometimes the term LPG is used loosely to
refer to NGL or propane. The more natural gas liquids in the gas mixture the greater the
energy, and the "richer" or "wetter" the gas. For various economic reasons, wet gas is
commonly sent by pipeline to a gas processing plant for removal of substantially all natural
gas liquids, before sale. The remaining gas mixture, called residue gas or dry gas, is over 90
percent methane and is the natural gas burned for home heating, gas fireplaces, and many
other uses.
Crude oil can be many different mixtures of liquid hydrocarbons. Crude oil is classified as
light or heavy, depending on the density of the mixture. Density is measured in API degree
(which is a measure of how heavy or light a petroleum liquid is compared with water).
Heavy crude oil has more of the longer, larger hydrocarbon molecules and, thus, has greater
density than light crude oil. Heavy crude oil may be so dense and thick that it is difficult to
produce and transport to market. Heavy crude oil is also more expensive to process into
valuable products such as gasoline. Consequently, heavy crude oils sell for much less per
barrel than light crude oils but weigh more per barrel. Both natural gas and crude oil may
contain contaminants, such as sulphur compounds and carbon dioxide (CO), that must be
substantially removed before marketing the oil and gas. The contaminant hydrogen sulfide
(H22S) is poisonous and, when dissolved in water, corrosive to metals. Some crude oils
contain small amounts of metals that require special equipment for refining the crude.
10

Liquefied natural gas operations encompasses a number of interdependent activities ranging

from gas gathering from the field, transmitting the gas to plants, treating the gas,
compressing the gas into liquid, transporting the gas by ship to buyers, receiving the
compressed gas at the buyers terminal and packing the gas into cylinders for storage and
distribution. Different mixtures of petroleum have different uses and economic value.
Numerous useful products that are derived from petroleum include the following:
(a) Transportation Fuels [Automotive Gas Oil (AGO), popularly known as diesel and
Premium Motor Spirit (PMS) popularly known as petrol, etc].
(b) Heating Fuels, like the Dual Purpose Kerosene (DPK), popularly known as kerosene.
Kerosene (DPK) is a thin, clear combustible hydrocarbon liquid with a density of
0.780.81g/cm obtained from the fractional distillation of petroleum between 150 and
275 C. Kerosene is widely used to power jet fuel engines, rockets and as a heating fuel
in households. The combustion of Kerosene is similar to that of diesel with Lower
Heating Value of around 18,500 Btu/1b, or 43.1 MJ/Kg, and its Higher Heating Value
is 46.2MJ/kg.
(c) Liquefied Petroleum Gas (otherwise known as cooking gas is made up of 70% propaneC3 and 30% butane-C4). It is a product of petroleum refining and, it can also be
obtained from natural gas processing. It consists of hydrocarbons as vapors, at normal
temperatures and pressures, but turns liquid at moderate pressures. LPG uses include;
cooking, heating in households, fuel for transport etc.
(d) Natural gas and residual fuel can be burned to generate electricity.
(e) Petrochemicals from which plastics, as well as clothing, building materials, cream,
pomade, soap, petroleum jelly, etc are produced.
4. Distribution and Marketing: Distribution and marketing involve the activities associated
with getting finished products from distribution points into the hands of end users. Marketers
are of different categories, namely major marketers (like Oando PLC, Mobil Unlimited, Con
Oil, Texaco, etc.), independent markets (like Azman oil and gas, Sani Brothers Ltd., Pure
Oil, Dan-Kano Petroleum, etc) and part-time marketers.
The first activity is above is referred to upstream activity, while the last three activities are
downstream activities. It is worthy to note that an oil company can either be integral or independent.
While an independent oil company is one involved primarily in Exploration and Production (E&P)
activities only. An integral oil company is one involved in Exploration and Production (E&P)
activities as well as at least one of the other segments, namely storage and transportation, refining
and hydro processing and marketing and distribution. An integrated company is also known as midstream.
Figure I: Organization of the Accounting Function in an Independent Oil Company

Controller

Field
Clerical
and
Services

Equipment
and
Supplies
Inventory

Accounts
Payable

Property
Accounting

11

Joint
Interest
Accounting

Revenue
Accounting

General
Accounting

Taxes and
Regulatory
Compliance

Equipment and Supplies Inventory

1. Maintains equipment and supply inventory records.
2. Prices and records warehouse receipts, issues, and field transfers.
3. Oversees physical inventory taking.
4. Prepares reports on equipment and supplies inventory.
Accounts Payable
1. Maintains accounts payable records.
2. Prepares vouchers for disbursements.
3. Distributes royalty payments.
4. Maintains corporate delegated limits of authority and verifies that disbursements are made within
those limits.
Property Accounting
1. Maintains subsidiary records for
(a) Unproved properties,
(b) Proved properties,
(c) Work in progress,
(d) Lease and well equipment, and
(d) Field service units.
2. Accounts for property and equipment acquisition, reclassification, amortization, impairment,
retirement, and sale.
3. Compares actual expenditures of work in progress to authorized amounts.
Joint Interest Accounting
1. Maintains files related to all joint operations.
2. Prepares billings to joint owners.
3. Reviews all billings from joint owners.
4. Prepares statements for jointly operated properties.
5. Prepares payout status reports pursuant to farm-in and farm-out agreements.
6. Arranges or conducts joint interest audits of billings and revenue distributions from joint venture
operations.
7. Responds, for the company as operator, to joint interest audits by other joint interest owners.

Revenue Accounting
1. Accounts for volumes sold and establishes or checks prices reflected in revenues received.
2. Maintains oil and gas revenue records for each property.
3. Maintains records related to properties for purposes of regulatory compliance and production
taxes.
4. Computes production taxes.
5. Maintains Division of Interest master files, with guidance from the land department, as to how
revenue is allocated among the company, royalty owners, and others.
6. Computes amounts due to royalty owners and joint interest owners and prepares reports to those
parties.
7. Invoices purchasers for sales of natural gas.
8. Maintains ledgers of undistributed royalty payments for owners with unsigned division orders,
owners whose interests are suspended because of estate issues, and other undistributed production
payments.
9. Prepares revenue accruals.
12

General Accounting
1. Keeps the general ledger.
2. Maintains voucher register and cash receipts and disbursements records.
3. prepares financial statements.
4. Prepares special statements and reports.
5. Assembles and compiles budgets and budget reports.
Taxes and Regulatory Compliance
1. Prepares required federal, state and local tax returns for income taxes, production taxes, property
taxes, and employment taxes.
2. May prepare other regulatory reports.
3. Addresses allowable options for minimizing taxes
Figure II: Organization of Accounting Functions in Small Integrated Oil Company
Corporate
Controller

Financial
Accounting
&

Budget,
Cost
Analysis &
Reports

Considerations

Pipeline

Corporate
Tax

Accounting
Policy &
Research

Production
Accounting

&
Crude oil
Trading
Accounting

Refining
Accounting

Marketing
Accounting

Figure III: Organization of Accounting Functions in Production Division of Large Integrated

Company
Controller
Production
Division
Budgets &
Internal Reports

Compliance
&
Taxation

Budgets

Revenue
Accounting

Policy Planning
& Support

Financial
Accounting &
Investments

Regulatory
Compliance

Oil

Recruitment and
Development

General
Accounting

Taxes

Gas

Administrative
Support

Investments

Internal Reports

Performance
Management

Management
Information
System
Accounting
Policies

Internal Control

13

Joint Interests

External Reports

1.3 The History of the Nigerian Oil and Gas Industry

In order to understand the importance and nature of financial accounting and reporting in the
petroleum industry, it is helpful to briefly review the industry's history, particularly in Nigeria, right
from its inception to date.
In ancient history, pitch (a heavy, viscous petroleum) was used for ancient Egyptian chariot axle
grease. Early Chinese history reports the first use of natural gas that seeped from the ground; a
simple pipeline made of hollowed bamboo poles transported the gas a short distance where it fueled
a fire used to boil water. Seventeenth century missionaries to America reported a black flammable
fluid floating in creeks. From these creeks, Indians and colonists skimmed the crude oil, then called
rock oil, for medicinal and other purposes. Later, the term rock oil would be replaced by the term
petroleum from petra (a Latin word for rock) and oleum (a Latin word for oil). Eventually, the term
petroleum came to refer to both crude oil and natural gas. By the early 1800s, whale oil was widely
used as lamp fuel, but the dwindling supply was uncertain, and people began using alternative
illuminating oils called kerosene or coal oil extracted from mined coal, mined asphalt, and crude oil
obtained from surface oil seepages. Therefore, the petroleum exploration and production industry
may be said to have begun in around mid 1800s. There was mention of an oil discovery in Ontario,
Canada, in 1858, and Pennsylvania, in USA in 1859, with a steam-powered, cable-tool rig with a
wooden derrick used in drilling. Shortly thereafter, a number of refineries began distilling valuable
kerosene from crude oil, including facilities that had previously extracted kerosene from other
sources.
Transportation of crude oil was a problem faced from the earliest days of oil production. The
coopers union constructed wooden barrels (with a capacity of 42 to 50 US gallons) that were filled
with oil and hauled by teamsters on horse-drawn wagons to railroad spurs or river barge docks. At
the railroad spurs, the oil was emptied into large wooden tanks that were placed on flatbed railroad
cars. The quantity of oil that could be moved by this method was limited. However, the industry's
attempts to construct pipelines were delayed by the unions whose members would face
unemployment and by railroad and shipping companies who would suffer from the loss of business
by the change in method of transportation. Nevertheless, pipelines did come into existence in the
1860s; the first line was made of wood and was less than a thousand feet long.
New demands for petroleum were created in the 1920s, largely because of the growing number of
automobiles, as well as, the use of petroleum products to generate electricity, operate tractors, and
power automobiles. The oil industry was able to increase production to meet the greater demand
without a sharp rise in price. Compared with World War I, World War II which had its onset in
1939, used more mechanized equipment, airplanes, automotive equipment, and ships, all of which
required huge amounts of petroleum.
The search for oil in Nigeria dates back to 1908 when a German Company, by name the Nigerian
Bitumen Corporation, obtained a licence to explore for oil in Okitipupa area of Ondo State.
The companys efforts were unsuccessful and with outbreak of the First World War, its
operations were disrupted.
Two decades later, Shell DArcy (the predecessor of Shell Petroleum Development Company of
Nigeria Ltd) started exploration of Niger Delta in 1937 having acquired exploration right from the
British Colonialists over the entire Nigerian territory under an exclusive exploration licence. The
company operated under the Mineral Ordinance No. 17 of 1914 which gave companies registered in
14

Britain or any of its protectorates the right to prospect for oil in Nigeria. Except for a brief disruption
of operations of the company in 1941 to 1946 because of the Second World War, it continued as the
sole concessionaire in Nigeria until 1959 when exploration rights became available to oil companies
of other nationalities.
The first deep exploration well was in 1951 at Iho, 10 miles North-east of Owerri to a depth of
11,228 feet, but it was a dry hole. Shell discovered oil in a commercial quantity at Oloibiri, Rivers
State (presently in Bayelsa State), in 1956, after half a century of exploration, with an equivalent
investment of N120 million. This oil field came on stream in 1958 producing 5,100 bpd. From 1938
to 1956, almost the entire country was covered by concession granted to the Company (Shell-BP) to
explore for petroleum resources. This dominant role of Shell in the Nigerian oil and gas industry
continued for many years, until Nigerias membership of the Organization of the Petroleum
Exporting -Countries (OPEC) in 1971. After which the country began to take firmer control of its oil
and gas resources, in line with the practice of other members of OPEC.
In 1960 the Organization of Petroleum Exporting Countries (OPEC) was formed by Saudi Arabia,
Kuwait, Iran, Iraq, and Venezuela. Later, eight other countries joined OPECthe United Arab
Emirates and Qatar in the Middle East; the African countries of Algeria, Gabon, Libya and Nigeria;
and the countries of Indonesia and Ecuador. Ecuador, who joined OPEC in 1973, suspended its
membership from December 1992 to October, 2007. By 1973 OPEC members produced 80 percent
of world oil exports, and OPEC had become a world oil cartel. Member countries began to
nationalize oil production within their borders.

Table 2: GDP Per Capita and Population Estimates of OPEC Countries

S/No.

Name of Country

1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.

Algeria
Angola
Ecuador (**)
Indonesia
Iran*
Iraq*
Kuwait*
Libya
Nigeria
Qatar
Saudi Arabia*
United Arab
Emirates
Venezuela*

13.

Date joined
OPEC
1969
2007
Rejoined 2007
1962
1960
1960
1960
1962
1971
1961
1960
1967

Location
Africa
Africa
South America
Asia
Middle East
Middle East
Middle East
Africa
Africa
Middle East
Middle East
Middle East

1960

South America

Source: OPEC at http://www.opec.org/library/

Notes: # as at 2006 * Founder members (**) Ecuador joined OPEC in 1973, suspended its
membership from December 1992 to October, 2007

15

Figure IV:

2010/2011 statistics shows that the bulk of OPEC oil reserve is located in Venezuela with 24.8% and
Saudi Arabia with 22.2% , followed by four middle East countries, namely Iran 12.7%, Iraq 12.0%,
Kuwait 8.50% and United Arab Emirates 8.2%. The statistics show that two third of the OPEC oi
reserve (65.70%) is located in the Middle East countries. OPEC (2011) shows that Nigeria has
proven oil reserve of 3.1% of total OPEC reserve.
Figure V:

However, as against what obtains in some OPEC member countries where National Oil Companies
(NOCs) took direct control of production operations, in Nigeria, the Multi-National Oil Companies
(MNOCs) were allowed to continue with such operations under Joint Operating Agreements (JOA),
clearly specifying the respective stakes of the companies and the Government of Nigeria in the
ventures. As a result, this period also witnessed the arrival on the scene of MNOCs such as the Gulf

16

Oil and Texaco (now ChevronTexaco), Elf Petroleum (now Total), Mobil (now ExxonMobil), and
Agip, in addition to Shell, which was already playing a dominant role in the industry. To date, these
companies constitute the major players in the Nigerian oil industry, with Shell still maintaining a
leading role. Joint Venture Agreements (JVAs) and Production Sharing Contracts (PSCs) also
dominate the production agreements between the oil companies and the NNPC. Similarly, it is worth
noting that the exploration of oil and gas in Nigeria had taken place in five major sedimentary
basins, namely, the Niger Delta, the Anambra Basin, the Benue Trough, the Chad Basin and the
Benin Basin. But, the most prospective basin is the Niger Delta which includes the continental shelf
and which makes up most of the proven and possible reserves. All oil production to date has
occurred in this basin.
In 1971, as oil became more important to the economy, the country established the Nigerian
National Oil Corporation (NNOC) and joined OPEC as the 11th member. It acquired 33 /3% in
Nigerian Agip and 35% in Elf. NNOC ran as an upstream and downstream company and the
petroleum ministry had a regulatory function. On April 1, 1977, a merger between NNOC and the
ministry of petroleum created Nigerian National Petroleum Corporation (NNPC). This was to
combine the ministrys regulatory role and NNOCs commercial functions: exploration, production,
transportation, processing, oil refining and marketing. The Nigerian National Petroleum Company
(NNPC) was established as a state owned and controlled company, as a dominant player in the
downstream sector and a major player in the upstream sector through joint venture agreements with
all major international players. The regulatory role was later to be assumed by the Petroleum
Inspectorate, a unit of NNPC. Through the years, NNPC has been active in seismic exploration
onshore and offshore. Its seismic crew, known as Party X, has made several discoveries such as a
field in block OPL- 110 in the Niger Delta, the Oredo field, etc. It also carried out work on contract
for Phillips Petroleum and other E&P companies in the Chad, Anambra and Benue Basins. But
NNPC has depended on the technological capabilities of the major operators, like Shell, Mobil, Gulf
(Chevron) and others, which produced the bulk of Nigerian oil and did most of the exploration work.

The NNPC in 2010 developed a comprehensive framework designed to herald the intensification of
exploration activities in the Chad Basin. The move was seen as a fresh boost to the Federal
Government's efforts to build up the nation's proven oil reserve through exploration of new frontiers
for oil and gas production. Oil may be found in commercial quantity in the Chad Basin, because of
the discoveries of commercial hydrocarbon deposits in neighboring countries of Chad, Niger and
Sudan which have similar structural settings with the Chad Basin. Discoveries made in
neighbouring countries in basins with similar structural settings are: Doba, Doseo and Bongor all in
Chad amounts to over 2 Billion barrels (Bbbls); Logone Birni in Southern Chad and Northern
Cameroun, over 100 Bbbls; and Termit-Agadem Basin in Niger totals over 1bbbls. The search was
not limited to the Chad Basin alone but covers extensive inquest in the entire Nigerian Frontier
Sedimentary Basins which include- The Anambra, Bida, Dahomey, Gongola/Yola and the Sokota
Basins alongside the Middle/Lower Benue Trough. Petroleum has recently (i.e. in 2012) discovered
in Anambra Basin, which is now to join the league of oil producing states.

The NNPC New Frontier Exploration Services (NFES) Division which is leading the search for
crude oil find in the entire Inland Basins acquired 3,550 sq km of 3- D seismic data for processing
and interpretation in addition to the already acquired 6000km of 2-D data that was reprocessed. Over
600,000 seismic section and 30,000 well logs were scanned and vectorised for the eventual drilling.
Before, 2010, 23 wells have been drilled with two of the wells, Wadi-1 and Kinasar encountering
non-commercial gas.
17

1.4 The Nature of Petroleum Assets and the Process of Acquiring it

Before an oil company drills for oil, it first evaluates where oil and gas reservoirs might be
economically discovered and developed. The procedure involved in acquiring petroleum assets
includes the following:
(i) Leasing the Rights to Find and Produce: When suitable prospects are identified, the oil
company determines who (usually a government in international areas) owns rights to any oil
and gas in the prospective areas. In the Nigeria the government own both the surface and the
subsurface, as all lands are granted by the government on rent for 99 years. In contrasts, in
United States, whoever owns "land" usually owns both the surface rights and mineral rights to
the land. Whoever owns, (i.e., has title to), the mineral rights negotiates a lease with the oil
company for the rights to explore, develop, and produce the oil and gas. The lease requires the
lessee (the oil company), to pay all exploration, development, and production costs, and pays
royalty to the lessor. The oil company may choose to form a joint venture with other oil and
gas companies to co-own the lease and jointly explore and develop the property.
(ii) Exploring the Leased Property: To find underground petroleum reservoirs requires drilling
exploratory wells. Exploration is risky, as a number of exploration wells may have to be
abandoned as dry holes, i.e., not commercially productive. Wildcat wells are exploratory wells
drilled far from producing fields on structures with no prior production. Several dry holes
might be drilled on a large lease before an economically producible reservoir is found. To drill
a well, an oil company typically subcontracts much of the work to a drilling company that
owns and operates rigs for drilling wells, who can do the drilling more effectively, efficiently
and economically because of experience. Drilling contracts may take the form of footage rate
contract (requiring installmental payment per foot of hole drilled until the required depth is
reached), day rate contract (requiring daily payment of specified amount in respect of the
number of feet drilled) or turnkey contract (where the contractor is paid only after satisfactory
drilling of well to the required depth and other conditions specified in the contract).
(iii)Evaluating and Completing a Well: After a well is drilled to its targeted depth, sophisticated
measuring tools are lowered into the hole to help determine the nature, depth, and productive
potential of the rock formations encountered. If these recorded measurements, known as well
logs, along with recovered rock pieces, i.e., cuttings and core samples, indicate the presence of
sufficient oil and gas reserves, then the oil company will elect to spend substantial sums to
"complete" the well for safely producing the oil and gas.
(iv) Developing the Property: After the reservoir (or field of reservoirs) is found, additional wells
(known as development wells) may be drilled and surface equipment installed to enable the
field to be efficiently and economically produced.
(v) Producing the Property: Oil and gas are produced, separated at the surface, and sold. Any
accompanying water production is usually pumped back into the reservoir or another nearby
underground rock formation. Production life varies widely by reservoir between over 50 years
to only a few years, and some for only a few days. The rate of production typically declines
with time because of the reduction in reservoir pressure from reducing the volume of fluids and
gas in the reservoir. Production costs are largely fixed costs independent of the production
rate. Eventually, a well's production rate declines to a level at which revenues will no longer
cover production costs. Petroleum engineers refer to that level or time as the well's economic
limit.
(vi) Plugging and Abandoning the Financial Property: When a well reaches its economic limit,
the well is plugged, i.e., the hole is sealed off at and below the surface, and the surface
equipment is removed. Some well and surface equipment can be salvaged for use elsewhere.
Plugging and abandonment costs, or P&A costs, are commonly referred to as dismantlement,
restoration, and abandonment costs or DR&A costs. Equipment salvage values may offset the
18

