Basic cost analysis in petroleum upstream industry part a
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Basic cost analysis in petroleum upstream industry part a

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Cost control and management is not appropriate only for manufacturing and commercial industry; ...

Cost control and management is not appropriate only for manufacturing and commercial industry;
cost management is applied in upstream industry such as Petroleum exploration, development and
production cost. Many Petroleum Companies don’t pay more attention to cost control and
especially during exploration phase except if Companies face financial dilemma, declining
production or if they see they cannot meet their planned schedule of Capital program that lead
them to not meet their obligation, commitments and required return, therefore, they start
considering cost reduction or control. This paper provide management accountant, cost controller,
financial controller, financial manager, internal auditor and cost recovery auditor with brief of cost
control, how cost is analyzed and managed and performance is measured in Petroleum upstream
industry.

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  • 1. Fundamental Cost Analysis In Petroleum Upstream Industry –Part AHamdy Rashed, CMA, CAPMBsc of Accounting,E-mail: rashed.hamdy@gmail.com,February 15, 2013AbstractCost control and management is not appropriate only for manufacturing and commercial industry;cost management is applied in upstream industry such as Petroleum exploration, development andproduction cost. Many Petroleum Companies don’t pay more attention to cost control andespecially during exploration phase except if Companies face financial dilemma, decliningproduction or if they see they cannot meet their planned schedule of Capital program that leadthem to not meet their obligation, commitments and required return, therefore, they startconsidering cost reduction or control. This paper provide management accountant, cost controller,financial controller, financial manager, internal auditor and cost recovery auditor with brief of costcontrol, how cost is analyzed and managed and performance is measured in Petroleum upstreamindustry.Keywords: Cost Management and analysis for petroleum exploration, Optimizing production, exploration anddevelopment programs, Project Cost Management and Analysis for Petroleum Upstream Industry, ProcurementCost Management, Drilling Cost Management, Production Cost Management, G&A Cost reduction.It was noticed that few major oil companieshired management accountant and cost controlaccountant who are assigned to the correct tasksand duties that include measuring management,department and overall company’s performance,support management and provide with requiredfinancial and non-financial information that canhelp management to take a decision, participatein putting plan and strategy for the company.Before discussing about the cost managementand performance evaluation in oil and gas E&Pcompanies, we like to draw our reader’sattention that this paper does not criticizing thedrilling practices of oil and gas companies but itprovides fundamental concepts for thepossibility of managing costs in such industry.Accountant and internal auditor needs tounderstand what is the type of costs per functionin oil and gas industry, to assign KPI of costmanagement to each functional department. Thecosts that are assigned to each functionaldepartment shall be direct costs that are effectedby cost drivers rather than decision-making suchas barrels produced of petroleum, hours spendby staff, meters or days drilled, KM2 seismicrun, processed or interpreted, meter square orcubic meter of space occupied.1) Oligopolistic MarketOligopoly is created when there are few numberof large firms in the industry that explore andproduce somewhat similar commodities of oiland gas and there are many buyers because
  • 2. Cost Management and analysis for performance evaluation Hamdy Rashed; CMA, CAPM    2 entering the market is not easily because it is toocostly for exploring and producing oil and gas,the major part of such cost are fixed or sunk costthat increase the break-even output. The profit ismaximized when the marginal cost equalsmarginal revenue. In summary, we assess thepetroleum upstream producers market asoligopolistic market due to the followingcharacteristics:1- Small number of large firms2- Somewhat similar commodities thatcould be differentiated by its nature thatis referred to the quality of oil and gasproduced.3- Natural barriers to entry that high set-upcost and exploration costs.4- Elasticity of oil supply is relativelyinelastic [Tom Konrad, Jan 26, 2012.The End of Elastic Oil. Forbes] & [JohnC.B Cooper. March 2003. PriceElasticity of demand for crudeoil:estimates for 23 countries.Organization of Petroleum ExportingCountries]Oligopolistic Company could take advantage ofeconomics of scale that reduce production costsby reducing average fixed costs and takeadvantage of high price that is determined bysetter who has price power. The disadvantage ofoligopolistic company can allocate the resourcesand produce inefficiently.But many less experienced small or medium Oiland Gas Companies pay less attention to costreduction in exploring and producing oil and gasbecause many of such companies thought that allcosts incurred for