plugging and abandonment costs of onshore wells so that net DR&A costs are zero. However,
for some offshore wells, estimated future net DR&A costs may exceed $1 million per well due
to the cost of removing offshore platforms, equipment, and perhaps pipelines. When a leased
property is no longer productive, the lease expires and the oil company plugs the wells and
abandons the property. All rights to exploit the minerals revert back to the lessor as the
mineral rights owner.
1.5 Accounting Dilemmas in Oil and Gas Accounting
The nature, complexity, and importance of the petroleum E&P industry have caused the creation of
an unusual and complex set of rules and practices for petroleum accounting and financial
presentation. The nature of petroleum exploration and production raises numerous Accounting
problems. Here are a few:
(1) Should the cost of preliminary exploration be recorded as an asset or an expense when no
right or lease might be obtained?
(2) Given the low success rates for exploratory wells should the well costs be treated as assets or
as expenses? Should the cost of a dry hole be capitalized as a cost of finding oil and gas
reserves? Suppose a company drills five exploratory wells costing $1 million each, but only
one well finds a reservoir and that reservoir is worth $20 million to the company. Should the
company recognize an asset for the total $5 million of cost, the $1 million cost of the
successful well, the $20 million value of the productive property, or some other amount?
(3) The sales prices of oil and gas can fluctuate widely over time. Hence, the value of rights to
produce oil and gas may fluctuate widely. Should such value fluctuations affect the amount
of the related assets presented in financial statements?
(4) If production declines over time and productive life varies by property, how should
capitalized costs be amortized and depreciated?
(5) Should DR&A costs be recognized when incurred, or should an estimate of future DR&A
costs be amortized over the well's estimated productive life?
(6) If the oil company forms a joint venture and sells portions of the lease to its venture partners,
should gain or loss be recognized on the sale?
1.6 The Upstream and the Downstream Sectors of the Nigerian Oil Industry
As earlier stated, Shell DArcy was the first to discover oil in commercial quantity in Nigeria at
Oloibiri, Rivers State (presently, Bayelsa State) in 1956. However intensified search for oil from
1957 to 1959 resulted in discovery of Ebubu and Bomu oil fields in Rivers State, and Ughelli in
Delta State, which was the first hydrocarbons find, west of the Niger. By 1961 Mobil, Gulf (now
Chevron), Agip, Tenneco and Amoseas (now Texaco) etc joined the search for both onshore and
offshore oil and gas in Nigeria. This led to the first offshore discovery in 1964 in Okan field in Delta
State. Currently, all the early explorers have discovered oil and are producing it, with an upwards of
3,000 producing oil wells in the country.
Prior to 1971, the Government had no joint venture participation in the operations of oil companies
in Nigeria. By 1971 all concessions earlier granted to the companies were converted to joint venture
agreements. In 1973, production sharing contract emerged between the NNPC and Ashland,
followed by risk service contract between NNPC and Agip Energy and Natural Resources in 1979
and agreements involving these types of contracts were entered into between the NNPC and the oil
companies. Foreign oil companies largely dominated the upstream sector until the first discretionary
allocation of acreages to indigenous companies in 1990. Oil blocks were allocated to eleven (11)
indigenous companies. The companies who operated sole risk contracts, were encourage farm-out
(i.e. to assign an interest in a licence to another party) 40 per cent of their interest to foreign
19

companies, mainly for financial and technological back-up (the foreign companies who acquire
interest in a licence from another party, are said to have farm-in in indigenous companies minning
interest). More allocations were made between 1991 and 1993 and there are now an upwards of forty
(40) indigenous private sector companies licensed to prospect for oil in Nigerias upstream sector.
Some of the companies, including Summit Oil, Consolidated Oil and Amni Petroleum Development
Company have made commercial discoveries and are already producing oil, while others are at
various stages of exploration and production.
In addition the NNPC through two of its subsidiaries- the Nigerian Petroleum Development
Company (NPDC) and Direct Exploration Services of the National Petroleum Investment
Management Services undertake oil exploration and production. In total, an upwards of 55
companies are operating in Nigeria under joint venture, production sharing contract, service contract,
sole risk contract and NNPC direct exploration efforts.
Nigerias expertise in the upstream sector in the African Subregion, which is relatively superior, had
attracted a number of African countries to look up to it for assistance. For example in 2010 Uganda
and Nigeria have signed MOU on oil and gas industry. The agreement covers human resource
training, technological transfer, joint projects and offering support on evaluation of the crude oil.
Crude oil and gas production is expected to start by 2012. There will also be construction of a
refinery with a capacity of 150,000 to 200,000 barrels of oil a day. Four companies, including
Heritage, Dominion, Neptune and Tullow Oil, are exploring for oil and gas in the Lake Albert basin.
The MOU signed between Nigeria and Uganda is a positive development. With increased E&P
activities in the region, more countries would be fortunate to discover Oil and Gas reserves in their
territories.
Activities in the downstream sector were given boast in 1965 with the construction of the first
refinery in Port Harcourt by Shell-BP, with an initial capacity of 35,000 bpd, which was later
increased. As the economy grew, demand for petroleum products grew along with it necessitating
the establishment of Warri refinery in 1978, Kaduna refinery in 1980, and subsequently, another
refinery, which is the forth refinery, was built at Port Harcourt to supplement the old one. However,
these refineries at various points in time have been bedeviled with problems of sabotage, fire out
breaks, poor management and lack of regular turnaround maintenance, thereby making it difficult for
the refineries to meet local demands for petroleum products.
In similar vein, petrochemical plants were built in Warri and Kaduna in 1988 and subsequently,
another company was built in Eleme, near Port Harcourt. These companies were meant to produce
polypropylene, carbon black, linear alkyl benzene (LAB), heavy alkylate, benzene, polyethylene and
chlorine, among others.
Table 3: Installed Capacity of Nigerian Refineries
S/N
NAME OF THE COMPANY
1
2
3
4

Kaduna Refinery and Petrochemical Company Limited

(KRPC).
Warri Refinery and Petrochemical Company Limited
(WRPC).
Port-Harcourt Refinery Company Limited (PHRC).
Eleme Petrochemical Company Limited (EPCL).

Total

Date
Installed
Commissioned Capacity (bpd)
1980

110,000

1979

125,000

1965
1989

35,000
150,000

445,000

20

1.7 NNPC, DPR and Their Roles

1.7.1 Nigerian National Petroleum Corporation (NNPC)
The NNPC occupies a central position in the Nigerian oil and gas industry. It was incorporated on
April 1, 1977 through Decree No. 33 of 1977, by a merger of the defunct Nigerian National Oil
Corporation (NNOC) created by Decree 18 of 1971, and the former Federal Ministry of Petroleum
Resources, with Chief Festus Marinho, as the pioneer GMD. NNPC is charged with the
responsibility of managing the Nigerias oil and gas resources in all segments of the petroleum
industry (namely Exploration and Production (E&P), storage and transportation, refining and hydro
processing and distribution and marketing). The roles of the corporation include the following:
1. refining, treating, processing and handling of petroleum for the manufacture and
production of petroleum products and its derivatives;
2. the conduct of research on petroleum and its derivatives and promotion of activities to
utilize the results of such research;
3. giving effects to agreements entered into by the Federal Government with a view to
securing participation by the Government or the Corporation;
4. engaging in activities which would enhanced the overall well being of the petroleum
industry in the overall interest of the country;
5. undertake such activities considered necessary or expedient for giving full effect to the
provisions of the law establishing it; and
6. managing Government investment in the oil companies in which the Government has a
stake.
In l985 the Corporation was organized into five semi-autonomous sectors in the quest to enhance its
operational efficiency. These sectors were (1) oil and gas sector, (2) refineries sector, (3)
petrochemical sector, (4) pipelines and products marketing, and (5) the petroleum inspectorate.
Similarly, the Corporation was re-organized in 1988 with a view to putting it on commercial footing,
with three basic areas of responsibilities. These are (1) corporate services (which include finance,
administration, public affairs, personnel, legal and technology), (2) operations (which include
exploration and production, refining, gas processing and petrochemicals) and (3) National Petroleum
Investment Management Services (NAPIMS) -which supervises Government investment in joint
venture companies, markets oil that accrues to the Government and engages in exploration activities
in areas where oil companies consider too risky to venture in to.
Another important aspect of the 1988 re-organization was the transfer of the Petroleum Inspectorate
back to the Petroleum Resources Department of the Ministry of Petroleum Resources from which it
was originally brought to be part of the NNPC. In 1992, another reorganization of the Corporation
was carried out which led to the establishment of six directorates (namely (i) exploration and
production, (ii) refining and petrochemicals, (iii) engineering and technical, (iv) finance and
accounts, (v) commercial and investment and (vi) corporate services), which each headed by a
Group Executive Director (GED) who reports to the Group Managing Direct (GMD). The 1992
reorganization of the Corporation conferred on the crude oil and marketing division of the
exploration and production inspectorate the responsibility for marketing the crude oil that accrues to
the Government.
Similarly, twelve (12) strategic Business Units (SBUs) or subsidiary companies were also
established in the 1992 reorganization. Nine of the subsidiaries are fully owned by NNPC, while the
remaining three subsidiaries are jointly own with foreign oil companies. The ful1y owned
subsidiaries of the Corporation are:

21

1. The Nigerian Petroleum Development Company Limited (NPDC) charged with the
responsibility for exploration, development and production of petroleum.
2. The integrated Data Services Limited (IDSL) charged with the responsibility of seismic
data acquisition, processing and interpretation, petroleum reservoir engineering and data
evaluation for NNPC and other oil and gas companies in Nigeria and West Africa.
3. Warri Refinery and Petrochemicals Company Limited (WRPC) charged with the
responsibility of refining petroleum and the production of carbon black and polypropylene
petrochemicals.
4. Kaduna Refinery and Petrochemicals Company Limited (KRPC) charged with the
responsibility of refining petroleum and the production of linear alkyl benzene and heavy
alkylalates.
5. Port Harcourt Refining Company Limited (PHRC) charged with the responsibility of
refining petroleum especially for export.
6. Pipelines and Products Marketing Company Limited (PPMC) charged with the
responsibility of transporting crude oil to the refineries and refined products through its
pipelines and deports to markets both locally and internationally.
7. Nigerian Gas Development Company Limited (NGC) charged with the responsibility of
gathering, treating and developing gas resources for transmission to major industrial and
utility gas companies in Nigeria and neighbouring countries.
8. Eleme Petrochemicals Company Limited (EPCL) charged with the responsibility of
manufacturing a range of petrochemicals products such as polyethylene, polyvinyl chloride
etc from natural gas and refinery by-products and market them locally and internationally.
9. Nigerian Engineering Technical Company Limited (NETCO) charged with the
responsibility of providing engineering services to the NNPC group and other oil companies
in the country.
The three other subsidiaries that are jointly own with foreign oil companies are:
10. Nigeria Liquefied Natural Gas Limited (NLNG) owned jointly by the NNPC, Shell, Elf,
Agip and International Finance Corporation (IFC) charged with the responsibility of
harnessing, processing and marketing gas resources.
11. Calson (Bermuda) Limited initially owned jointly by the NNPC and Chevron (but the
Government has now divested from the company). Calson is charged with the responsibility
of marketing the countrys excess petroleum products abroad.
12. Hydrocarbon Services Nigeria Limited (HYSON Limited) owned jointly by the NNPC
and Chevron, and charged with the responsibility of providing logistics and support services
to Calson (Bermuda) Limited.
In addition to these subsidiaries, the industry is also regulated by the Department of Petroleum
Resources (DPR), a department within the Ministry of Petroleum Resources. The DPR ensures
compliance with industry regulations; processes applications for licenses, leases and permits,
establishes and enforces environmental regulations. The DPR, and NAPIMS (National Petroleum
Investment Management Services), play a very crucial role in the day to day activities throughout the
industry. In order to realize its vision and mission as well as provide optimal service to its customers,
the Nigerian National Petroleum Corporation (NNPC) has been structured as follows:

22

Figure VI: Organizational Structure of NNPC

GMDS SUPPORT STAFF
GGM, LNG & POWER

MD NETCO

GROUP MANAGING DIRECTOR

NNPC
M1

MD HYSON
MD PPMC

GGM CSLD

GGM PUBLIC AFFAIRS

GGM CPDD
GGM AUDIT
GGM ETD
GGM RENEWABLE ENERGY
GGM INVESTMENT
GGM R & D
GGM NIG. CONTENT

GGM GREENFIELD EXPORT REF.

GGM ITD

GGM CORPORATE STRATEGY

MD NIDAS

MD NIKORMA

GED E&P

GGM NAPIMS
MD IDSL
MD NPDC

GED R&P

GED F&A

GGM ACCOUNTS

MD PHRC
MD WRPC
MD KRPC

GED CS

GGM HR

GGM FINANCE

GGM MEDICAL

GM TREASURY

GGM P&G

MD NGC

GM INSURANCE

GGM COMD

GGM LONDON
OFFICE

GGM INTL VEN. OPP.

1.7.2 THE DEPARTMENT OF PETROLEUM RESOURCES (DPR)

Prior to independence in 1960, the Hydrocarbons Section of the Ministry of Lagos Affairs handled
petroleum matters in the country. However, when petroleum activities gathered momentum in the
country, a petroleum division (later named DPR in 1970) was created under the Ministry for Mines
and Power. In 1971, Nigerian National Oil Corporation (NNOC) was created as the commercial arm
of the DPR, while DPR itself continued as art of the Ministry of Mines and Power. In 1975, DPR
was upgraded to a ministry and named the Ministry of Petroleum and Energy (later renamed the
Ministry of Petroleum Resources-MPR).
The promulgation of Decree 33 of 1977 merged the MPR with NNOC to form the NNPC.
Under the Decree, an inspectorate arm (called the Petroleum Inspectorate) was set up to act
as the regulatory arm of the oil and gas industry. In 1985, the MPR was re-established. However,
Petroleum Inspectorate remained with NNPC until its re-organization of March
1988 that resulted in the excision of the Inspectorate and its transfer back to the Petroleum
Resources Department of the Ministry of Petroleum Resources. The functions of the DPR include
the following:

23

1. supervising all petroleum industry operations being carried out under 1iences and leases in
the country, with a view to ensuring compliance with the established laws and regulations;
2. monitoring the petroleum industry in order to ensure that operations are in line with national
policies and goals;
3. enforcing safety regulations and ensuring that operations conform to national, as well as,
international industry practices and standards;
4. keeping and updating records on petroleum industry operations relating to reserves,
production/exports, licences and leases, as well as rendering regular reports of them to the
Government;
5. advising the Government and relevant agencies on technical matters and public policies,
which may have impact on the administration and control of petroleum;
6. processing all applications for licences to ensure compliance with laid down guidelines
before making recommendations to the Minister of Petroleum Resources; and
7. ensuring timely and adequate payments of all rents and royalties as and when due.

1.8 PPPRA and the Proposed Petroleum Industry Bill (PIB) 2011
1.8.1 Petroleum Products Pricing Regulatory Agency (PPPRA)
The Government on 14th August 2000 set up a 34 member Special Committee on the review of
Petroleum Products Supply and Distribution drawn from various Stakeholders and other interest
groups to look into the problems of the downstream petroleum sector. It mission is to reposition
Nigeria's downstream sub-sector for improved efficiency and transparency. Its vision is to attain a
strong, vibrant downstream sub-sector of the petroleum industry, where refining, supply, and
distribution of petroleum products are self-financing and self-sustaining. Prior to the setting up of the
Committee, the downstream sector was characterized by the following problems:
1. Scarcity of petroleum products leading to long queues at the service stations
2. Low capacity utilization and refining activities at the nation's refineries (poor state of the
refineries)
3. Rampant fire accidents as a result of mishandling of products- products adulteration
4. Pipelines vandalisation
5. Large scale smuggling due to unfavourable economic products borders' prices with the
neighbouring countries
6. Low investment opportunities in the sector.
Functions of PPPRA
1. To determine the pricing policy of petroleum products;
2. To regulate the supply and distribution of petroleum products;
3. To create an information databank through liaison with all relevant agencies to facilitate the
making of informed and realistic decisions on pricing policies;
4. To oversee the implementation of the relevant recommendations and programmes of the
Federal Government as contained in the White Paper on the Report of the Special Committee

24

on the Review of the Petroleum Products Supply and Distribution, taking cognizance of the
phasing of specific proposals;
5. To moderate volatility in petroleum products prices, while ensuring reasonable returns to
operators.
6. To establish parameters and codes of conduct for all operators in the downstream petroleum
sector;
1.8 Petroleum Industry Bill (PIB) 2011
The Petroleum Industry Bill is an attempt to bring under one law the various legislative, regulatory,
and fiscal policies, instruments and institutions that govern the Nigerian petroleum industry. The Bill
is expected to establish and clarify the rules, procedures and institutions that would entrench good
governance, transparency and accountability in the oil and gas sector. It aims to introduce new
operational and fiscal terms for revenue management to enable the Nigerian government to retain a
higher proportion of the revenues derived from operations in the petroleum industry. The
government argues that, since the commencement of oil and gas production in Nigeria in 1958 after
the discovery of oil in 1956 in Oloibiri (Bayelsa State), no comprehensive law has been put in place
for effective administration of the Nigerian petroleum industry. The PIB therefore seeks to replace
sixteen (16) petroleum industry Acts, which have many inadequacies, with an omnibus Act that
provides for better fiscal and regulatory management of the oil and gas sector.
Oil and gas production commenced in Nigeria in 1958 after the discovery of oil in Oloibiri (Bayelsa
State) two years earlier. By the 1990s Nigeria engaged in a number of unincorporated joint ventures
with international oil companies to develop the industry. However, the country had challenges
funding its commitments to the joint ventures. As a result, Production Sharing Contracts (PSC) were
introduced as alternative funding mechanisms. However, PSCs lack transparency, good governance
practices, and are not in line with international best practices. For instance, Nigeria does not capture
any part of windfall profits from increases in crude oil prices. Additionally, cost controls, accounting
procedures, and acreage management are inadequate.
In response to these challenges, the Obasanjo government in 2000 constituted the first Oil and Gas
Reform Implementation Committee (OGIC) to recommend a policy for reforming the sector. The
recommendations defined the need to separate the commercial institutions in the sector from the
regulatory and policymaking institutions. In 2007, the YarAdua government reconstituted OGIC
under the chairmanship of Dr. Rilwan Lukman to use the provisions of the National Oil and Gas
Policy to setup legal, regulatory, and institutional structures for managing the oil and gas sector.The
Lukman Report, submitted in 2008, recommended regulatory and institutional frameworks that when
implemented will guarantee greater transparency and accountability. This report formed the basis for
the first Petroleum Industry Bill (HB 159) that was submitted in 2008 as an Executive Bill.
The controversy raised by the Bill prompted the constitution of a federal interagency team headed
by Dr. Tim Okon (former NNPCs Group General Manager on Strategy) to review the Bill. The
teams report submitted in 2010 (IAT 2010) is at the crux of the controversies around the PIB
because it introduced more stringent fiscal provisions that guarantee a higher share of oil revenues to
Nigeria.In 2011, the Senate submitted its version of the Bill (SB 236) that is seen as a
muchweakened version. Subsequently, the House of Representatives submitted its version of the
Bill (HB. 54) in 2011. The Bill was sponsored by six Honourable Members.
The draft Petroleum Industry Bill (PIB) was designed to act as an all-encompassing piece of
legislation and as a result, some 15 pieces of existing legislation will be revoked upon ratification. It
25

will create a number of new institutions with mandates over the upstream sector. Specifically, the
policy making function will reside with the Petroleum Directorate. The Petroleum Inspectorate will
replace the Department of Petroleum Resources (DPR), currently within the Ministry of Energy.
This commission will act as the independent regulatory body and licensing agency for the upstream
sector. On the operational side, NNPC will be replaced by the Nigerian National Petroleum
Company Limited (NOC). The vision is to turn NNPC into an integrated oil and gas NOC, and a
limited liability company. The National Petroleum Investment Management Services (NAPIMS),
currently part of NNPC, will be replaced by the National Petroleum Assets Management Agency
(NAPAMA). This body will monitor and approve all upstream costs and manage tax/royalty oil (but
not profit oil). NAPAMA will exist outside of the NOC as a separate and independent agency. The
Research and Development division within NNPC will be carved out into an independent entity, the
National Petroleum Research Center. A separate Frontier Service will also be created. The key
objectives of the PIB include:
1. Enhance exploration, exploitation and production of oil and gas: The PIB will eliminate
funding bottlenecks, increase investments by comprehensive deregulation of the downstream
sector to make it attractive to investors, and increase acreage available for investment by
reclaim acreage that is not being developed by the current owners.
2. Increase domestic gas supplies: The Bill provides that all existing and future petroleum
mining lessees shall meet their domestic gas supply obligations for the specified periods as the
gas will be used for power generation and industrial development. Failure to meet this
obligation attracts a stiff penalty.
3. Create a peaceful business environment: The Bill seeks to align the interest of the host
communities to those of the oil companies and the government. The Petroleum Host
Communities Fund, which will be funded with 10% of the net profit of the oil companies
operating in the communities, shall be used to develop the economic and social infrastructure
of the host communities. Communities will forfeit contributions in the Fund when vandalism or
unrest causes damage to upstream facilities.
4. Fiscal Framework for increased revenue: The PIB establishes a progressive fiscal framework
that encourages further investment in the industry whilst increasing accruable revenues to
government. The Bill simplifies collection of government revenues from the oil assets,
increases the share of royalties in the case of high oil prices, etc.
5. Create a commercially viable National Oil Company: The Bill provides for the full
commercialisation of NNPC and the creation of other institutions that will ensure a
restructuring of the sector for improved efficiency.
6. Deregulate petroleum product prices: The Bill proposes the full deregulation of the
downstream oil sector. A number of the institutions will be responsible for developing the
infrastructure to support the sector, funding concessionaires and facility management operators.
The Petroleum Equalisation Fund will be phased out in line with the development of the
support infrastructure.
7. Create efficient regulatory entities: The Bill provides for the creation of eight institutions to
drive greater transparency and accountability.
8. Create transparency: The Bill makes public the terms of the licenses, leases, contracts and
payments in the petroleum sector. When passed, the legislature will transform Nigeria from
being one of the most opaque oil industries in the world to one that sets the standards of
transparency.
9. Promote Nigeria content: The PIB has farreaching local content components. No project
will be approved without a comprehensive Nigeria Content Plan including obligations of the
investor to purchase local goods and services, engage local companies, employ Nigerians,

26

ensure knowledge transfer and encourage Research and Development. The Nigeria Content
Monitoring Board will regularly verify compliance. Through the local content provisions in the
Bill and the opportunity to develop small indigenous oil and gas companies, Nigerians will
begin to participate more actively in the industry and jobs will be created.
10. Protect health, safety and environment: Every company requiring a license, lease or permit
in the upstream and downstream petroleum industry in Nigeria shall conduct their operations in
accordance with internationally accepted principles of sustainable development which includes
the necessity to ensure that the constitutional rights of present and future generations to a
healthy environment is protected.
Controversies in the PIB 2011
Different stakeholders have raised concerns about certain provisions of the Bill. Below is a list of
the most controversial issues.
1. Fiscal provisions may increase cost of doing business: The Bill provides for multiple taxes
(Nigeria Hydrocarbon Tax, Company Income Tax), higher rents and royalties, and levies (Niger
Delta Commission Levy, Petroleum Host Community Fund, Education Tax). This is most
noticeable in the deep offshore operations.
2. Retroactive reversal of contracts: The PIB advocates reversal of provisions of prior
agreements and contracts, and introduces new fiscal regimes even for old Petroleum Sharing
Contracts.
3. Relinquish acreage: The PIB provides for the revocation of acreage that is yet to be developed
by the allocated owners. Opponents of this provision claim that it is an infringement on earlier
agreements while its proponents argue that it is required to bringing new investment to the
industry.
4. Calculating payments: The Bill advocates that oil companies will pay for quantities produced
instead of quantities exported. The oil companies have argued that solving the security
challenge and fixing sabotage of logistics infrastructure is the core responsibility of
government.
5. Duplication of roles: There are overlaps of roles and responsibilities with a number of the
institutions created under this Bill. For instance, the Nigerian Petroleum Inspectorate, Petroleum
Products Regulatory Agency, and Petroleum Infrastructure Development Fund have conflicting
responsibility for funding the development of infrastructure especially for the downstream
sector of the petroleum industry.
6. Deadline for Gas flaring: According to the PIB (HB.54), December 31st 2012 is the deadline
for gas flaring. The integrity of this date is questioned given that the Bill is yet to be passed.
7. Too much power to Minister of Petroleum: The Bill provides the Minister of Petroleum too
much power to grant, revoke and reallocate licenses.
8. Lack of Regulatory Independence: Regulators need to be fully independent and not under the
supervision of the Minister of Petroleum.
9. Potential delays in passing the Bill and its Consequences on Nigerian economy: Can the 7th
National Assembly continue debates from where the last Assembly stopped? This is possible
according to Rule 111 of the Senate but there are voices in the Senate that dissent to this
interpretation and want the Bill to be reintroduced and for the process to be started all over
again. There is also the challenge of harmonizing the different versions of the Bill (Executive,
Senate, and House). Failure to pass the PIB has and will lead to a reduction of investments in
the Nigeria petroleum industry. To date, most of the oil companies have ceased investments in
the sector until there is clarity as to what provisions will be contained in the final Bill and how it

27

will affect the industry. With the rise of other attractive petroleum industries in Africa (Angola,
Ghana, etc), Nigeria must understand that investments are fungible and will eventually flow to
alternative countries that are more receptive.
2. Oil and Gas Drilling, Cost Classification and Reserves Valuation
2.1 Oil and Gas Drilling
Oil and gas drilling is highly capital intensive, requiring a large number of technocrats with fantastic
remuneration, thus necessitating pre-drilling operations, before actual drilling. Drilling operations
basically comprised of: (i) staking (locating oil well site after dues consideration of a number of
natural surface attributes-terrain, body of water, marshy environment, etc) (ii) compliance with
regulatory requirements on spacing of oil wells (iii) providing access road to the drilling location,
leveling of drill site for placement of working equipments and erection of field offices, and
increasing permeability through fracturing, acidizing and thermal process.
Two methods of drilling have been used in the oil and gas industry, namely rotary-rig drilling and
cable-tool drilling. The cable-tool method is one of the oldest mechanical means known for drilling
into the earth's surface. Cable-tool rigs have long been used for drilling water wells and salt brine
wells.
Cable-Tool Drilling
In the cable-tool method of drilling, a heavy piece of forged steel is lowered into the hole. The bit,
which weighs several hundred pounds, is raised and then dropped in the hole, literally pounding a
hole in the earth. Water is pumped into the hole to float the cuttings of rock away from the bottom of
the hole.
Rotary Rig Drilling
Rotary drilling is by far the most widely used method of drilling for oil and gas today. In rotary
operations, the hole is drilled by rotating a drill bit downward through the formations.
The usual oil and gas drilling practice entails the engagement of an independent drilling
contractor, who can do the drilling more effectively, efficiently and economically because of
experience. Drilling contracts may take the form of (i) footage rate contract (requiring installment
payment per foot of hole drilled until the required depth is reached), (ii) day rate contract
(requiring daily payment of specified amount respect of the number of feet drilled) or (iii) turnkey
contract (where the contractor is paid only after satisfactory drilling of well to the required depth and
other conditions specified in the contract). Presently, footage rate contracts are the most popular
although day rate contracts are also common, while turnkey contracts are less common.
Some of the major problems encountered in oil and gas drilling may include the following:
1. the excess of formation pressure which may lead to blowout which is dangerous to the
ecosystem. For example on 22 April 2010 estimated 550-900 kb of oil leaked into the sea in US
very significantly affecting local economic activities like fishing, farming and tourism. Similarly,
in 1982, a high profile blowout at Amoco Canada killed 2 workers and hundreds of cattle.
2. twisting off of part of drill string which may lead to the abandonment of oil well and the drilling
of another well;
3. collapse of part of the drilled hole may be experienced, leaving the pipe trapped in the depths;
and

28

4. the formation may exude hydrogen sulphide, which is a gas with a very foul odour, thereby
necessitating abandonment of well. For example In 2003, 243 people in China were killed, and 3
workers of Abu Dhabi Company operating at Shah Oilfield in Iran were killed by the toxic
hydrogen sulphide gas emitted from crude oil. The gas is heavier than air, and even at low
concentrations it can cause respiratory failure and brain damage.
2.2 Types of Oil and Gas Wells
There are different types of oil and gas wells and the drilling methods and logistics usually depend
on the type of well to be drilled. Eight types of oil and gas wells can be identified. These are:
(1) Wildcat (exploratory) well (an oil well that is drilled to establish the presence or otherwise of oil
and gas, which may result in proved reserves or dry hole);
(2) discovery well (this is a wildcat well in which hydrocarbons is discovered in commercial
quantity);
(3) appraisal well (this is a well that is drilled after successful exploratory drilling, to provide
information about the volume-customarily measured in acre-feet- and its commercial viability);
(4) development (production) well (this is a well that is drilled with a view to obtaining access to
proved reserved and to produce oil).
Other types of oil and gas wells include:
(5) deviated well (a well that is progressively digresses from the vertical due to inability to access the
site selected with a view to meeting the location that is most likely to yield oil);
(6) injection well (a well that is drilled to injecting subsurface water or gas for the purpose of using
secondary drilling methods;
(7) observation well (a well that is drilled in order to permit further survey and study of a reservoir
as production continues); and
(8) obligatory well (an exploratory well that is obligatorily drilled as part of the conditions for
granting a mineral licence).
However, it is important to note that the volume of oil-in-place can be estimated after determining
the (i) thickness the oil zone (also called the pay zone), (ii) the porosity and permeability.
This estimate will provide the basis for the desirability of further investment or the plugging or the
abandonment of the well. If indications show that further investment is justifiable because revenues
will exceeds the additional cost of completion, the operator would go ahead to complete the well.
Well completion refers to the preparations and installations made in a well in order to get it ready for
oil and gas production. Thus, at the completion of the drilling operations, the hole drilled is cased to
ensure that it does not collapse and that it does not flow to the surface or to other formations. The
flow of oil and gas to the surface is made possible with the help of reservoirs Bottom Hole Pressure
(BHP). However, if the flow of oil and gas is not possible due to low BHP, installation of artificial
pumps may be necessary. In order to control the flow at the surface, a number of valves, fittings,
choke and pressure gauges are mounted on the wellhead. A flow line is connected to the pressure
gauges through which the oil is evacuated to a storage and processing centre.
As a single well will not permit timely and economical extraction of oil, development wells will
have to be drilled, after the successful drilling of exploratory wells. Because the fluids from the wells
may contain oil, gas, water, sand and other impurities such as hydrogen sulphide, the crude oil must
have to be cleaned to remove all impurities before it is piped to the refinery or gas plants.
Equipments found in oil storage centre are test separators, production filters, tank batteries,
circulating pumps, gas metres, and salt water disposal pits, etc. Crude oil is sold or transmitted to
refineries and gas is piped to gas plant. BHP that enables oil and gas to flow to the surface
diminishes as the reservoir is depleted.
29

Recovery of hydrocarbons that occur by BHP or simple artificial lift is known as primary recovery.
When the oil can no longer flow to the surface due to diminishing BHP, more complex techniques
known as secondary and tertiary recovery methods may have to be applied to enhance recovery from
the reservoir oil. The enhancement techniques used may be broadly grouped in to two, namely
injection projects (which include water flooding, high pressure gas drive, enriched gas drive, etc)
and thermal processes (which include fire flooding and steam heating). In 2007,2008 and 2009
improved recovery increased oil volumes by 20, 37 and 86 million barrels worldwide, respectively.
In 2009, the largest addition was related to improved secondary recovery in Nigeria.
2.3 Classification of Costs in the Oil and Gas industry
In the oil and gas industry, costs are classified either by nature and function of the costs (namely (i)
acquisition cost, (ii) exploration and appraisal costs, (iii) development costs, (iii) production costs
and (iv) supporting facilities and equipments costs) or by the physical characteristics of the assets
acquired (namely (i) tangible and (ii) intangible costs).
Acquisition Costs: These are incurred to purchase, lease or otherwise acquire a property (whether
proved or unproved). Example includes the cost of signature or lease bonuses, options to purchase or
lease properties, brokerage, legal fees, etc.
Exploration and Appraisal Costs: These are cost incurred to prospect for oil, before oil reservoir is
developed. Examples include costs associated with geological, geophysical and other pre-drilling
costs, including remuneration of personnel involved. It also include costs of drilling, dry hole and
bottom hole pressure enhancement. They also include depreciation, amortization and allocated
operating costs of support equipment facilities.
Development Costs: These are costs incurred to gain access to proved reserves and provide
facilities for drilling, lifting, treating, gathering and storing oil and gas. They include depreciation
and allocated operating costs of support equipment facilities.
Production Costs: These are costs incurred in lifting, treating, gathering and storing oil and gas.
They include costs of personnel engaged in operation of wells and related equipment facilities, repair
and maintenance of production facilities, materials, supplies, insurance, services and fuel consumed
in such operations. They also include allocated operating costs of support equipment facilities, but
do not include DD&A of license acquisition, exploration and development costs and cost of
decommissioning.
Supporting Facilities and Equipment Costs: These are cost relating to trucks, drilling equipments,
workshops, warehouses, camps division and field offices. Usually, these facilities and equipment
serve one or more activity relation to acquisition, exploration, development and production. These
costs are therefore capitalized and apportioned to the different activities.
Tangible and Intangible Costs
Tangible costs are cost of assets, like machinery, equipment, vehicles, which have physical
properties (including the costs of labour to install them even though those costs do not result in a
physical asset). On the other hand, intangible cost is cost that result in assets that have no physical
properties, or assets that have physical properties but that cannot be salvaged at the end of an
operation e.g. cost of drilling paid to contractor, labour for clearing services such as acidizing,
fracturing and thermal processes.

30

2.4 Estimation and Valuation of Oil and Gas Reserves

Despite the large figure for property, plant and equipment that the balance sheet of an oil and
gas companies usually show the true value of an oil and gas company is its proved oil and gas
reserves in the ground. The assets may not be worth much without the reserves. Therefore, the value
of oil and gas reserves is critical for the evaluation of financial position and results of oil and gas
companys exploration and production activities.
Oil reserves can simply be defined as the value of oil and gas recoverable from oil-in-place.
Oil-in-place is defined as the oil and gas in the earth, the presence of which is confirmed by drilling.
It is an estimation of the original volume of hydrocarbons that occupied the reservoir before
production. The importance of proper understanding of reserves and reserve estimates includes the
following:
(i)
serves as a basis for financing or investment decision;
(ii)
serves as a basis for computing the depreciation, depletion, and amortization rates;
(iii) it is an important item of disclosure in annual reports and accounts (SAS 14);
(iv)
serves as a basis for managements estimate of internally generated cash flows and better
operational decisions; and
(v)
serves as a basis for determining cost ceiling (in companies using full cost method of
accounting) and finding cost (for all companies either using full cost and successful effort
method of accounting).
However, oil and gas reserves estimates are usually imprecise due to inherent uncertainties and
limited nature of information on which reserves estimation is based. Two or more petroleum
reservoir engineers, using the same data about a producing field may arrived at widely dissimilar
estimates of the reserves. Hence, the use of outside consultants by most large oil and gas companies
to carry our reserve audit with a view to adding credibility to estimates prepared internally. Usually,
the reliability of reserves estimation will increase after reservoir has been fully developed and the
field goes into production.
However, in developing estimates of reserves the following information is essential. These are:
(a) area and thickness of the productive zone;
(b) porosity of the reservoir rock;
(c) permeability of the reservoir rock to fluid;
(d) oil, gas and water saturation, i.e. the portion of the pore space that is filled with oil, gas and
water;
(e) physical characteristics of oil and gas, i.e. the shape and size of oil-bearing formation which
affects both porosity and permeability;
(f) depth of the producing formation;
(g) reservoir pressure and temperature;
(h) production history of the reservoir; and
(i) ownership of the oil and gas property.
After petroleum reservoir engineers have estimated reserve quantity, it must then be valued in
monetary terms. The following are the factors that may affect reserve valuation:
(i)
projected rate of inflation and expected future price changes;
(ii)
political stability of host countries;
(iii)
Macro economic conditions.
(iv)
Prospective changes in legislation and taxation.
(v)
Contractual obligations.
(vi)
Crude oil prices, especially OPEC Prices; and
31

(vii)

Discount rate and cost of capital

2.5 Classification of Reserves

Classifications of reserves are usually based on the professional judgments of petroleum reservoir
engineers and geologists arising from a range of geological and geophysical studies carried out. Oil
and gas reserves may be classified into (i) primary, (i) secondary and (iii) tertiary reserves.
Primary reserves are reserves that are recoverable using any method possible where the oil and gas
enters the well bore by the action of the natural reservoir pressure (BHP). Primary reserve may be
classified based on:
(i) degree of proof (comprising of proved, probable and possible reserves);
Proved reserve is further subdivided into proved developed and proved under-developed
reserves. Proved developed oil and gas reserves are reserves that can be recovered through
existing wells with existing equipments and operating methods. While, proved underdeveloped
reserves are oil and gas reserves that are expected to be recovered from new wells on undrilled
acreage or from existing wells where relatively major expenditure is required for completion.
Probable reserves are estimated quantities of commercially recoverable oil and gas reserves that
may be estimated or indicated to exist based on geological, geophysical, and engineering data.
Possible reserve are estimated quantities of commercially recoverable oil and gas reserves that
are less well defined than probable reserves and that may be estimated or inferred largely on the
basis of geological and geophysical evidence.
(ii) development status (comprising of developed and under-developed reserves); and based on
(iii) production status (comprising of producing and non-producing reserves).
However, secondary and tertiary reserves are reserves that are recoverable through secondary and
tertiary recovery methods, involving injection projects and thermal processes.
The world's reserve values by country are not publicly disclosed, but estimated reserve volumes are.
Table 2 summarizes the world's proved oil and gas reserves, production, and oil wells by country.
Over 92 percent of the world's proved oil and gas reserves are found in the 17 countries listed in
Table 2. The top ten countries have nearly 80 percent of the worlds oil and gas reserves and the
majority of the worlds current production. Sixty-four percent of the world's proved oil reserves are
in five Middle East countries, and the majority of the world's proved oil and gas reserves are in only
four countriesSaudi Arabia, Canada, Iran and Iraq.

32

Table 4: Summary of Top 17 World Reserve Data as at Dec.,2008

Reserve
Reserves
Production
Life
Country
109
109
106
years
bbl
m3
bbl/d
m3/d
Saudi Arabia
42.4
10.2
1,620
72
267
Canada
28.5
3.3
520
179
149
Iran
21.9
4
640
95
138
Iraq
115
18.3
2.1
330
150
Kuwait
104
16.5
2.6
410
110
United Arab Emirates
98
15.6
2.9
460
93
Venezuela
87
13.8
2.7
430
88
Russia
60
9.5
9.9
1,570
17
Libya
41
6.5
1.7
270
66
Nigeria
36
5.7
2.4
380
41
Kazakhstan
30
4.8
1.4
220
59
United States
21
3.3
7.5
1,190
8
China
16
2.5
3.9
620
11
Qatar
15
2.4
0.9
140
46
Algeria
12
1.9
2.2
350
15
Brazil
12
1.9
2.3
370
14
Mexico
12
1.9
3.5
560
9
Total Top 17 Reserves 1,243 197.4
63.5
10,080
54
Source: NNPC Newsletter, December 11, 2009

3. Arrangements, Agreements and Contracts in the Nigerian Petroleum Industry

The (i) high risk, technology and capital intensiveness of oil and gas operations often require that
negotiations are made between the host country and foreign oil company for hydrocarbon
exploitation, disposal, risk sharing and pooling of capital. Similarly, because of the (ii) international
politics of oil and gas, as well as, (iii) its strategic position in the economy of the producing countries
in particular and the world at large, most Government prefer to work out participation arrangements
with multinational oil and gas company rather than just overseeing the operations. The conditions
and term of the agreements result in operating agreements, with varied modus operandi among
countries.
3.1 Types of operating contracts in the petroleum industry
There are at least seven basic types of operating agreements in the international oil and gas industry.
These are (i) concession, (ii) joint venture, (iii) production sharing contract, (iv) service contract
with or without risk (v) indigenous contracts, (vi) direct exploration and (vii) hybrid contract.
3.1.1 Concession: In a concession agreement, a country grants to an oil company or a group of oil
companies the exclusive right to carry out certain types of petroleum operations within a given oil
area of its territory for a specified period of time for payment of royalties. This agreement, which
was type of agreement in many host nations, has the least advantages to the host government as it
relinquishes its sovereignty to operating oil company and its fiscal returns, state participation, and
training of nationals is at lowest level. As explained earlier, Shell DArey which was the first oil
company to discover oil in commercial quantity in Nigeria operated under a concession arrangement

33

and an exclusive exploration right. Others like Mobil, Gulf (now Chevron), Safrap (now Elf),
Tenneco and Amoseas (now Texaco) also operated under the concession agreement.
3.1.2 Joint Venture (JV): A JV is defined as a situation where one or more foreign oil companies
enter into agreement with the host government (through its agent like the NNPC) for joint
development of jointly held oil mining licenses and facilities. Each partner in the joint venture
contributes to the costs and shares the benefits or losses of the operation, in accordance with its
proportionate equity interest in the venture. One company is designated as the operator and is
responsible for the day-today running of the venture, and all budgets, work programmes and any
contract awarded must, however, be agreed by all parties. Joint ventures are the agreements in place
for shallow water and onshore exploration and for downstream ventures. Production from JV
accounts for approximately 95 percent of the Nigerias crude oil production. The largest JV operated
by Shell Petroleum Development Company of Nigeria Ltd and NNPC, produces nearly half of
Nigerias crude oil, with average daily production of approximately 1.1 million bpd.
In JV arrangement, the government (NNPC) is a non-operating partner with the oil company as the
operator of the concessions. The Government contributes proportionately to the costs of carrying out
the oil and gas operating and lifts its equity share of the crude oil won. In addition, Memorandum of
Understanding (MOU), governs the manner in which revenues from the venture are allocated
between the partners, including payment of taxes, royalties and industry margin. The income derived
from the operations is also shared in proportion to the equity interests of the parties to the JV, with
each party bearing the cost of its royalty and tax obligations in the same proportion. Allocations are
also made from the revenue to take care of operating cost.
Some of the constraints associated with JV are namely (i) poor funding and consequential loss in
revenue; (ii) allegations of gold plating of operating costs by the non-operators of the venture
leading to mutual suspicious; and (iii) pressure on the operator to meet incessant demands by oil
producing communities.
However, the emergence of offshore oil and gas operations in Nigeria has witnessed a shift from
JVA regimes to Production Sharing Contracts (PSCs). This shift is attributed to a number of factors
ranging from the complexity of operations in the offshore terrain to (which makes regulations under
the JVA more difficult); to dwindling resources of the country (which makes funding under JVAs
precarious for the government).