exploration, development andproduction will be cost recovery, the finding andoperating costs of one barrel or mscf does notreflect major part of oil and gas price. In otherword, whatever it has been spend for finding andproducing oil, the large recoverable reservescould payout the costs in very short time andsuch costs will be spread among the recoveredreserves which lead to reduce the average coststo the level which make it immaterial. However,low finding cost and operating costs could leadto have more feasible well and attract companiesto produce oil for such well.2) Cost Analysis and EstimationAll costs have not same behavior, there are costsare proportion to changes in volume range ofproduction, other costs such as Labor hours andmachine hours of production facilityequipments. And there are costs that are notchanged in responding to changes in volumerange of production. Understanding Costbehavior enable Oil and Gas Companies to thefollowing:a) Identify the breakeven and Cost-volume-profit analysisb) Evaluate organizational or departmentalperformance.c) To make routine decisionsd) To make non-routine decisionsBefore identifying the direct or indirect costs.Management accountant should identify criticalcosts in petroleum upstream Companies. Thenbreak the costs into elements and costs drivers toenable the management accountant to identifyand group the controllable costs from non-controllable costs and the responsibility centers.2.1) Critical Costs Identification.Petroleum Company in Upstream Industry shallmaintain detailed and accurate records if theyare serious in cost control-orientation to enableCompany to track the costs and to find ways forcost management improvements.When Drilling Department or ExplorationManger finalized Project Management Plan andWork Breakdown Structure (WBS) they specify
  • 3. Cost Management and analysis for performance evaluation Hamdy Rashed; CMA, CAPM    3 which materials and services they need to buyand what are the specifications of thosematerials and services. Also, OperationDepartment need to determine how muchmaterials and what are the services they need tobuy based on their Materials and ServicesRequirement Plan and based on theirexperimental judgments and historical data.Responsibility centers, Program Manager orinvestment center manager should conduct withmanagement accountant or cost controller tounderstand the critical costs and cost behaviorsand identify the controllable costs.All Oil and Gas Exploration and ProductionCompanies financially categorize the costs intofive major category as follow:2.1.1) Pre-acquisition and AcquisitionCostManagement accountant should help programmanager or investment center manager to getand analyze the acquisition costs to enable theprogram manager to get in very good negotiationwith government or third party to acquire licenseat lower costs. The Pre-acquisition andacquisition costs include cost of purchasingseismic data, cost of G&G analysis for this data,cost of license bonuses and signature bonuses,broker’s fees and legal costs for acquiring thelicenses.Before taking decisions for acquiring thelicenses and signing the related contracts withhost government. Management accountantshould prepare Contract cash flow projectionand understanding the effect of the Contractterms to the cash flow projection and providingrecommendation to program or explorationmanager to have good negotiation with hostgovernment. The contract terms that couldimpact on the Production Sharing Contracts cashflow projection are as follow:a) Royaltiesb) Profit Oil Splitc) Work commitmentsd) Non-recoverable Costs1. Annual Bonuses2. Signature Bonuses3. Acquisition Costs, If any.e) Cost Recovery ceilingAlso, management accountant should considerother variable inputs for PSC cash flowprojection such asa) Petroleum Priceb) Required Rate of Returnc) Estimated Finding (Exploration,development and facility) Costsd) Preliminary chance of successe) Preliminary potential Petroleum reservesf) Corporate Income Taxg) Estimated Operating CostsIf there is no attractive potential reserves or thepreliminary chance of success is very low due tonew discovery area, the Company can get intogood negotiation with host government andobtaining Production Sharing Contract withgood terms but if the expected rate of return ofthe cash flow projection does not encouragecompany to acquire the license2.1.2) Exploration CostExploration costs are costs incurred afteracquiring the license and before decision ismade for developing the license. Such costsinclude the following:- Geological and Geophysical studies that covers- Seismic Acquisition cost- Seismic processing/reprocessing- Seismic interpretation- Velocity modeling- Other G&G study- Cost of holding the undeveloped licenses- Cost of drilling and testing exploratory wells