3.1.3 Production Sharing Contract (PSC): Production sharing contract (PSC) on the other hand,
focuses on the sharing of the output of oil and gas operations in agreed proportions between the Oil
company, as a contractor to the Government, and the NNPC as the representative of government
interests in the venture. This form of contract which originates from Indonesian in 1996, was
modeled along the lines of share cropping in agriculture, where the landlord grants a farmer the
rights to grow crops on his land and shares the proceeds with the farmer in agreed proportions after
the harvests. This type of agreement was first signed in Nigeria with Ashland oil in June 1973. From
the proceeds, up to 40 percent was set aside to amortize the companys investment and pay royalties
(cost oil), and about 55 percent was set aside for the payment of Petroleum Profits Tax (PPT) (Tax
oil). The remaining proceeds of 5 percent called profit oil are then shared between the Government
and the company in crude oil in a ratio of 65:35 respectively. There was a proviso for the
Governments percentage share of profit oil to increase to 70 percent when production reaches
50,000 or more barrels per day. A barrel is a measure representing 35 Imperial gallons or 42 US
gallons. Companies engage in PSC in Nigeria include Statoil, Snepco, Elf, Model, Chevron etc.
34

In PSC, host government (through its agent) engages a competent contractor to carry out petroleum
operations Governments wholly owned acreage (oil block). The contractor undertakes the initial
exploration risks and recovers his costs only when oil is discovered in commercial quantities. If no
oil is found, the company receives no compensation. Under the PSC, royalty oil is a first-charge item
assigned to the government free of any exploration, development and production costs. Thereafter,
the contractor has the full right to only cost oil (i.e. oil to guarantee return on investment). He can
also dispose of the tax oil (oil to defray tax obligations) on Governments behalf. The residual oil is
the profit oil, if any, and the company shares with the concession holder in some agreed percentage.
The main law which regulates the operation of PSCs in Nigeria is the deep Offshore and Inland
Basin Product Sharing contracts Act N0.9, LFN, 1999. This law provides for payment of a flat rate
of 50% tax on petroleum profits by PSC operators, and sets different royalty regimes, depending on
the water depth in which the operation is carried out, ranging from 12% for water depths of 200500m, to 10% for water depths in excess of 1,000m. PSCs in inland basins attract a flat rate of 10%.
Some of the advantages of PSC include relative flexibility in the management of the operations, no
financial burden on the host country, payment to the contractor is made in oil after a commercial
find, reliance on the technical know-how and experience of the contractor oil company, etc. some of
its drawbacks include risky nature of operations due to non-transferability of costs from now
acreage to another when no oil is found and the allegations of gold plaiting costs by the host
country.
3.1.4 Service Contract with or without Risk: Service contract (SC) is an operating arrangement
similar to PSC whereby service contractor provides all the funds for exploration, development and
production activities, while the title to the oil is owned by the NNPC. Like in PSC, the initial
duration of the contract is usually 5 to 6 years and the contract terminates automatically of no
commercial discovery is made. In the event of such termination both the NNPC and the contractor
owe each other no further obligation with respect to the contract. If exploration is successful and
production commences, the contractors Exploration and development (E&D) costs are recovered in
accordance with the conditions stipulated in the contract. Usually the E&D costs are paid
installmentally over an agreed period of time, usually 5 years. Unlike PSC, the contractor has no
little to any of the portion of the crude oil produce, but may be allowed the option to be given
reimbursement and remuneration in oil as an additional incentive for the risk taking. Similar, the
contractor has the first option to purchase certain fixed quantities of crude oil produced from Sc
areas. At a point in time there was only one SC in place in Nigeria between the NNPC and Agip
Energy and natural resources, which covers only one oil mining lease.
Service Contract without risk is a contract agreement whereby an oil company carries out
exploration, development and production activities on behalf of and on account of the national oil
company, with the state bearing all risks and the exclusive right to all resources discovered. While,
service contract with risk is similar to service contract without risk, except that if no discovery is
made, the contractor is negated and the oil company loses all its investments. Similarly, if oil is
located, the contractor oil company receives monetary compensation, usually payment in crude oil.
3.1.5 Indigenous Contracts: Indigenous Contract is an arrangement whereby concessions are
owned by the NNPC but allocated to indigenous companies to operate. The NNPC regulate and
approve technical aspects of the operations and make no financial contribution to E&D activities.
Unlike JV or PSC where the NNPC is entitled to crude oil in one form or the other, the indigenous
companies only pay royalties and petroleum profits tax to the Government. It is a step taken by the
Government to encourage indigenous participation in the E&P of oil and gas in the country. There
are an upwards of 38 companies that are engage in this arrangement, among which are Summit oil,
35

consolidated oil, General, Sufra, Union dubri and Amni Petroleum development Company. Some of
the companies have made commercial discoveries and are already producing oil, while others are at
various stages of exploration and production.
3.1.6 NNPCs Direct Exploration: The NNPC through its subsidiaries (NAPIMS and NPDC) carry
out all operations associated with the search, development and production of oil and gas resources in
Nigeria.
3.1.7 Hybrid Agreement: It is usually common to find a hybrid agreement that combine elements
of different agreements. For example NNPC worked out an alternative funding arrangement with the
oil companies known as PSC hybrid NNPC carry arrangement, due to the inability of the Nigerian
Government to fund JVAs as a result of dwindling revenue. In this arrangement, which is a hybrid of
JV and PSC, the oil companies in the JV carry the NNP share of capital costs while the NNPC
continues to be cash called for operating expenses.
3.2 Financial and Fiscal Monitoring Mechanisms in the petroleum Industry
Monitoring mechanism can be defined as the procedures and controls (both internal and external) put
in place by the Government with the support of the operating partner with a view to ensuring that
exploration, development and production activities are hitch-free and are carried out efficiently and
effectively in the upstream sector. The monitoring mechanisms for the various types of contract
arrangements (i.e. JV, PSC and SC) are similar in nature and can be grouped into three broad
categories, as follows:
(i)Administrative Monitoring Mechanism (AMM);
(ii)Technical Monitoring Mechanism (TMM); and
(iii)Financial and Fiscal Monitoring Mechanism (F&FMM)
Administrative monitoring mechanism is mainly about ensuring due process, mutually beneficial
negotiations, appropriateness of contractual arrangement and appointment of the right contractor.
Technical monitoring mechanisms are meant to ensure that the production and development of oil is
done efficiently and is carried out in a hitch-free operating upstream sector. While financial and
fiscal monitoring mechanisms are instituted to ensure financial and fiscal accountability of oil and
gas operations, through the following measures:
(i)
Yearly Budget Preparation and Approval: Yearly budgets are prepared and submitted
for scrutiny and approval of the management committee, which is made up of
representatives of the operators, the Government and other parties that are involved,
based on the participating agreement. The committee is responsible for betting the
budget, recommending for approval (after amendments if any suggested by the
committee), providing supervisory control and monitoring on the implementation of the
budget and comparing the actual budget results against the standard at the end of the
budget period. While the NNPC appoint the committees chairman, the operator appoints
the secretary. The committee is responsible for creating sub-committees to take care of
finance, budget monitoring and other similar issues.
(ii)
Book-keeping, Financial Reports and Returns: The operator or contractor is
responsible for keeping proper books of accounts in line with modern petroleum industry
accounting practices and procedures and reports such information in accordance with
stipulated format of reporting in the industry. Members of the management committee
have the right to access such books and accounts which must be kept at the registered
office of the contractor in Nigeria, along with the statement of account in the stipulated
format, within 60 days from the end of each month and each quarter and 90 days from the
end of the financial year. The operator must not omit or amend any item of the budget
36

without a written approval of the management committee and its relevant subcommittee(s).
(iii) Internal Audit: The operator is obligated to establish an effective system of internal audit
base on well establish internal control system in respect of operations. Members of the
management committee have right of access to all the internal audit reports and replies to
audit queries raised by the internal auditor in respect of the operations.
(iv) External or Statutory Audit: The operators financial statements with respect to the
operations must be audited by the operators statutory auditors as examined and verified
by each of the non operators appointed auditors.
(v) Non-Operators Right of Audit: A non-operator may carry out or course to be carried out,
periodic audit of the books of accounts and all accounting records relating to the operation.
Any discrepancies in the account must be queried within 36 days from the date of receipt of
the account by the non-operator. This time limit does not apply in the case of fraud. The
NNPC today carry out value for money audit with a view to ascertaining the effectiveness,
economical and efficiency of all JV operations in which it is a partner.
(vi) Cost Oil Approval: In the case of PSC petroleum won from operation are classified into
royalty oil, cost oil, equity oil, tax oil and profit oil. While profit oil stipulates the
percentage of allocation of profit oil base on monthly average production, the contractor
cannot recover any cost oil unless there is prior approval by the NNPC.
(vii) Over Expenditure of Work Programme and Budget: When it is necessary to carry out
agreed work programme, an operator may during any calendar year over-expend any
budget line item by an amount not exceeding:
(a) 10% of the amount budgeted;
(b) In case of JV operation, either 10% of the amount budgeted or 2 million US Dollars,
whichever is less.
However, the foregoing shall not authorize the operator to over-expend the total amount of the
budget for any calendar year by more than 5%, without informing the other parties to obtain
approval, as soon as the over-expenditure is foreseen by the operator.
4. Accounting Principles and Standards in the Oil and Gas industry
4.1 Petroleum Accounting and Generally Accepted Accounting Principles (GAAPs)
Accounting principles could be defined as those rules of action or conduct, which are adopted by the
Accountants universally while recording accounting transactions. IAS I defined Accounting
principles as a body of doctrines commonly associated with theory and procedures of accounting,
serving as an explanation of current practices and as a guide for selection of conventions or
procedures where alternatives exist. The principles that impact most on oil and gas accounting
practices can be classified into two categories, namely:
a) accounting concepts; and
b) accounting conventions.
4.1.1 Accounting Concepts
This refers to those basic assumptions or conditions upon which the science of Accounting is based.
They are usually rules and conventions that lay down the way in which activities of a business are
recorded. These are:
1) Entity Concept: According to the standard, every economic entity regardless of its legal
form of existence is treated as a separate entity from parties having propriety or economic
interest in it. In Accounting, business is considered to be a separate entity from the
proprietor(s). This concept is applicable to all forms of business organizations, including the
oil and gas companies.
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2) Going-Concern Concept: This is the assumption that a business will continue to operate
indefinitely into the foreseeable future; that is, the business is not expected to liquidate in the
near future. The economic environment of oil and gas industry is highly political and the risk
of nationalization is high. Also, companies may be nearing the expiration of their lease
periods without any hope for renewal of the lease or obtaining another lease. Such events
must be taken into account in determining their going concern status.
3) Periodicity Concept: According to this concept, the life of the business should be divided
into appropriate segments for the purpose of determining its financial performance. In
accounting, such a segment or time interval is called accounting period. It is usually a
period of twelve months, which can start any time and end any time, without necessarily
required to be in line of a calendar year, which must start January and end 31st December. In
the oil and gas industry, the financial year is line with government fiscal year which must
starts January 1 and ends December 31st and companies do not mostly have the discretion to
vary it.
4) Realization Concept: This concept states that revenue is recognized when a sale is made.
Sale is considered complete at the point when the property in the goods passes to the buyer
and he becomes legally liable to pay. The specific application of this principle is that in the
petroleum industry, crude oil is deemed sold as produced and therefore revenue may be
recognized on crude oil produced. However, on the basis of this principle, revenue cannot be
recognized on oil and gas reserves.
5) Matching Concept: According to this concept, the earned revenue and all the incurred costs
that generate that revenue must be matched and reported for the period with a view to
determining the net financial performance of a business. The term matching means
appropriate association of related revenues and expenses. This concept applied in oil and gas
accounting more especially in accounting for impairment and in computation of depreciation,
depletion and amortization.
6) Historical Cost Concept: This concept states that the basis for initial accounting recognition
of all assets acquisitions, services rendered or received, expenses incurred, creditors and
owners interests is the actual cost for the transaction(s). This principle is greatly applied in
computing depreciation, depletion and amortization, allowances for impairments, and
recognition of gain or loss on conveyances. An extension of this principle in oil and gas
accounting is the ceiling test concept, which stipulates that the total capitalised cost in the oil
and gas company books should not exceed the estimated value of reserves at the reporting
date, since the oil reserves are the most important economic assets own by the company. The
whole essence is to ensure that cots are not capitalized in the books that are not backed up by
economic assets.
7) Money Measurement: Accounting is only concern with those activities that can be
measured in money terms with fair degree of accuracy and objectivity. The peculiar nature of
oil and gas accounting is that its major economic asset, oil and gas reserves are not reflected
in the balance sheet, yet the final accounts provide a true and fair representation of the
financial results.
8) Dual Aspect Concept: This states that there are two aspects of accounting; one represented
by the resources owned by a business and the other, by the claim against them. Double entry
is therefore meant to uphold this concept. This concept is applicable to all forms of business
organizations, including the oil and gas companies.
4.1.2 Accounting Conventions
These are customs or traditions, which guide the Accountant while preparing the accounting
statements. In other words, accounting conventions are approaches to the application of accounting
concepts. These include:
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1) Conservatism/Prudence: This states that greater care in the recognition of profit should be
exercised whilst all known expenses, even those that cannot be accurately calculated with fair
degree of accuracy and objectivity should be adequately provided for by way of provision.
Prudence runs through the whole gamut oil and gas accounting and should be effectively
applied because oil operations are particularly more risky and has higher potentials for loss.
Prudence in oil and gas accounting requires that reserves should he estimated objectively
and only the latest reserve estimates should be used. It is also prudent to recognize
impairment in the cost of unproved properties and ensure that only valuable costs are
retained in the books.
2) Materiality: The principle holds that only items of material values are accorded their strict
accounting treatment. This means that perfect accounting treatment may not be applied to
transactions that are of insignificant value both in amount, intention and effect on the user. In
this respect, a purely capital item may be expensed if it is not material. This convention
applies to oil and gas accounting.
3) Consistency Concept: This concept holds that when an enterprise has adopted an accounting
method of treating transactions, it should continue to use that method in subsequent periods
so that comparison of accounting figures overtime could be made possible. Oil and gas
accounting principles accommodate different practices based on defined assumptions,
though the consistency principle states that once an oil company adopts FC or SE, it should
stick to the method, and disclosure is required when change in an accounting method
becomes inevitable, and the consequences of such change on the financial statements should
also be disclosed.
4) Substance over Form: This convention states that business transaction should be accounted
for and presented in accordance with their substance and financial reality and not merely with
their legal form. This convention applies in the oil and gas industry.
5) Objectivity/Fairness: According to this convention, data presented on the financial
statements should be supported by verifiable evidence and demand the independence of
judgment on the part of the Accountant preparing the financial statements. Similarly, it is
required that accounting reports should be prepared not to favour any group or segment of
society. Because of its peculiarities, financial statements of oil and gas companies require
far more disclosures than that of other industries. These disclosures are expected to
corroborate the statements, provide supporting information and provide details for the
numbers on the financial statements.
4.2 Method of Accounting in the Oil and Gas Industry
Two methods of accounting are now generally accepted for the oil and gas industry. These are
Successful Efforts Method (SEM) and Full Cost Method (FCM). SEM is the method where all
exploration costs (namely acreage cost, costs of geological and geophysical surveys, cost of dry
holes etc) are charged to expenses, while those that lead to discovery of reserves are capitalized. It
gives due cognizance to the accounting concept of conservatism/prudence. On the other hand, the
FCM is a method in which all acquisition, exploration and development costs are capitalized
whether they lead to the discovery of oil reserves or not. Proponents of FCM are of the view that
finding commercially producible hydrocarbons is an overall objective that should not be evaluated
on well by well basis, as such all costs incurred are part of the cost of whatever reserves are found,
because the good must support the bad. While advocates of successful efforts method held that any
drilling effort that proves to be unsuccessful is a loss that must be expense immediately.

39

Prior to 1950, most oil and gas companies used some form of SEM to account for oil and gas
exploration, development and production. Generally, the practice was to expense dry hole costs and
intangible drilling costs on productive wells and capitalizes the costs of property acquisition, wells
and equipment. These capitalized costs are amortized if reverse were found or charged to expense if
reserve were not discovered. However, with emergence of more sophisticated exploration
technology in the 1960s a new method of accounting oil and gas activities know as full cost
method, in which all cost incurred in exploration and development of oil and gas reserves were
capitalized in a cost centre regardless of whether reserves were discovered or not.
While controversy raged, practical application of each of the two methods varied from company to
company. Some users of SEM capitalized all geological and geographical exploration costs, others
expense them. Similarly, while some users expense dry exploration wells, others capitalize dry
development wells, etc. In an attempt to ensure a decision-relevant financial reporting, the FASB
issue an explore draft in 1977 titled: Financial Accounting and Reporting by Oil and Gas Producing
Companies: which indicated the need for all companies to use the SEM in their reports. However,
the FASBs effort was scuttled by US SEC and other government agencies; and their argument were
simply on the fact that; not until the viability of the SEM over the FCM is proved, the call for
adopting the SEM was uncalled for.
Therefore, oil and gas reporting practice has been a source of concern to stakeholders since the
1970s and the recent accounting scandals of the 1990s have once again brought the issue into the
limelight. One of the major issues bedeviling the industry is the fact that the conventional cost
accounting does not cater for the information needs of various stakeholders. The non appearance of
the most valuable assets i.e. oil reserves, on oil and gas companies financial reports is unique to the
industry. Consequently, since such assets constitute the basis for determining the companys
performance and the fact that the cost of such assets are accounted for, differently by different
companies puts the value-relevance of the reports into question. The two methods used to account
for costs in the industry result to a number of inconsistencies: thus ensued the debate on which of the
methods is most suitable to be used by the oil and gas companies.
Unlike many other industries, costs here are classified based on the nature of operations rather than
the nature of a particular cost itself. As such the costs that characterized the operations of the
industry are basically incurred at four stages which include (i) the costs incurred in acquiring the
mineral interest in property (leasing), (ii) exploring the property (drilling), (iii) developing the
proved reserves, and (iv) producing (lifting) the oil and gas.
However, the fundamental accounting issue lies at the exploration stage, i.e. whether to capitalize or
expense the exploration cost which do not result to proved reserves. Since all other costs are treated
alike by all companies, companies that capitalize only the exploration cost which result to proved
reserves are called SE companies, whereas companies that capitalize all exploration costs, even
those that do not result to proved reserves, are called FC companies. This is obviously a source of
concern, since the two methods used to account for exploration costs differ significantly.
Consequently, accounting standard setters are faced with a serious challenge that bedeviled the
profession for decades. The choice of either of the methods generated a heated debate amongst
stakeholders; including the following;
1.
Economic Perspective
The proponent of the FCM argued that because the FC companies are smaller than the SE
companies, switching from SEM would reduce their reported earning; increase the possibility for
them to default on their loan servicing; making it difficult for them to assess capital which will
40

reduce the companies competitiveness. Also, they contend that the FC companies are most
aggressive in exploration activities. Hence, the method offers higher value-relevance than the SEM.
On the other hand, the need for the adoption of the SEM is based on the fact that the method better
reflects the realities (risk and failures) associated with the industrys operations. Hence, the method
would eliminate the inconsistencies bedeviling the industry, offer better means for comparison
among the oil and gas companies, and provide reliable economic information to all stakeholders.
2.
Accounting Perspective
SEM can be justified based on its adherence to matching and conservatism concepts hence, the
debate seems to carry weight on its side compared to FCM which does not adhere to any of the two
concepts. Accounting principles are not adhered to in the case of FCM. FC companies have
flagrantly ignored the fundamental accounting principles that ought to be observed by all and sundry
by matching cost with an income that does not exist. More so, from the asset point of view, asset
capitalization under the FC methods is flawed, because the so-called asset capitalized does not
possess the features of an asset i.e. there is no future benefit from it; because it (the so-called asset)
does not even exist. Hence, the fundamental accounting concepts have been, temporarily, discarded
by companies in an attempts to gain investors confidence. Overall, since the controversy centres on
either capitalizing or expensing cost and based on the fact that expenditure ought to be capitalized
only if it meet the definition of an asset; then the FCM is fundamentally flawed. This is because
companies reports should not purport to show the companies value, but rather provide stakeholders
with all the necessary information for them to determine the companys performance over a specific
period of time and the value of the companies at a particular point in time.
3.
Political Perspective
In an attempt to ensure a decision-relevant financial reporting, FASB issued an exposure Draft (ED)
in 1977, titled: Financial Accounting and Reporting by Oil and Gas Producing Companies: where
indicated the need for all companies to use the SEM in their reports. However, the FASBs effort
was scuttled by US SEC and other government agencies. Politics and lobbying played a big role in
this decision, as different stakeholders responded to the ED in the way it would serve their interest
the most. Although, it is difficult to attribute the decision of SEC, for overriding the outcome of the
ED, as a single factor, but it is aptly argued that the problem was a consequence of the political clout
of oil and gas producers and dissention among accounting standard setters. Indeed, oil and gas
industry operations have been influenced by politicking for long and this has been one of the factors
for failure to agree on a single acceptable method of accounting in the industry.
4.3 Reserve Recognition Accounting (RRA)
Some concerned accounting practitioners were against the recommendation of FAS 19, which allow
companies to use either FCM or SEM. This made SEC to propose the development of a new method
of accounting for oil and gas known as RRA, with a view to remedy, the inherent weakness of SEM
and FCM. Under the RRA, companies would be allowed to recognize the value of proved oil and gas
reserves as assets and changes in such reserve values as earnings in the financial statement. Just like
FCM or SEM, RRA came under severe criticisms, because it ignore the fact that measurement of oil
and gas reserves are imprecise and merely an estimate, and the projected revenue and cost may not
materialize. Similarly, RRA is criticized for ignoring the realization concept, thereby recognizing
revenue before receiving it.
4.5
Development of Accounting Standard in the Oil and Gas Industry
An accounting standard is a statement issued by the appropriate standard-setting body locally or
internationally on a specific area or topic in financial accounting, the acceptance/application of
which is mandatory for preparers and users of financial statements. Criticisms of FCM and SEM and
41

RRA, triggered SEC to search for solution, thus culminating in FAS 69 by FASB in November,
1982. Similarly, the UK Oil industry Accounting Committee published four statements of
recommended practice (SOR) to be used by oil and gas companies. These statements are: (1)
Disclosures of oil and gas E & P activities; (2) accounting for oil and gas E & D activities (3)
accounting for abandonment costs; and (4) accounting for various financing revenue and other
transactions of oil and gas E & P companies.
The Nigeria Accounting Standard Board (NASB) followed suit by issuing SAS 14 (Accounting in
the Petroleum Industry: Upstream Activities) through Chief R.U. Uches Committee. The standard
came into effect from January 1, 1994. Similarly, through the effort of the same committee, NASB
issue SAS 17 (Accounting in the Petroleum Industry: Downstream Activities) which came into
effect on January 1, 1998.
The standards which are applicable in Nigeria are Statement of Accounting Standards (SAS) issued
by the Nigerian Accounting Standards Board (NASB), International Accounting Standards (IAS)
issued by the International Accounting Standards Committee (IASC) and the International Financial
Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB). All the
standards, IAS, IFRS and SAS are applicable in Nigeria except that if an IAS/IFRS is inconsistent
with an SAS, the IAS/IFRS would be inapplicable to the extent of the inconsistency. This implies
that on any matter on which an IAS/IFRS and an SAS make conflicting pronouncements, the SAS
shall supersede the IAS/IFRS in Nigeria. However, with effect from first January 2012, when
Nigeria adopts IFRS in financial reporting, the reverse is the case. In other words, with effect from
first January, 2012, IAS/IFRS will be adopted in Nigeria, and SAS will only be applicable where no
IAS or IFRS is issued on the same item. Sequel to this, SAS 14 and 17 are still applicable in Nigeria.
4.5.1 Required Practice and Disclosure by SAS 14
1. Method of accounting for cost incurred and the manner of disposing capitalized costs.
2. Policy on accounting for restoration and total amount relating to each.
3. Method of accounting use either FCM or SEM, which should be consistently applied and
disclosed.
4. Cost should be classified by nature and function of cost element e.g. mineral interest in
proved and unproved properties, wells and related equipment and facilities, wells and
equipment in progress etc.
5. For FC companies: (i) initial costs incurred relating to mineral rights acquisition, exploration,
appraisal and development activities should be capitalized; (ii) all capitalized costs (on
country-wide basis) are to be depreciated on unit of production basis, using proved reserves;
(iii) ceiling tests should be conducted (using discounted values for revenue, costs, taxes and
future development costs) at least annually at balance sheet date, on a country-wide basis,
using proved reserves and price ruling as at the date of the balance sheet; (iv) where accounts
are prepared in US Dollars cash flows shall be discounted at 10%, otherwise if Naira is used,
the CBN rediscount rate should be used; (v) if net discounted revenue is lower than the
capitalized costs, the difference should be written off.
6. For SE companies: (i) initial costs incurred prior to acquisition of mineral rights not
specifically directed to an identifiable structure should be expensed in the period they are
incurred; (ii) all costs incurred relating to mineral rights acquisition, exploration, appraisal
and development activities should be capitalized initially on the basis of wells, fields or
exploration cost centres, pending determination and written off later if the well is dry; (iii)
maximum of 3 years in offshore and 2 years in onshore are allowed as retention period for
further appraisal cost pending determination; (iv) capitalized costs should be amortized over
the remaining life of the licence and the balance should be reviewed annually for impairment
42

on wells basis, and any impairment should be written off; (v) drilling costs are to be
amortized using unit-of-production basis using proved developed reserves.
7. Cost of providing amenities for communities in areas of operation should be written off as
incurred.
8. Treatment of carrying interest and amount of carried expenditure to date.
9. Treatment of farmouts and similar arrangements.
10. Treatment of unitization and redetermination arrangements.
11. Treatment of joint venture
12. Accounting for over-lifts and under-lifts
13. Provision for restoration and abandonment cost
14. Recognition of gains or losses under conveyances/surrender/sold of unproved property.
15. Information on proved oil and gas reserve quantity.
16. Disclosure of standardize measure of discounting future net cash flows relating to proved oil
and gas reserves.
4.5.2 Required Practice and Disclosure by SAS17
The Accounting Standard comprises paragraph 44-59 of this statement covers the provisions as
follows:
Accounting policies
44. All companies engaged in downstream activities in the petroleum industries shall state in their
financial statement all significant accounting policies adopted in the preparation of those statements.
45. The accounting policies should be prominently disclosed under one caption rather than as notes
to individual items in the financial statements.
Refining and petrochemicals operations
Catalysts
46. Costs of short life catalyst should be expensed in the year in which they are incurred while costs
of long life catalysts should be capitalised and written off over the life of the refinery. Where long
life catalysts are generated, the costs of regeneration should be capitalised and amortised over the
life of regeneration.
Turn-Around Maintenance
47. Turn-around maintenance costs should be capitalised and amortised over the expected period
before the next turn around maintenance will be due.
Stand-by Equipment
48. Stand-by Equipments should be depreciated over the expected useful life of similar equipment in
use.
Depreciation of plants and Equipment
49. The costs of refining or petrochemicals plants and equipments should be depreciated on a
straight line basis over the useful life of the assets or, if operating at normal levels of production, on
the basis of expected throughput. The method used should be disclosed and consistently applied.
Debottlenecking, Major Plant Rehabilitation and Replacement of Major Components
50. Where major plant rehabilitation, debottlenecking or replacement of major components result in
a significant and identifiable increase in output or betterment of the plant, the cost should be
capitalised and amortised over the period over which the benefits is expected to last. In any other
case, it should be expensed as incurred.
43

Marketing and Distribution Operations

Bridging Costs Claims
51. Bridging costs which are recoverable from government through NNPC should be set up as
claims receivable. Where they remain outstanding for an unreasonable length of time, adequate
provision should be made for them. Claims not recovered within two years should be fully provided
for.
ATK Overbilling Claims
52. ATK overbilling claims should be set up as a receivable. Where they remain unpaid for an
unreasonable length of time, they should be provided for claims not recovered within two years
should be fully provided for.
Liquefied Natural Gas Operation Take or Pay Contracts
53. Where a purchaser is unable to take his entitlement under a take or pay contract, with a right of
make-up, the purchaser should treat the amount paid as receivable. Conversely, the supplier should
treat the advance received as deferred revenue. The deferred revenue should be recognized when the
makeup right is exercised by the purchaser.
54. Where a supplier is unable to deliver the quantity contracted, the amount received from the
purchaser should be treated as a liability by the supplier while the purchaser should treat the amount
paid as prepayment.
Disclosures
55. In addition to the disclosures requirements of SAS 2 Information to be Disclosed in Financial
Statements, companies operating in the downstream sector of the petroleum industry should disclose
the following the following as they relate to their activities;
(a) Refining and Petrochemical Companies
(i) Processing fees from third parties
(ii) Any amount of turn-around maintenance capitalized and or expensed split into material costs
and lab our costs and where capitalized the rate of amortization
(iii) Debottlenecking, major plants rehabilitation and replacement of major components costs
incurred, capitalized or expensed and, where capitalized, the rate of amortization
(iv) The cost of research and developments
(v) Basis of valuation of products and intermediates
(vi) For an integrated plant, revenue earned for each class of activities
(b) Marketing and Distribution Companies
(i) Bridging claims and related provision made
(ii) ATK overbilling claims and related provision made.
(c) Liquefied Natural Gas Companies
Details of Take or Pay contracts not yet fulfilled and the related deferred revenue or

prepayment.

Packaging and Non-core Businesses

56. The operating results of packaging and other non-core businesses owned by companies operating
in the downstream sector of the petroleum industry should be separately disclosed.
Transfer Pricing
57. The transfer pricing methods adopted should be disclosed.

44

58. The requirements of this standard are complementary to any accounting and disclosure
requirements of the companies and Allied Matters Decree, 1990 and relevant laws and
regulations
5.0 Procedures in Oil and Gas Accounting
5.1 Impact of Order of Drilling on Petroleum Accounting Methods
There are two methods of accounting used in the oil and gas industry. These are SEM and FCM. The
SEM and FCM of accounting give significantly different results based on purely chance factors like
the order or chronology of successful and unsuccessful wells. Assuming that, a company in an
attempt to develop an oil reservoir, drills a total of four wells. The first two wells (A and B) are
successful while the last two wells (C and D) are unsuccessful. Under the SEM, the four wells will
be capitalized as wells C and D are now development wells. The income statement will show a
buoyant picture. However, if the first two wells drilled are unsuccessful and the last two wells are
successful, the cost of wells A & B will be charged to expense while the cost of wells C & D will be
capitalized. Thus, merely changing the order in which wells are drilled will result in a vast difference
in the financial statements. With increased exploration drilling, net income drops under the SEM
when compared to the full cost accounting method. When there is an increased rate of discovery,
that is, a greater percentage of successful wells rather than dry holes, this result in increasing net
income under the SEM as fewer dry holes are written off. However, all these have no effect on FCM
companies.
5.2 Similarities and Differences between SEM and FCM
Two of the very few similarities between the two methods are in the treatment of development costs
and production costs. Development costs in both cases are capitalized whether successful or not
while production costs are expensed.
Table 5: Comparison between SEM and FCM and Compliance with GAAPs
Basis of
S/No. Comparison
1 Presenting a true
and fair view of the
result
of
the
operations of the
business.
2 Return on assets

Share values

Investment
Lenders.

Successful Efforts Method

As all exploratory costs that are
Successful are charged to expense,
financial statements present a true
and fair view of the result of
operations.
The accounting rate of return of the
business is higher as only
productive assets are capitalized.

Full Cost Method

Capitalizing the monetary values of
unsuccessful exploration costs impair
the true and fair view of the financial
statements of the company.

The accounting rate of return of the

business is lower because both
productive and non-productive assets
are capitalized. This may result in
takeover bids.
The share value may be higher The low rate of return may adversely
because the accounting rate of affect the share value.
return is higher.
and Net profit figures are generally Financial statements are more stable
lower and fluctuate drastically thereby attracting investors and
especially in years where huge write lenders into the business.
offs are made, This discourages
investors
and
lenders
from
providing funds for the business.

45

Basis of
S/No. Comparison
Successful Efforts Method
5 Survival of the new New
entrants
and
growing
entrants and growing companies cannot afford the huge
companies.
write offs of the exploration losses
of initial years and their corporate
survival is threatened.
6 Production
of Information on the performance of
information
for individual wells is more readily
managerial decision available to support managerial
making.
decision making.
7 Performance
Enables the performance of
evaluation
of managers to be evaluated.
managers
8 Comparison
of Because of the erratic movement of
financial statements. the net profit results, meaningful
comparison of the financial
performance over years is impaired.
9 Dividend decisions
Since all losses are recognized
before the net profit results are
arrived at, dividend decisions are
more prudent.
10

Compliance
GAAPs

with

This method is more in accord

With the prudence and matching
concepts of accounting.
11 Record keeping and Relatively simple to operate and
associated costs.
record keeping is less expensive as
only one set of records are kept.

12
13

Ceiling Test
Ceiling test is not mandatory.
Exploration
and Potential effect-of writing off dry
drilling activities
hole
expenses
may
affect
exploration and drilling activities.

Full Cost Method

New and growing companies can
thrive better under this method
because most of costs incurred are
capitalized.
Information on individual wells is
concealed in a country pool. Costs of
inefficiencies are therefore not easily
identified for managerial action.
Managerial performances cannot be
accurately determined as the costs of
inefficiencies are capitalized.
Because results are more stable,
performance
comparisons
are
enhanced.
Exploration losses not written off
may cause published profits to be
overstated, which, may lead to
dividends being declared on them.
The enterprise may be de-capitalized.
Full cost method does not strictly
accord with the accounting concepts
of prudence and matching.
Method is complicated, especially
the calculation of ceiling tests.
Record keeping is more expensive as
memorandum records have to be
maintained in order to provide
information for each well.
Ceiling test is mandatory.
Potential effect on exploration and
drilling activities is minimal as dry
holes are not charged to expenses in
the income statement.

Figure VI and VII give the accounting procedure of FCM and SEM.

46

Figure VII: Full Cost Accounting for Costs

47

Figure VIII: Successful Efforts Accounting for Costs

48

5.3 Differences in Balance Sheet and Profit & Loss Account of FCM and SEM
FCM
SEM
Balance Sheet
(Capitalized amounts)
Geological and geophysical costs
xx
--Carrying costs and overhead
xx
--Surrendered and impaired leases
xx
--Unimpaired leases
xx
xx
Exploratory wells
Successful
xx
xx
Unsuccessful
xx
-Development wells
xx
xx
DD& A
xxH
xxL
FCM
SEM
Profit And Loss Account
(Expensed amounts)
Geological and geophysical costs
-xx
Carrying costs and overhead
-xx
Surrendered and impaired leases
-xx
Unimpaired leases
--Exploratory wells
Successful
--Unsuccessful
-xx
Development wells
--xxL
DD & A
xxH
xxH Comparably higher
xxL Comparably lower
5.4 Differences between Tangible Costs and Intangible Costs
Tangible costs relate to costs of assets that have physical properties. Tangible is said to have been
derived from the Latin word tangere meaning to touch, impling that such assets can be touched or
felt. They include machinery, equipment vehicles etc. Tangible costs also include labour to install
equipment etc. even though such costs do not result in a physical asset. Intangible costs relate to
costs that result in an asset that has no physical properties. Examples are contract costs paid to a
contract driller for drilling a well, mud pits etc. In oil and gas operations and accounting, a
distinguishing feature between classification as tangible and intangible is salvageability. If the
property can be salvaged at the end of operations, such properties are usually classified as tangible
whereas those properties (the underlying costs) that cannot be salvaged at the end of an operation are
classified as intangible. The distinction between both types of costs is usually important for tax
purposes.
Examples of Intangible Drilling Costs
Drilling contractors charges
Site preparation, roads, pits
Bits, reamers, tools
Labour
Fuel, power and water
Drill stem tests
49

Coring analysis
Electric surveys and logs
Geological and engineering
Cementation
Completion, fracturing, acidizing, perforating
Rig transportation, erection and removal
Overhead
Other services
Examples of Tangible Drilling Costs
Casing (production and surface)
Tubing
Well head and subsurface
Pumping units
Tanks
Separators
Heater-treaters
Engines and automotives
Flow line
Installation costs of equipment
Sundry equipment
Question One
Janguza Oil Company, a joint venture operator, incurred the following costs in drilling an oil well:
N
i. Drilling (on footage basis)
675,256
ii. Cost of clearing and grading unpaved roadways to the drill site
23,560
iii. Construction of overflow mud pits
56,700
iv. Surface casing used in the well
675,908
v. Services such as acidizing and testing
246,200
vi. Cementing services for casing
17, 890
vii. Tubing and control valves
57, 500
viii. Flow lines, tanks and treaters
116, 700
ix. Labour to install lines and tanks
26, 500
Solution to Question One

I
Ii
Iii
Iv
V
Vi
Vii

Drilling (on footage basis)

Cost of clearing and grading unpaved
roadways to the drill site

Intangible
Drilling
Costs (IDC)
675,256

Tangible
Drilling
Costs
(TDC)

23,560

Construction of overflow mud pits

Surface casing used in the well
Services such as acidizing and testing
Cementing services for casing
Tubing and control valves

56,700
675,908
246200
17, 890
57, 500

50

viii Flow lines, tanks and treaters

Ix Labour to install lines and tanks
1,001,716

116, 700
26, 500
675,908

5.5 Accounting for Depreciation, Depletion and Amortization

Oil and gas companies classify costs incurred on oil and gas properties into two broad categories,
namely mineral acquisition costs and wells and related equipment and facilities costs. These
capitalized costs are written off to the profit and loss account through depreciation, depletion and
amortization (usually abbreviated as DD&A). Depreciation is associated to the decrease in the
values of physical or tangible assets, amortization is associated with the expiration of the cost of
intangible assets, while depletion refers to the reduction in the costs of natural resources of wasting
nature resulting from the diminution in the value of the resources. However, emphases here would
be on amortization and depletion, as depreciation is perhaps well known in other aspects of financial
accounting.
5.5.1 Basis for Amortization
The most commonly used method of computing amortization of oil and gas properties is the unit of
production method. This is in line with the provision of SAS 14 and 17. The unit of production
method assigns a pro-rata portion of capitalized costs of oil and gas properties to each unit of
reserves. The oil company then expenses the pro-rata assigned amount as it produces each unit of
reserves. These are explained below:
1. Unit of Production (UOP) Method
The formula for the unit of amortization method is:
(C - AD S) P
R
Where: C= Capital cost of equipment
AD= Accumulated DD&A
S= Salvage Value
P= Production during the year (in barrels)
R= Reserves remaining at the beginning of the year
This concept may be expressed as follows: Unamortized cost at end of the period X Production for the period
Reserve at beginning of period
An alternative form of the above formula is:
Production for the period
X Unamortized cost at the end of period
Reserves at beginning of period
Question Two
Kabuga Petroleum Company PLC had the following data at end of its financial year ended 31st
December, 2011. You are required to calculate the DD&A for that year.
Capitalized cost at the end of year
N 1,700,000
Accumulated amortization
N 100,000
Reserves estimate at beginning of the year 5,000,000 bbls
Production during the year
250,000 bbls

51

Solution to Question Two

Amortization would be calculated as follows:
250,000 bbls X (1,700,000- 100,000)= N 80,000
5,000,000 bbls
5.5.2 Revision of Reserve Estimates
Reserves of oil and gas companies are frequently revised and, in any event, should be reviewed at
least annually. This is in line with SAS 14. When the estimate of reserves is reviewed and a revision
becomes necessary at the end of a period, the estimate of reserves originally made at the beginning
of the period is ignored. In other words, the amortization rate per barrel may change due to revision
of valuation of oil reserves. Such changes in rates are made prospectively, affecting current and
future periods, but necessitating no adjustment in the accumulated amortization of prior periods.
Question Three
Kabuga Petroleum Company PLC had the following data at end of its financial year ended 31st
December, 2011. You are required to calculate the DD&A for that year.
Capitalized cost at end of the year
N 1,700,000
Accumulated amortization in prior years
N 100,000
Reserves estimate at the beginning of the year
5,000,000 bbls
Production during the year
250,000 bbls
Reserves estimate at the end of the year
4,000,000 bbls
Solution to Example Three
DD&A =

DD&A =

Production during the year

X Unamortized cost (year end)
[Reserves estimate (year end) + Production during the year]
250,000
(1,700,000 100,000)
4,000,000 + 250,000

250,000 X 1,600,000 N 94,118

4,250,000

It should be noted that this question uses identical figures as the preceding illustration except for the
revision of the estimate of reserves carried out at the end of the year. This additional information
changes the reserves at the beginning of the year, the amortization rate, and consequently, the
DD&A for the year from N 80,000 to N 94,118.
5.5.3 Nature of Cost Centre
Amortization amount is also affected by the nature of the cost centre i.e. whether it is carried out on
a well-by-well, field-by-field, or countrywide basis. This is clearly illustrated in Question four
below.
Example Four
Assume the following data are in respect of the entire leases owned by BUK Oil Company in
Nigeria. You are required to calculate the DD&A for the year Ended 31st December, 2011 on
(i)property-by-property basis and (ii) countrywide basis.
Concessions
Lease 1
Lease 2
Lease 3
Total

52

Capitalized cost - end of

the period (Net)

600,000

1,000,000

2,000,000

3,600,000

Estimated reserves - end

of the period (bbls)

4,000,000

3,000,000

6,000,000

13,000,000

Production during the

period (bbls)

1,000,000

500,000

1,200,000

2,700,000

Solution to Question Four

Computation of DD&A for BUK Oil Company
For the Year Ended 31st December, 2011
(i) Property-by-property Basis
Lease 1:

1, 000, 000 bbls

X 600,000 = N120, 000
4,000,000 + 1,000,000 bbls

Lease 2:

X 1,000,000 = N 142, 857

500,000 bbls
3,000,000 + 500,000 bbls

Lease 3:

1, 200, 000 bbls

X 2,000,000 = N 333, 333
6,000,000 + 1,200,000 bbls
.
N 596, 190

Total Amortization

(ii) Country-wide Basis

2, 700, 000 bbls
X N 3, 600,000
13,000,000 + 2,700,000 bbls

2, 700, 000 bbls

X N 3, 600,000 = N 619, 108
15,700,000 bbls
5.5.4 Amortization under SEM and FCM of Accounting
Amortization of capitalized costs under SEM of accounting is broadly similar to the FCM. Under
both methods, DD&A is usually based on the unit of production method. Acquisition costs of proved
properties are amortized on the basis of total estimated units of proved (both developed and
undeveloped) reserves. If significant development costs (such as offshore production platforms) are
incurred in connection with a planned group of development wells before all of the wells have been
drilled, a portion of such development cost is excluded until the additional development wells have
been drilled. Similarly, the proved developed reserves that will be produced only after significant

53

additional developed costs are incurred, such as enhanced recovery systems, are excluded in
computing the DD&A rate. When a property contains both oil and gas reserves, the units of oil and
gas used to compute amortization are converted to a common unit of measure on the basis of their
relative energy content, known as the BTU (British Thermal Units). Despite the broad similarities
mentioned above, DD&A under the full cost and successful efforts method of accounting differs
fundamentally. The differences may be summarized as follows:
Successful Efforts Method (SEM)
1. Wells and related facilities costs are amortized using proved developed reserves.
2. The amortization must be on the basis of unit of production. Unit of revenue method is not
permitted.
3. Future development costs are considered in the amortization computation.
4. Costs are accumulated for each cost centre. For the purpose of capitalizing costs and
amortization, the centre is essentially the individual lease, block, licence area, concession or
field.
Full Cost Method (FCM)
1. Costs are accumulated separately for each cost centre. For this purpose, each country or
continent is considered a separate cost centre.
2. Costs are amortized using proved reserves (i.e. both developed and undeveloped).
3. Costs to be amortized include:
(a) Capitalized costs (net of previous depreciation, depletion and amortization);
(b) Future development costs to develop proved reserves are included in amortization
base;
(c) Future dismantlement and restoration cost.
4. Unit of revenue method may be used.
5. A cost ceiling based on a standardized measure of underlying value of assets is mandatory.
5.5.5 Computation of Depletion
As earlier stated, both full cost and successful efforts companies deplete mineral acquisition costs
using proved reserves. However, a successful efforts company amortizes capitalized costs, other than
acquisition costs, using proved developed reserves, whereas a full cost company amortizes such
costs using proved reserves. This is because the mineral acquisition costs apply to all recoverable
reserves in the field or property whereas wells and related equipment relate only to the portion of
reserves recoverable from the wells already drilled-proved developed reserves.
Question Five
(i) Calculate DD&A for New-Site Oil and Gas Nigeria Limited, a full cost company, assuming the
following:
Abandonment costs
N 15,000,000
Development costs
N 5,000,000
Capitalized costs
N 30,000,000
Proved reserves
5,000,000 bbls
First year production
500,000 bbls
(ii) Calculate DD&A for above company for the second year, assuming that production is 300,000
bbls.
(iii) Calculate DD&A for New-Site Oil and Gas Nigeria Limited, a succesful cost company,
assuming the following:
Abandonment costs
N 15,000,000
Development costs
N 5,000,000
54

Capitalized costs: Wells and equipments

N 20,000,000
Acquisition costs
N 10,000,000
Proved reserves
5,000,000 bbls
Proved developed reserves
3,00,000 bbls
Production
500,000 bbls
Solution to Question Five
(i) Abandonment costs
Development costs
Capitalized costs

N 15,000,000
N 5,000,000
N 30,000,000
N 50,000,000

DD&A 500,000 X N50,000,000 = N 5,000,000

5,000,000
(ii) Second year DD&A
300,000
X [50,000,000-5,000,000]
[5,000,000 - 500,000]
300,000 X 45,000,000 = N 3,000,000
4,500,000
(iii) DD&A on Acquisition costs = 500,000 X 10,000,000
5,000,000
DD & A on wells & equipt. 500,000 X N20,000,000
3,000,000
Total DD&A
(1,000,000 + 3,333,333)

= N l,000,000
= N 3,333,333
= N4,333,333

5.5.6 Joint Production of Oil and Gas

For properties that produce both oil and gas, the units of oil and gas used to compute amortization
are converted to a common unit of measure on the basis of their relative energy content known as the
BTU, except:
(a) the relative proportion of oil and gas are expected to continue throughout the life of the
property, in which case, the DD&A should be based on any one of the two minerals; or
(b) oil or gas is clearly dominant in both reserves and production, in which case, the unit of
production may be based on the dominant mineral.
Usually, one barrel of oil contains six million BTUs and one mcf of gas contains about one million
BTUs. Accordingly, it is generally accepted that six mcf of gas is equal to one barrel of oil in
determining the relative energy content for conversion. This ratio continues to be used despite the
fact that the market no longer reflects the relative energy contents in prices of oil or gas. For
instance, based on this ratio, a barrel of crude oil should sell for six times the price of one mcf of gas
but in most cases, this is not the case. The ratio may be as much as almost 20 times. Furthermore,
because oil and gas are differentiated products, their energy contents vary from reservoir to reservoir
or even within different strata of the same reservoir. An oil company may therefore have reasonable
justification for using a conversion factor that more precisely reflects the energy equivalencies of
both minerals.

55

5.5.7 Exclusion of Significant Development Costs

When significant development costs are incurred in connection with a planned development plan, a
portion of such costs should be excluded in computing amortization until such
additional development wells have been drilled. This is in order to avert distortions that may occur
where large development costs are incurred on assets that will be used to produce both proved
developed and proved undeveloped reserves. If a compensating adjustment is not made, the
matching of costs with related reserves will not be achieved. Portion of development costs to be
excluded is usually based on the ratio of proved developed reserves to total proved reserves or
number of wells not yet drilled compared with total of all wells (drilled and to be drilled).
.
5.5.8 Revision of Reserve Estimates and Interim Financial Statements
It is sometimes necessary to revise the estimate of reserves because of new information, changes in
technology etc. The effects on amortization rates of such reserve revisions are usually adjusted
prospectively. Changes in reserve estimates impact significantly on companies that prepare interim
financial statements say on a quarterly or semi-annual basis.
5.5.9 DD&A through Addition and Disposal on Production Equipment
Changes often occur in the capitalized cost of production equipment after the initial investment.
Addition may be made through new purchases and transfers, while disposal may be made through
sales, retirements, catastrophic loss or transfer to another property. Additions to production
equipment are treated for accounting purposes the same way as the initial investment. When
production equipment is disposed, the difference between the book value of the equipment and
disposal value i.e. fair market value or sale price is adjusted through the accumulated amortization.
No gain is to be recognized in this transaction but a loss may be recognized, in compliance with the
concept of conservatism.

5.5.10 Dismantlement, Restoration and Abandonment Costs

When oil and gas reserves are fully depleted or production falls to an uneconomically low level and
it is no longer feasible to produce minerals even under enhanced recovery techniques, equipments
are salvaged and operations are abandoned. Oil and gas operations regulations require that wells be
plugged, all facilities and equipment removed and the terrain restored, as much as possible, to its
natural state.
Dismantlement and restoration costs can be quite enormous and sometimes may even exceed the
cost of the original installations, especially when account is taken of inflation and the time interval
between the commencement of production and abandonment of property. Some companies assume
that the amount realized from dismantled facilities less salvage costs, will offset dismantlement and
restoration costs. Accordingly, such companies either ignore making any provisions for such
terminal costs or make the provision in the year in which abandonment occurs. Clearly, by not
making accruals, such companies would not be achieving the matching of revenues with related
costs. Sound accounting principles require that estimated dismantlement, restoration and
abandonment costs, if material, be included in the cost pool in determining amortization rates.
The amortization relating to dismantlement, salvage and reclamation is usually charged to DD&A
(or a profit and loss account titled dismantlement, salvage and reclamation costs) and credited to a
contingent liability account. When the company abandons the property and incurs the dismantlement
and restoration costs, the costs incurred are charged to the liability account. Any difference between
actual dismantlement and restoration costs and the liability is charged or credited to income.
56

5.6 Ceiling on Capitalized Costs

In addition to capitalizing all acquisition costs, exploration costs (including G,G& costs) a full cost
company carries development dry holes as an asset. There is therefore a distinct danger that the
value of proved reserves and other mineral assets in the cost centre may not be adequate to recover
the unamortized costs in the full cost pool. Consequently, a full cost company is required to perform
a ceiling test annually. A ceiling test is a determination of the upper limit of the total amount of costs
that can be capitalized in the books by taking into consideration an estimation of the value of
underlying reserves. For each cost centre, capitalized costs less accumulated amortization and related
deferred income taxes should not exceed the estimated fair market value of the reserves.
Where the capitalized costs exceed the ceiling, any excess over the ceiling is charged to expense and
disclosed separately in the financial statements. In accordance with the prudence concept, if in a
subsequent year, the capitalized cost is higher than the estimated value of reserves (ceiling), no write
back is permitted.
5.7 Accounting for Unproved Properties
5.7.1 Mineral Properties
In Nigeria, the right over surface area of land and its subsurface locations are separated. In other
words, even if a famer owns the land, he does not own the minerals that lie underneath it. Section 1
of the Petroleum Act, 1969 vests the entire ownership and control of petroleum resources in all land
within Nigeria and its territorial waters and continental shelf in the Government.
The Minister for Petroleum Resources may, on behalf of the Government, grant
any of the following:
a) Oil Exploration Licence (usually covers a period of 1 year) - to explore (discover) for
petroleum.
b) Oil Prospecting Licence, which usually covers a period of 3 to 5 years (to prospect/search
for petroleum); and
c) Oil Mining Lease, which usually covers a period of 20 to 30 years (to win, work, carry away
and dispose of petroleum) to a licensee or lessee.
The grant of a licence or lease notwithstanding, the licensee or lessee is obliged to pay fair and
adequate compensation to the lawful owners and occupants of the land. Reasonable compensation
must also be paid to land owners for specific damages done by felling of economic trees and
interference with fishing rights.
Typically, an oil and gas company acquires mineral properties in one of the following ways:
(a) After a company determines the lessor of the property on which it desires to drill, the company
evaluates any seismic data available on the area. If an individual or oil company owns the property,
such may be approached for a negotiation that may either take the form of an assignment, outright
purchase or joint venture agreement provided the required legal provisions are met and the consent
of the Minister is obtained.
(b) Periodically, Government offers some blocks to the public for bidding. Each interested oil
company submits a sealed bid to the Government together with the stipulated bidding fee for each
block to be leased. Although the blocks are usually awarded to the highest bidder, other factors such
as minimum work programme, financial resources, experience in exploration and production, track

57

record in international operations, premium payable, signature bonus payable and political factors
are also taken into account.
Acquisition costs for licences, concession or leases, yet to have proved reserves discovered in them,
are classified and referred to as Unproved Properties. Although the basic provisions in leases and
licences are similar, each lease and/ or licence may contain unique provisions. Basic provisions for
Oil Prospecting Licence (OPL) and Oil Mining Lease (OML) are as follows:

Signature Bonus
The signature bonus is the cash or other consideration paid to the lessor (property-owner) by the
lessee (leaseholder) in return for the lessor granting the 1essee the rights to explore for minerals, drill
wells, and produce oil. The bonus is computed at per-acre basis.
Duration
The Minister for Petroleum Resources determines the duration of an Oil Prospecting Licence (OPL)
or Oil Mining Lease (OML). In the case of an OPL the duration may not be more than 5 years
including any renewals, whereas an OML may not have a term of more than 20 years but may be
renewable.
Rent
The agreements typically provide for rentals to be paid on concessions. Such rentals are based on
acreage or hectare granted by the lease.
Royalty Provisions
Lease contracts provide for royalty to be paid to the lessor of a mineral concession. Royalties are
based on the quantity of oil and gas produced. The Federal Government of Nigeria fixes royalty
rates, which may vary from time to time.
Right to Assign Interest
The lease contract grants the lessee the right to assign, subject to approval by the Minister for
Petroleum Resources, any part or all of its rights and obligations.
Drilling
The lessee or licensee is required to commenced exploration using accepted geological and
geophysical techniques within six months and to commence drilling operations in eighteen months
of the grant of the relevant concession.
5.7.2 General Principles of Accounting for Acquisition Cost of Unproved Properties
Successful Efforts Method
In successful efforts accounting, costs associated with the acquisition of unproved properties are
initially capitalized when incurred. These consist of costs incurred in obtaining a mineral interest in a
property such as signature bonuses, options to lease, brokers fees, legal costs, stamp duties and
other similar costs in acquiring property interest. Unproved .properties should be assessed at least
once a year to determine if there is any loss in value (impairment). If there is any impairment, it must
be recorded as a loss.

58

Full Cost Method

Under the FCM, all costs associated with the acquisition of unproved properties are capitalized
within the appropriate cost centre. Unproved properties that are excluded from the amortization base
should be periodically assessed for impairment until it can be determined if proved reserves are
attributable to them. If impairment is indicated, the amount of impairment should be included in the
amortization base and not charged to profit and loss.
5.7.3 Impairment of Unproved Properties
At the time an oil company acquires an interest in an unproved property, the value of the property is
assumed to be equal to the cost. With the effluxion of time, certain events occur which may give rise
to reassessment of the value of the unproved property vis-a-vis the recorded costs.
Unproved properties are assessed periodically in order to determine whether they have been
impaired under successful efforts accounting. A property may be considered impaired if a dry hole
has been drilled in a part of it or nearby property and the company has no intention of further drilling
on the property. Also, as the expiration of the lease term approaches and the company has not
commenced drilling on the property or adjoining properties, the possibility of partial or total
impairment of the unproved property may increase.
Basis of Impairment
Impairment may be assessed either on individually significant properties or on group of properties.
Impairment on individually significant unproved properties is assessed on a property-by property
basis. If a property is found to be impaired, an impairment provision is made and a loss is
recognized.
Unproved properties whose costs are not individually significant may be aggregated and assessed in
groups. This is done on the basis of the experience of the company in similar situations and
considering such factors as the duration of the lease, the average holding period of unproved
properties, and the relative proportion of such properties that has become proved in the past. Factors
such as acreage and estimated future expenditures may also be considered. Determination of what is
individually significant can be a matter of individual judgement since it may not depend on relative
costs or percentage of portfolios alone. A basic rule of thumb for significance is 10 percent of the net
capitalized cost of the cost centre.
Recovery in Value of impaired Property
Occasionally, the value of a property on which impairment provision had earlier been made may
exceed the original cost of such property. Accounting prudence dictates that, in such situations, the
impairment provision previously made should not be reversed. No profit should be recorded for
appreciation in value of such properties.
Impairment and Joint Working Interests
The objective of assessing a property for impairment is to ensure that assets that have no service
potential are not carried in the balance sheet. Assessment of impairment is faced with subjectivity
especially with joint working interest property where each working interest owner can make a
decision as to whether the property is significant and the amount of impairment that may be allowed.
Impairment and Post Balance Sheet Events
It is also to be noted that impairment events occurring after the balance sheet date but before the
issuance of audit report should be taken into account in evaluating conditions that existed at the
balance sheet date.
59

Transfer to Proved Properties

If a successful well is drilled on an unproved property on which individual impairment has been
previously recorded, the net book value of the property is transferred to Proved Properties account,
and subjected to amortization. It should be noted that unproved property cost remains in the account
at net carrying value until the result of the first successful well has been determined.
Surrender and Abandonment of Unproved Properties
The licensee or lessee of a concession (OML/OPL) may terminate or effect a partial surrender of the
concession by giving the Minister of Petroleum Resources three months notice to that effect.
Furthermore, the Minister may revoke the lease or licence under certain conditions, which are stated
in paragraphs 23 and 24 of Schedule 1 to the Petroleum Act, 1969. When an unproved property on
which individual impairment has been recorded is surrendered or terminated, a successful efforts
company should write-off the net carrying value of the property to profit and loss account, while full
cost company should not write off the book value to expense as above; it should merely increase the
costs subject to amortization.
5.8 Accounting for Drilling and Development Costs
Accounting for exploration, drilling and development costs can be quite complex especially where
the lessee or the original working interest owner has assigned fractional interests to other oil
companies. The practice in most oil companies today is to contract drilling to independent
contractors. Even where the oil company decides to perform the drilling and equipping of a well by
itself, it is still customary to engage the services of outside specialists for such services as electric
logging, cementation, perforating, acidizing and fracturing.
Preparation for Development and Drilling
As earlier stated, investments in oil and gas assets can be quite enormous, requiring various levels of
approvals. Typically, an oil company plans and controls investment in oil and gas assets by requiring
that request for authorization to drill and equip oil wells be prepared and approved for each new
well. Such authorization is referred to as an authorization for expenditure (AFE).
AFE includes an estimate of costs to be incurred, by service or asset category and in total, whether
the company itself or an outside contractor is to conduct the drilling and development operations. An
AFE procedure assists in rational allotment of funds available for capital expenditure and provides
an effective cost control mechanism, through the comparison of budgets with actual costs and
investigation of variances. Where it becomes apparent that actual costs will exceed budgeted
amounts, it may be necessary to prepare a supplementary AFE. Most oil companies will require
preparation of a supplementary AFE when budget will be overrun by a specified percentage e.g. 10
percent. For drilling and development AFEs, expenditure subheads may include:
Intangible Expenditure
Drilling contractors charges
Site preparation, roads, pits
Bits, reamers, tools
Labour
Fuel, power and water
Drill stem tests
Coring analysis
Electric surveys and logs
Geological and engineering
60

Cementation
Completion, fracturing, acidizing, perforating
Rig transportation, erection and removal
Overhead
Other services
Tangible Expenditure
Casing (production and surface)
Tubing
Well head and subsurface
Pumping units
Tanks
Separators
Heater-treaters
Engines and automotives
Flow line
Installation costs of equipment
Sundry equipment
Additional Information
Apart from details of estimates and actual costs under the above subheads, AFEs contain the
following additional information: (i) AFE number and date; (ii) approvals required both from
company and joint venture parties; (iii) purpose of expenditure i.e. whether exploratory drilling or
development drilling; (iv) location of project or well; (v) well number; projected total depth; and
(vii) type of well i.e. whether oil, gas, or condensate.
5.8 Accounting for Exploration and Drilling Costs
Examples of exploration and drilling costs are: a) Costs of topographical, geological and geophysical studies, rights of access to properties to
conduct those studies, and salaries and other expenses of geologists, geophysical crews, and
others conducting those studies. Collectively, those are sometimes referred to as or G&G
(geological and geophysical) costs.
b) Costs of carrying and retaining undeveloped properties, such as delay rentals, tax on the
properties, legal costs for title defence and the maintenance of land and lease records.
c) Dry hole contributions and bottom hole contributions.
d) Costs of drilling and equipping exploratory wells
e) Costs of drilling exploratory-type stratigraphic tests wells.
Accounting treatment of exploration and drilling costs depends on whether the enterprise uses the
successful efforts method or full cost method of accounting.
5.8.1 Successful Efforts
An oil company which adopts the SEM of accounting will expense all G&G costs and carrying costs
of undeveloped properties, regardless of whether exploration activities led to discovery of reserves
or not. All other exploration and drilling costs such as costs of drilling wells and exploratory- type
stratigraphic test wells are charged to expense if they result in dry holes and capitalized if reserves
are discovered in them.
The reason for the divergent treatment of G&G costs and other exploration and drilling costs is
61

because a successful efforts company treats G & G costs as cost of obtaining information, similar to
research and development costs (R & D) which generally must be charged to expense as incurred.
The costs that may be capitalized are held temporarily in a well in progress account until a
determination is made as to whether the wells are productive or not. If an exploratory well is
determined to be dry, the costs accumulated in work in progress, less salvage value, are written off
as expense.
5.8.2 Full Cost
Under the FCM, all exploratory and drilling costs are capitalized. The work in progress account is
used temporarily to accumulate costs of wells being drilled in the same manner as a successful effort
company, until the outcome of the well is known. If the well proves successful, the accumulated cost
in the wells in progress account is transferred to Wells and Related Facilities account and amortized.
The work in progress account can either be included or excluded from the amortization base.
However, as soon as the outcome of the well is known, it must be reclassified to wells and related
facilities and included in the amortization computation.
5.9 Accounting for Development Costs
Development costs are costs incurred to obtain access to proved reserves and to provide facilities for
extracting, treating, gathering, and storing the oil and gas. More specifically, development costs,
including depreciation and applicable operating costs of support equipment and facilities and other
costs of development activities are costs incurred to:
a) Gain access to and prepare well locations for drilling, including the survey of well locations for
the purpose of determining specific development drilling sites, clearing ground, draining, road
building, and relocating public roads, gas lines, and power lines, to the extent necessary in
developing the proved reserves.
b) Drill and equip development wells, development-type stratigraphic test wells, and service wells,
including the costs of platforms and of well equipment such as casing, tubing, pumping
equipment, and the wellhead assembly.
c) Acquire, construct, and install production facilities such as lease flow lines, separators, treaters,
heaters, manifolds, measuring devices, and production storage tanks, natural gas cycling and
processing plants, and utility and waste disposal systems.
d) Provide improved recovery systems.
Development costs are basically classified into two i.e. IDC (intangible drilling and development
cost) and LWE (Lease and well equipment cost). Generally intangible drilling cost are down hole
costs up to and including the wellhead. They include cost of preparation for drilling, drilling cost,
well servicing (fracturing, acidizing) and the cost of subsurface well equipment. Equipment includes
cost of well equipment and other lease equipment.
An oil company capitalizes all development costs. The costs of drilling development wells are
temporarily included in Wells in Progress account - Development Wells until drilling is complete.
Upon completion, the costs are re-classified to wells and related equipment account and amortized.
In effect, development well costs are capitalized whether or not they result in discovery of
hydrocarbons. This is because development wells are regarded as costs incurred to produce reserves
already located by an exploratory or discovery well. Accounting for development costs is the same
under both full cost and successful efforts method.
It is clear from the foregoing that a proper distinction must be made between exploratory wells and
development wells since the accounting treatments are not the same. An exploratory well is a well

62

drilled to find and produce oil in an unproved area, to find a new reservoir in a field previously
found to be productive.
Question Six
First Hydrocarbon Company Limited incurred the following costs for a development well drilled
during 2011 in a recently acquired concession.
N
Site survey
150,000
Bush clearing
500,000
Road building and bridges
2,500,000
Tubing and casing pipes
1,400,000
Well head assembly and valves
2,100,000
Flow lines
4,000,000
Separators
10,000,000
Treaters and heaters
2,000,000
Desander
1,500,000
Required:
a) Prepare journal entries to record the cost of the development well, assuming BUK Hydrocarbon
Company uses successful efforts method of accounting.
b) Prepare journal entries to record the development well assuming that the full cost method of
accounting is used.
c) Would it make any difference if the development well were dry or productive? Comment.
Solution to Question Six
(a) Successful Efforts Company
General Journal
Particulars
Wells and related facilities (Intangible)
Wells and related facilities (equipment)
Bank Account
Being cost of development wells incurred.
(b)
(c)

Dr
3,150,000
21,000,000

Cr

24,150,000

Entry for full cost company is the same as for successful efforts company above.
It would not make any difference. Both full cost and successful efforts companies are required
to capitalize costs of development dry holes and producing development wells.

5.10 Production Accounting

Production accounting is the process of identifying and measuring the revenues, expenses and net
income or loss attributable to the operation of petroleum producing properties. Production
accounting provides a basis for sound property management and evaluation of profitability. A typical
oil company may have several producing properties with varying acreages, working and nonworking interests. It is essential that revenues and expenses (production or lifting costs) of individual
properties be determined in order to provide an effective measure of the profit margin on all wells.
5.10.1 Types of Economic Interests in Oil and Gas Properties

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For a proper understanding of revenue accounting it is necessary to explain the various types of
economic interest in oil and gas property. The particular types of economic interest owned by the
parties involved in a property determine how the benefits and obligation of the property i.e. costs and
revenue is shared. Economic interest consists of ownership of minerals in place that gives the owner
the right to share in the mineral produced or in the proceeds from the sale of minerals produced.
Basic types of ownership interests are as follows:
Royalty Interest (RI)
This is basic type of interest in production that is retained by the mineral interest owner when he
leases the property to another party. It is a non-working interest and the owner is entitled to receive a
fraction of the oil produced in form of royalty.

Working Interest (WI)

This is the interest remaining after deduction of all non-working interest.
Joint Working Interest (JWI)
This is a situation in which two or more parties own undivided fractions or percentage of the
working interest.
Pooled Working Interest (PWI)
This situation is the result of combining two or more working interest with or without the same
ownership interest. It may be mandatory by State regulation or as the option of the lessees.
Unitized Working Interest
Unitization is similar to pooling except that it is on a large scale and always involves the
combination of working interest owned by two or more parties.
5.10.2 Revenue from Oil
Broadly, revenue from oil and gas operating interest may be revenues from oil, revenues from gas
and miscellaneous revenue. Revenue from oil may or may not include inventory in tank batteries.
Revenue from gas is usually limited to revenue from gas sold. Miscellaneous revenue consists of
such incidental income as ullage fees, rentals, power sales, management fees etc. An important step
in accounting for revenue from oil is the determination of the volume lifted. Although field
personnel such as gaugers, perform the actual measurement of volume, the accountant must be
familiar with measurement procedures in order to meaningfully record revenues in the books of
accounts.
Oil is usually produced in association with gas as only few reservoirs produce gas or crude oil only.
Therefore, after oil is produced from an oil well, it is passed through a separator to remove gas from
liquids (crude oil) or remove liquids (condensate) from gas. The oil is also passed through a heatertreater to remove water and other impurities from the oil. The gas removed from the oil is referred to
as casinghead gas. The treated oil is then usually stored in large stock tanks, collectively referred to
as tank farms or tank batteries.
At the time a tank battery is put into operation each stock tank is strapped or measured. This
measurement or strapping determines exactly how many barrels of oil can be held in the tank for
each fraction of an inch of oil contained in the tank. Because the tanks have been strapped, it is
possible to determine the volume lifted by tankers or transferred to refineries through pipelines by
using tank tables. Usually, the task of recording the lifted volume rests with a gauger who records it
64

on a run ticket. By the use of a device known as a thief, samples of crude oil are taken at various
levels from the tank, centrifuged and measured to determine the B.S. & W content i.e. Basic
Sediment (BS) and Water (W) content.
Other information included in the run ticket are the tanker or pipeline names, the lease or well
identification, tank number, the observed temperature, the observed gravity, B.S & W content,
signatures of the gauger and other witnesses such as Customs, Petroleum Inspectorate, Nigeria Port
Authority personnel and other interested parties. All of the foregoing data are necessary because the
volume, and consequently the value of a barrel of oil, can be significantly affected by a change in the
oils gravity, temperature, pressure, or, basic sediment and water content.
The specific gravity of oil is expressed in degrees API. The thinner (less viscous) the oil, the higher
the API gravity, and the higher the API gravity of the oil, the more valuable the oil. This is because
higher gravity oil usually produces a higher yield of white products and requires less complex
operations to refine into useable products. API gravity is related to specific gravity and oil with 10o
API gravity will have a specific gravity of 1, the same as the specific gravity of water. The formula
for API gravity is:
141.5
APIo =

-131.5
Specific gravity

Temperature has a dual effect on the measurement of crude oil. Not only can temperature change the
gravity of oil, it can also change the volume. The gravity changes because oil will become lighter
(less viscous and thinner) when it is heated. Obviously, if no adjustment were made, the change in
gravity would affect the price of oil. The effect of temperature on volume can be appreciated when
one considers that 10,000 barrels of oil at 40F could increase to as much as 10,300 barrels at 90F.
This is an increase of 12,600 US gallons of oil. The standard unit of measurement of crude oil is a
barrel of 42 US gallons at a temperature of 60F. The composition of oil itself can also affect the
volume of oil sold. Most purchasers of crude oil set limits on the percent of B.S & W they will
allow. Where B.S. & W exceeds 1%, the price is usually discounted.
The efficiency of production measurement has been enhanced by automated techniques using Lease
Automatic Custody Transfer (LACT) units to measure the volume and quality of crude oil adjusted
for temperature, gravity, compression and B.S & W content. After the adjusted volumes of oil have
been calculated or determined, they are valued on a property-by-property basis in accordance with
the sales contract with the purchaser. Each lifting is then valued for each purchaser, summarised for
the month, and billed.
5.10.3 Revenues from Gas
Accounting for revenue from gas is similar to accounting for revenue from oil in that it involves
measurement, pricing and formal recording of values. The difference is that quantitative
measurement and pricing are more complex. The volume of gas delivered from a well (or the point
at which oil and gas are separated) is calculated from orifice meter charts and accumulated by
months. An orifice meter is a device in which the pressure differential between the two sides of an
opening or construction called an orifice is used as a factor for determining the volume of flow.
Gas Sales Contracts
Take - or - Pay Provision
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A gas sales contract normally provides that if the purchaser does not take the specified delivery, he
must pay for the shortfall (deficiency) even if not taken. However, the purchaser is usually entitled to
make-up for the deficiency payment in future supplies.
Minimum Royalty
Under this arrangement, the purchaser agrees to pay to a minimum amount for a stated period. The
excess of the minimum payment over the value of the gas taken for a given period may or may not
be deductible from the shortage arising in any future period. The essence of both the take-or-pay
provision and the minimum royalty provision is to compel the purchaser to live up to the terms of
agreement both in quantity and value.
5.11 Accounting for Production Costs
Production cost consists of the costs of gathering, field processing, treating and field storage of oil
and gas. Production commences with the lifting of oil and gas to the surface and terminates at the
outlet valve on the field production storage tank. However, sometimes due to operational factors, the
production function is regarded as terminating at the point at which oil or gas is delivered to a trunk
line, a refinery or marine terminal. Production costs are the cost of producing oil and gas.
Accordingly, they should be charged to expense. Although DD&A of capitalized acquisition,
exploration and development costs form part of the cost of oil and gas produced, they are usually not
classified as production costs. The practice is to disclose them separately in the financial statements.
5.11.1Classification of Production Costs
Production costs may be classified in many ways. One basis of classification is by the nature of the
object of the expenditure, e.g. salaries, taxes, materials and supplies. Another is by the nature of
operational function served, e.g., pumping and gauging, sub-surface maintenance, secondary
recovery operations. The various types of production costs classified as to their nature are as follows:
Salaries
This category includes salaries and wages of pumpers, gaugers, roustabouts, maintenance crews,
welders etc. It also includes the salaries of the tank farms superintendent and production foremen.
Where such supervisors have responsibility for more than one lease - as is often the case - the
practice is to allocate their salaries to individual leases or wells.
Contract Services
Services such as pump maintenance, recompletion and workover, catering, casing repairs, paraffin
control and desanding may be contracted out by an oil company.
Insurance
Typical insurances that may affect production costs are medical, workmens compensation, fire and
windstorm, boiler explosions, etc.
Fringe Benefits
Fringe benefits are part of total compensation of labour and should be allocated to individual leases.
Repairs and Maintenance
Costs incurred in repairing lease equipment such as tank farms, separators, desanders, desalters, flow
lines, lease cabins, engines, motors, pumps and other surface production equipment are classified as
repair and maintenance and form part of production costs.

66

Royalties
Royalties are based on quantities produced, valued at posted prices and levied at various rates.
Overhead and Supervision
This category usually includes an allocated portion of the expense of operating the district office. In
some companies, general and administrative expenses are allocated to district offices and thus
become part of the district expenses allocated to individual leases. Two of the allocation bases most
commonly used are: (a) Number of wells served, and (b) Barrels of crude oil produced.
5.11.2 Functional Classification of Expenses
Company practices vary with respect to functional groupings or classification of production costs.
The following functional groups or subgroups are typical:
Pumping and gauging
Subsurface maintenance: Pumps
Tubing
Casing
Workovers and recompletions
Treatment of oil
Gas Dehydration
Saltwater disposal
Gathering
Surface maintenance: Lease and well equipment
Roads
Cutting of grass and weeds
Secondary recovery operations
5.11.3Direct and Indirect Expenses
Production costs of oil and gas companies are classified as either direct or indirect. Direct
production Costs are generally regarded as those expenditures that are absolutely essential to the
production operation. Costs of gauging and pumping, sub-surface maintenance, heating and treating
costs of oil and/or gas are typical direct production costs. Indirect production costs are those that
facilitate or are incidental to petroleum production but do not directly contribute to it. Some
examples are taxes, royalties, insurance and overhead and superintendence.
If the productivity of a well is restored or enhanced, it would seem logical that since such costs will
benefit future periods, they should be capitalized and amortized to those periods. Industry practice,
however, is to expense workover costs. They justify the treatment on the basis of immateriality (for
large companies). Although prevailing practice may result in a more conservative financial
statement, proper matching of expenses with related revenues may not have been achieved. Well
workover costs that involve drilling to a deeper horizon or plugging back to a shallower producing
formation are referred to as recompletions. Since recompletions increase the production potential of
reserves, such costs are capital in nature and should be capitalized as intangible costs and amortized
to future periods.
Although generally accepted accounting principles require that production cost, being part of the
cost of oil and gas produced, should be allocated to cost of goods sold and inventory, very seldom do
oil companies value the oil in pipelines and tanks at cost. Inventories in pipelines and tanks are
generally ignored or are valued at selling prices. The oil in the tank is viewed as a fungible good,
with an assured market and therefore presumed sold as produced. Thus a portion of the revenue is
realized before actual sale, a practice contrary to the realization concept. Proponents of this method
67

argue that it does not materially distort income. Clearly, two principles - the matching principle and
realization principle had not been fully complied with, as costs would not have been matched
with revenues.
5.12 Financial Statements Disclosures
The oil and gas industry, in fact the extractive industry as a whole, differ from companies in other
industries in one significant respect - their most important economic asset, oil and gas reserves are
not recorded in the balance sheet. This uniqueness posed a peculiar challenge in financial reporting,
especially in reporting the financial position of oil companies without the real substance of
the enterprise.
In an attempt to make up for this limitation and meet the financial reporting requirements of
investors, oil companies have been disclosing information on reserves by way of footnotes and
supplemental information to the financial statements. It was in response to this need that the in April
1986, the U.K Oil Industry Accounting Committee issued Statement of Recommended Practice
(SORP) No. l to provide guidance on disclosures. Also, paragraph 134 in Part IV of SAS No. 14
issued by the NASB stipulates certain disclosures, including the following:
i. Method of accounting
ii. Capitalized costs relating to oil and gas producing activities
iii. Costs incurred
iv. Disclosure of the results of operation for oil and gas producing activities
v. Proved oil and gas reserve quantity information
vi. Disclosure of a standardized measure of discounted future net cash flows
relating to proved oil and gas reserves.
Broadly, the disclosure rules apply to quoted companies with significant oil and gas producing
activities. A company is deemed to have significant oil and gas producing activities if it meets any of
the following three tests: i. The revenue from oil and gas producing activities (including transfers to other activities of
the company) is 10 percent or more of the combined revenue from all the companys
industry segments.
ii. The assets identified as related to oil and gas producing activities are 10 per cent or more of
total assets of all industry segments.
iii. Income after taxes (before extraordinary items) from oil and gas producing activities is 10
percent or more of the consolidated net income before extraordinary items.
5.13 Accounting for Refining and Petrochemical Operations
Operations in the oil and gas industry are broadly divided into two, namely upstream and
downstream. Refining and petrochemical production are therefore part of the downstream. Crude oil,
which is the major raw material of a refinery, is a mixture of a family of organic chemical
compounds made up of hydrogen and carbon in various proportions called hydrocarbons. The nonhydrocarbon materials that are usually present in crude oil are sulphur, nitrogen, nickel, vanadium,
and other metals or salt which is usually in quantities less than one in a thousand. The distinguishing
feature of a mixture (as distinct from a compound) is that in a mixture the components retain their
individual characteristics and can be separated fairly easily. Crude oil almost has unlimited
possibilities as a raw material.
2.13.1 Key Drivers of Refining Economics and Profitability
The key drivers of profitability of refineries are:

68

1. Quality of Crude: A company that buys light crude will be more profitable. Light crude is
crude oil with API gravity that yields a high proportion of the lighter, more valuable
products after refining.
2. Conversion Capacity of Refinery Plant: A more complex refinery will produce a higher
total value of products from a given crude oil even though the total quantity will be reduced
through the greater use of fuel for process heating.
3. Other factors that affect refinery yields are
(a) Direct costs and yields
(b) Lead times for receipt of crude oil
(c) Storage considerations
(d) Spot markets considerations etc.

5.13.2 Types of Refineries

The quality of crude is a factor that most refineries have limited control over. Refiners compete
among themselves to buy the best quality of crude available, but the reality is that high-quality crude
is not abundantly available in sufficient quantities and in the final analysis refiners must buy what
they can get. Conversion capacity is however within the control of the refiners. The higher the
conversion capability of the plant, the higher the possibility of producing desired products from the
available crude. Refineries are classified according to their conversion capability. Refineries
consisting of atmospheric distillation units, reforming and hydro-treating units are often referred to
as hydro-skimming refineries. Those with any substantial units for changing the basic yield pattern
of crude oil barrel through catalytic or hydrocracking are referred to as complex or conversion
refineries.
5.13.3 Petroleum Refining Processes
Refining may be defined as a means of producing fuels and lubricants, among others. Basically it
involves vaporizing crude oil by heating it to a high temperature, collecting the resulting gases and
condensing them back to a liquid state. Crude oil refining comprises of a series of interrelated
processes, all involving heating, and each producing several products. Some of these products can
be put to end use without further processing while others have to undergo considerable postproduction refining, further cracking, reforming, synthesis and molecular arrangement. Refinery
operations are carried out in different processing units that follow one another in processing
sequence. Basic refining processes are:
i. Primary process or physical separation process (Crude distillation)
ii. Secondary or conversion processes
iii. Treating processes
iv. Blending
Primary Process (Crude Distillation)
The objective of distillation is to separate the many compounds contained in crude oil into groups of
similar compounds. The principle underlying this process is the fact that different liquids vaporize at
different temperatures (called boiling points). The separation of low and high boiling points
materials in this way is called fractional distillation (fractionation).
The process is accomplished by running the crude oil through a number of pipes lining a brick
furnace (heater/boiler). The crude oil is heated to a temperature of approximately 800o F after which
it rises to the top of the furnace as vapour and is then transferred to the fractionation tower. The
points at which they start to boil are called Initial Boiling Points (IBP) and where they stop boiling is
called End Boiling Points (EBP). At the EBP, the product would have been completely vaporized.
69

The fractions produced from this atmospheric fractionation towers can be used in their new state,
blended with other substances or further processed to make useful products. The maximum
temperature at which hydrocarbons can be separated in the atmospheric tower is 900oF. Steam keeps
the oil hot and low pressure allows the hydrocarbons to vaporize at temperatures below their
cracking points enabling them to be separated into fractions. The light and heavy gas oils are
separated from the heaviest residue.
The primary process separates the various fractions, which may serve as inputs for the secondary
process. These inputs are otherwise known as charging stocks. The term charging stock refers to
unfinished products that are to be further processed in some secondary refining operation. These
secondary processes either result in new products or bring primary products to required quality
standards. The intermediate products, in order of increasing boiling range, are listed below.
(a) Fuel gas -to refinery fuel gas - below 100F
(b) Light straight run gasoline - to sweetening and then to gasoline blending (Boiling range
100F-200F).
(c) Heavy straight - run gasoline -to hydrogenation, to catalytic reforming and then to gasoline
blending (Boiling range 200F-400F).
(d) Middle distillates to kerosene, jet fuel, furnace oils, diesel fuels (Boiling range 350F600F).
(e) Catalytic cracking charge to fluid catalytic unit charge (Boiling range
450F -750F).
(f) Fuel residue vacuum distillation unit. (Boiling range about 700F)
Secondary or Conversion Processing
The primary process can only separate crude oil into its natural components as they exist and cannot
alter the mix of the components. It is therefore necessary to use some form of conversion (or yield
shift or upgrading) process in order to change the proportions of the various products that can be
obtained from crude oil. Secondary or conversion processing consists of cracking and non-cracking
processes.
Cracking
Cracking is the most common form of conversion. Cracking involves breaking up of large
molecules to form smaller ones. Cracking can either by thermal cracking (which involves heating
the feedstock to very high temperatures, which cause the large molecules of heavy feedstock to
decompose into the smaller molecules of gas oil and motor spirit), or fluid catalytic cracking
(which involves the use of chemicals known as catalysts that break hydrocarbon molecules at a high
reaction temperature into smaller molecules. Oil is mixed with fresh catalyst and run through the
reaction several times in order to enhance the yield and turn all the cycle oil to useful petroleum
products), or hydro-cracking (which involves the use of extra hydrogen to saturate the chemical
bonds of the cracked hydrocarbons, thus resulting in reduction of the molecular size), or visbreaking (which is a refinery upgrading process that lowers (i.e. breaks) the viscosity of residues by
cracking at fairly low temperatures)
Non-cracking Conversion Processes
This is achieved through delayed coking (a more specialized process that normally uses the residue
from low-sulphur crude to produce electrode-grade coke used in the production of aluminum, gas,
motor spirit and gas oils), or fluid coking (a development of the coking process in which the yield of
the more valuable lighter products from the residue feedstock is maximized), or blending

70

(process that involves the selective mixing of basic components to give a wide range of individual
grades of the same product).
5.13.4 Petrochemicals
A petrochemical is a chemical substance produced commercially from feedstock derived from crude
oil or natural gas. Petrochemical plants are usually integral parts of large refining complexes and
often subsidiaries of major oil companies. Their function is to turn outputs of the refining process
either in form of crude oil fractions or their cracked or processed derivatives into feedstock that will
ultimately be used in the manufacture of a host of other products e.g. plastics, resins, synthetic
rubbers, printing ink, paints, acid, fertilizers, detergents, etc. Petrochemical feedstock falls into three
main classes based on the chemical structure and composition of each. The three main classes are:
(a) aliphatic compounds, (b) aromatic compounds, and (c) inorganic compounds.

5.14 Accounting for Refinery Operations

Accounting for refinery operations begins with the costs incurred from the receipt of crude oil, to the
costs incurred in various refining processes, the cost of additives, investments in plant machinery
and other operating costs. The accounting treatment of costs incurred in a refinery operations are
discussed under various headings below:
5.14.1 Basis of Capitalization
Any amount expended in order to improve the earning capacity of the refinery is capitalized while
any expenditure incurred in order to maintain the earning capacity of the business is charged to the
operations of the particular period. However, the assistance of engineers may be required in
determining which expenditure is capital or revenue.
5.14.2 Crude Oil Purchasing
In an integrated oil company, it is more often than not the case that the quantity, timing and mix of
crude oil produced do not match with the requirements of the refinery. 1t is a practice in the refinery
to strike a balance between the crude oil available in quantity, timing and mix and crude oil required
in quantity, timing and mix. This is achieved by crude exchanges with other companies, purchases of
crude oil and sale of crude oil. Crude oil exchanges are recorded in the accounting books by
memorandum entries only. Purchases of crude oil are accounted for in the cost of sales while sales of
crude oil are recorded as sundry income.
5.14.3 Transfer Pricing
As stated earlier, a refinery is frequently an integral part of an integrated oil company. It follows
therefore that, as in other integrated companies, inter-departmental transfers are common, hence, the
need to determine transfer price. It is also important to determine what the transfer prices of gasoline
and other products of the refinery transferred to the companys marketing division will be. Fixing of
transfer prices is a function of the management who rely heavily on the information supplied by the
accountant. It is important that transfer prices are fixed in order to ensure that:
i. the performance of the transferring divisions, departments or subsidiaries can be evaluated;
ii. goal congruence within the organization is enhanced;
iii. the autonomy of each division, department or is maintained;
iv. the overall organization is put at a tax advantage; and
v. the cost of inefficient operations or decision-making would be revealed for necessary
corrective action.
The following transfer pricing methods are frequently used .
(1) Market based pricing
71

(2) Cost based pricing

(3) Negotiated pricing
(4) Free market prices for both inputs and output
(5) Cost plus margin for value of services rendered
5.14.4 Processing of Crude Oil Belonging to Outsiders
Where the refinery receives crude oil belonging to third parties for processing, only memorandum
records are to be kept to control the quantity. The consideration received inform of processing fees
should however be treated as a deduction from operating costs.
Cost of Catalysts
The accounting treatment of the cost of acquisition of expensive catalysts in refinery operations is to
capitalize the costs of the initial supply and depreciate them in accordance with normal accounting
practices. The costs of reprocessing and replenishing them are however charged to the operation of
the period.
Cost of Periodic Turnaround Maintenance
Costs incurred in the periodic maintenance of the refinery are initially capitalized. A provision for
turnaround costs is then made monthly to operating expense.
Depreciation
Depreciation is computed on a composite straight-line basis for the entire plant. Total depreciation is
then distributed to production and other units on the basis of investment in the units.
Standby Equipment
Refineries have a considerable investment in standby equipment which may be used in case of
emergencies or when production operations increase. There are many ways f treating depreciation on
these equipments. The most acceptable treatment is to make periodic provision for standby wear and
tear on these equipments and exclude them from the composite depreciation base.
Inventory Valuation
In accordance with normal accounting practice, inventories are valued at lower of cost and net
realizable value. Inter-departmental profits must be eliminated from inventory.
.
Sundry Income
Outright crude oil sales and other incomes are included in sundry income.
5.15 Accumulation and Classification of Costs
Costs are generally classified and accumulated by object and by function. The object classification is
the normal classification in financial accounting where costs are classified as wages, salaries etc. For
managerial accounting purposes however, this classification will not provide adequate information.
Functional classification of costs means that costs are segregated by areas of managerial
responsibility for the purposes of cost control. All costs, including depreciation, are classified by
areas of managerial responsibility and segregated according to the various products and service units
except the following:
i. Cost of crude oil - This cost is charged to the purchases account and transferred to the
manufacturing account at the end of the period.
ii. Cost of materials and supplies in inventory - This cost is adjusted before determining the
amount consumed in operations and then treated as current assets in the balance sheet.

72

5.16 Allocation of Costs

Total production cost must be determined and spread over units produced in order to determine unit
product costs and selling prices. Costs of service unit must be spread over production units before
unit product costs are determined. Costs also have to be allocated to joint products.
5.16.1 Service Department Cost Allocation
Three methods are used to allocate service department costs to production costs and subsequently to
production units. They are:
(1) Direct method
(2) Step method
(3) Simultaneous method
5.16.2Allocation of Cost to Joint Products: When the allocation of service costs to production
units is completed, there still remains the task of allocating costs to joint products. The methods
commonly used for this allocation are:
(i) physical method
(ii) market method
(iii) relative sales value method
(iv) replacement cost method
(v) alternative use method, and
(vi) by-product method.

DISCUSSION EXERCISES
Question One
During the first quarter of 2012, BUK Oil Company Nigeria Limited produced 50,000
barrels of crude oil from field New-Site oil field, which is located onshore. 5,000 barrels out
of the total production were re-injected into the well to enhance crude oil recovery from an
adjoining lease. The power generators used for field operations consumed 1,000 barrels
during the quarter and 500 barrels were lost through evaporation. Assuming that posted price
for the crude stream is US$21.00 per barrel and exchange rate of US$1 is equal to N152.00
You are required to compute royalty liability for the quarter, assuming that the
applicable rate of royalty is 20 per cent.
Solution to Question One
BUK Oil Company Nigeria Limited
Computation of Royalty Liability for the First Quarter, 2012
Gross production of crude oil
Less:
Quantity of crude oil re-injected into the formation 5,000 bbls
Production used for field operations
1,000 bbls
Quantity lost through evaporation
500bbls

50,000 bbls

6,500 bbls
43,500 bbls
$21

Net production
Posted price per barrel

73

Chargeable value of crude oil in Dollars

Conversion to Naira ($1=N152)
Chargeable value of crude oil in Naira
Applicable rate of royalty
Royalty payable

$ 913,500
N 152
138,852,000
20%
N27,770,400

Question Two
Ramat Oil Company Limited is an integrated oil company whose operations include
exploration, production, refining, petrochemicals and transportation. During the year ended
31 December 2011, the company produced and transported 1,000,000 barrels of crude oil
through its network of pipelines. Out of the quantity produced 400,000 barrels were
transferred to the companys refineries in Nigeria.
The posted price of the crude oil transferred to the refinery was $22.00 per barrel and the
standard and actual API of the crude stream were 40 and 42 respectively. The pipelines
cost was N 95,000,000 and are depreciated on a straight- line basis at the rate of 5 per cent
per annum. N 8,000,000 were spent on repair and maintenance of the pipelines during the
year. Exchange rate of Naira to the Dollar is $1.00 = N 150.00
Required
Calculate the value of crude oil delivered to the refineries during year 2011, assuming that
posted price of crude oil are escalated or de-escalated by $0.03 for every API difference
between standard and actual API degree.
Solution to Question Two
Ramat Oil Company Limited
Computation of Value of Oil Delivered to Refinery
For the Year Ended 31st December , 2011
Quantity of oil transported to refinery
400,000 bbls
Posted price of crude oil per barrel
Standard API gravity
40
Actual API gravity
42
Difference
2
Escalation rate
$0.03
Escalation
Adjusted posted price per barrel (in Dollar)
Adjusted posted price per barrel (in Naira)

$22.00

$0.06
$22.06
N3,309
N

Value of oil for royalty purposes:

1,000,000 bbls @ N3,309/bbl =

3,309,000,000

Value of oil delivered to refinery

400,000 bbls @ N3,309/bbl =

1,323,600,000

74

Cost of extraction of oil deducted in determining

posted price:
Cost of maintenance of pipeline
N 8,000,000
Depreciation of pipeline
( 5% of N 95,000,000)
N 4,750,000
N 12,750,000
Add: Cost of transportation 4/10 X 12,750,000
Total cost of crude oil delivered to the refinery

5,100,000
N 1,328,700,000

Question Three
The following information relates to Gwarzo Oil and Gas Nigeria PLC for the year
ended 31 December 2009.
Trial Balance as at 31st December, 2009
Particulars
Dr.
Cr.
N' 000
N' 000
Crude oil Inventory at 1/1/2009
6,700,000
Export Sales
50,000,000
Local Sales
10,000,000
Production Cost
9,000,000
Transportation cost
1,500,000
Intangible oil and gas assets
117,000,000
Salaries and wages
300,000
Proved oil and gas properties
13,500,000
Unproved oil and gas properties
8,300,200
Accumulated DD&A: Oil and Gas Assets
5,200,500
Loan Interest
3,500,000
Bank interest
1,700,000
Geological and geophysical costs
800,000
Carrying costs and overhead
135,000
Surrendered and impaired leases
230,150
Unimpaired leases
1,500,000
Exploratory wells: Successful
15,672,000
Unsuccessful
2,250,000
Development wells
20,567,000
Wells in Progress
11,570,000
Expenditure for purchase of seismic data
683,650
Royalties
1,500,000
Derivative financial instruments
500,800
Loss on exchange
1,450,000
Trade and other receivables
3,500,000
Derivative financial instruments
2,503,200
75

Cash and cash equivalents

Trade and other payables
Investments in subsidiaries
Other current assets
Share capital
Share premium
Other reserves

500,000
12,500,000
14,500,000
50,250,100

289,111,300

200,500,000
9,850,000
560,000
289,111,300

The following additional information are also available (all the Naira figures are in
thousand N'000):
(i) Closing stock of oil and gas as at 31st December, 2009 N1,200,000
(ii) Accrued expenses as at 31st December, 2009 amounted to N3,500,700
(iii) Provision for decommissioning amounting to N564, 2000 is to be provided.
(iv) DD& A is to be provided on proved oil and gas properties. Production during the
year was 500,000 of oil and 600,000 mcf of gas. Reserves estimates of oil and gas at the
beginning of the year (i.e. 1st January 2009) were: oil 5,000,000 bbls and gas 1,800,000
mcf, and the relative proportion of oil and gas is not expected to continue throughout the
life of the property.
(v) All capitalized costs and intangible oil and gas assets are to be amortized at the rate
of 10% per annum.
(vi) The Director's proposed a dividend of N2, 000,000 on shares and Petroleum Profit
Tax is to be calculated at the rate of 70%.
(vii) All workings are to be made to the nearest Naira.
You are required to prepare the final accounts of the company in Horizontal form for
use of the Company's management for the year ended 31st December, 2009, using (i)
Full Cost Method, and (ii) Successful Efforts Method.
Solution to Question Three
(i) Full Cost Method

Gwarzo Oil and Gas Nigeria PLC

Trading, Profit and Loss Account for the Year Ended 31st December 2009
N'000
N'000
Opening stock
6,700,000 Export Sales
50,000,000
Production Cost
9,000,000 Local Sales
10,000,000
Transportation cost
1,500,000
Royalties
1,500,000
18,700,000
Less closing stock
1,200,000
17,500,000
Gross income from operations
c/d
42,500,000
76

60,000,000
Accrued expenses
Provision for decommissioning
DD&A on proved properties
Salaries and wages
Loan Interest
Bank interest
Purchase of seismic data
Loss on exchange
Amortization: Intangible assets
Other capitalized costs
Net income from operations c/d

PP Tax 70%
Proposed dividend
Balance c/d

60,000,000

Gross income from

3,500,700 operations b/d
5,642,000
939,566
300,000
3,500,000
1,700,000
683,650
1,450,000
11,700,000
4,115,415
8,968,669
42,500,000
Net income from
6,278,068 operations b/d
2,000,000
690,601
8,968,669

WORKINGS
(i) DD&A on proved properties

Production of oil and gas in bbls

Gas in bbls
600,000 X 1/6 =
Oil in bbls
Production of oil and gas in bbls

100,000
500,000
600,000

Opening reserves of oil and gas in bbls

Gas in bbls
1,800,000 X 1/6 =
bbls of oil
Opening reserves of oil and gas in bbls

300,000
5,000,000
5,300,000

Unamortized cost at the end of the year (13,500,000-5,200,500) =

8,299,500
DD&A

600,000

8,299,500=

N 939,566

5,300,000
(ii) Other Capital Costs
Geological and geophysical costs
Carrying costs and overhead
Surrendered and impaired leases

N
800,000
135,000
230,150
77

42,500,000

42,500,000
8,968,669

8,968,669

Unimpaired leases
Exploratory wells: Successful
Unsuccessful
Development wells
Total

1,500,000
15,672,000
2,250,000
20,567,000
41,154,150

Balance Sheet as at 31st December, 2009

N' 000

Share capital

Reserves
Share premium
Other reserves
P&L a/c balance
Shareholders' fund
Long Term Liability
Long Term Borrowings
Current Liabilities
Accrued expense
Provision for
decommissioning
Derivative financial
instruments
Trade and other payables
Petroleum profit tax
Proposed dividend

N'000
N'000
Accumlatd
Cost
DD&A
NBV
13,500,000 6,140,066
7,359,934

Fixed Assets
200,500,000 Proved properties
Unproved
properties
8,300,200
----8,300,200
Intangible assets 117,000,000 11,700,000 105,300,000
Other capitalized
9,850,000 costs (ii)
41,154,150 4,115,415 37,038,735
560,000 Wells in Progress 11,570,000
----11,570,000
690,601
191,524,350 21,955,481 169,568,869
211,600,601 Investment
Derivative financial instruments
Investments in subsidiaries
27,500,00

2,503,200
14,500,000

Current Assets
3,500,700 Stock

1,200,000

5,642,000 Trade and other receivables

3,500,000

500,800 Cash and cash equivalents

Other current
12,500,000 assets
6,278,068
2,000,000
242,022,169

500,000
50,250,100

55,450,100

242,022,169

(i) Successful Efforts Method

Other Capital Costs

N'000

78

Unimpaired leases
Successful exploratory wells
Development wells

1,500,000
15,672,000
20,567,000
37,739,000

Gwarzo Oil and Gas Nigeria PLC

Trading, Profit and Loss Account for the Year Ended 31st December 2009
N'000
N'000
Opening stock
6,700,000 Export Sales
50,000,000
Production Cost
9,000,000 Local Sales
10,000,000
Transportation cost
1,500,000
Royalties
1,500,000
18,700,000
Less closing stock
1,200,000
17,500,000
Gross income from operations c/d
42,500,000
60,000,000
60,000,000
Accrued expenses
Provision for decommissioning
DD&A on proved properties
Salaries and wages
Loan Interest
Bank interest
Purchase of seismic data
Loss on exchange
Geological and geophysical costs
Carrying costs and overhead
Surrendered and impaired leases
Unsuccessful exploratory well
Amortization: Intangible assets
Other capitalized costs
Net income from operations c/d

PP Tax 70%
Proposed dividend
Balance c/d

Gross income from

3,500,700 operations b/d
5,642,000
939,566
300,000
3,500,000
1,700,000
683,650
1,450,000
800,000
135,000
230,150
2,250,000
11,700,000
3,773,900
5,895,034
42,500,000
Net income from
4,126,524 operations b/d
2,000,000
(231,490)
79

42,500,000

42,500,000
5,895,034

5,895,034

Share capital

Reserves

Share premium
Other reserves
P&L a/c balance

Balance Sheet as at 31st December, 2009

N' 000
N'000
Fixed
Cost
Assets
Proved
200,500,000 properties
13,500,000
Unproved
properties
8,300,200
Intangible
assets
117,000,000
Other
capitalized
9,850,000 costs (i)
37,739,000
Wells in
11,570,000
560,000 Progress
(231,490)
188,109,200

Shareholders' fund

Current Liabilities
Accrued expenses
Provision for
decommissioning
Derivative financial
instruments

Trade and other payables

Petroleum profit tax
Proposed dividend

5,895,034

N'000
N'000
Accumlatd
DD&A
NBV
6,140,066

7,359,934

----

8,300,200

11,700,000 105,300,000

3,773,900

---11,570,000
21,613,966 166,495,234

210,678,510 Investment
Derivative financial
instruments
Investments in subsidiaries
Current Assets
3,500,700 Stock
Trade and other
5,642,000 receivables
500,800 Cash and cash equivalents
Other
current
12,500,000 assets
4,126,524
2,000,000
238,948,534

80

33,965,100

2,503,200
14,500,000

1,200,000
3,500,000
500,000

50,250,100

55,450,100

238,948,534

81