  • 4. Cost Management and analysis for performance evaluation Hamdy Rashed; CMA, CAPM    4 Cost Management or Cost Controller shouldestimate the exploration costs that be used inCash flow projection and viability analysis ofdiscovering petroleum. Program manager orexploration manager should understand that thehigher Capital Costs that represents explorationand development costs, the higher minimumtarget size of reserves will be, and the lowerexpected monetary value and higher opportunityloss may occur. Cost Controller or ManagementAccountant should analyze the service contractsthat are related to seismic acquisition,processing, drilling contracts and others andinvestigating for higher costs and find the bestalternative way to manage the costs withoutreducing the quality of service, materials or theperformance of subcontractor’s in HSES.Management Accountant or ExplorationManager need to know when to use 2D, 3D or4D seismic, the quality of providing seismicacquisition and management accountant shouldconsider the costs of high quality seismic incomparison of cost of drilling dry well. Also,exploration manager may not expect thatpetroleum will not be discovered in geologicalformation that its thickness will be less than 3meters, therefore, exploration manager maycontract with Seismic Compmany to use lessfrequency of seismic waves that include the lessthan 3 meter formation into prior or consecutivethicker formation which going to be neglected inthe seismic processing and the costs will bereduced, but exploration manager might bewrong, and Company may carry higher costs fordrilling wrong well or for not having accurateseismic mapping. Any decision for having somespecification in contracts should be reviewed bycost controller to check the cost and benefit ofsuch quality or specifications.Even the cost of exploratory or developmentwells, such costs are combined into drillingcontract, cementing, logging and fluid contracts.Cost Controller or contract specialists,management accountant and explorationmanager should not looking for only the lowercost of tender, they must consider the technicalperformance of such subcontractors. The lowerperformance the higher costs could be incurredin late time.2.1.3) Development and Facility CostDevelopment costs are costs incurred aftertaking the decision for developing the license orreservoir that include:- Cost of drilling and testing development well- Cost of completing and equipping productionwell- Cost of facilitating in producing oil or gas suchas building facility equipments of separator,treator, storage, waste disposal system.- Cost of improved recovery equipments.2.1.4) Operating CostThe third important activities that are performedfor producing oil or gas which include:- Labor costs engaged in operation of well andrelated facility equipments- Cost of repairs and maintenance of producingequipments- Cost of materials and fuel consumed and costof services that are used in operations of wellsand facility equipments.2.1.5) Site restoration CostIt is costs of plugging and abandoning wells anddismantling all the surface equipments inaccordance with production sharing agreementor local regulations.3) Elements of CostsWhatever the type of costs or the functionalactivities that cause costs, the costs are containsthree elements which are:- Materials- Labor- Other expense
  • 5. Cost Management and analysis for performance evaluation Hamdy Rashed; CMA, CAPM    5 And each of the above elements are eitherdirectly and completely assigned to specificunits or charged to prime costs or indirectlyelements that cannot be assigned to the specificunit or charged to prime costs the mostappropriate example of indirect costs areoverhead such as drilling overhead, explorationoverhead, administrative overhead.Exploration, development and production costscan be divided into materials and services, laborand overhead. Each of this costs can provide anopportunity for controlling and managing thecosts.3.1) Materials/Assets or services CostProcurement Department and Drilling Managershall ensure that they are obtaining the bestprices with very good quality of materials andassets, check with variety of suppliers to find thebest prices and materials via tenders and basedProcurement Management Plan.3.1.a) MaterialsProcurement Manager, Operation Manager,Drilling Manager, or Exploration Manager mayintend to buy in large volume of drillingmaterials or operation materials to obtainpurchasing discount, saving transportation cost,meet variations of drilling needs, but they mayneglect the following risks and the costsassociated of buying high volume and buildingup stock.- Obsolescence and selling the materialsless than actual costs at late time- High storage Cost- Opportunity costs of keeping high valueof surplus inventory. However, if suchmoney invested in bank with free-riskinterest, it can generate income to theCompany by 4% or more annuallydepends on the interest rates prevailed atthat time.Building materials and supplies Inventory in oiland gas upstream industry is subject to the typeof costing.When Company enter in production phase, itapplies costing process system for productionprocess, therefore, they follow MaterialsRequirement Plan, but they apply job-ordercosting system for exploration and developmentdrilling that allow to use Just-In Time Inventory.However, drilling wells in specific geologicalformation may vary from place to another, andavailability of suppliers may vary from countryto another, Many of Petroleum Companiesintend to buy their drilling materials or assets(Casing and wellheads) based on their estimatedrequirements of proposed wells to be drilled plus10% - 20% as contingency.Many PSAs require to pass title of drillingmaterials or assets to the host government at thetermination of PSAs, which lead Company tobear the loss of disposed assets. To mitigate suchloss, Petroleum Companies are supposed to havevery clear and practical drilling schedules inforeign Companies and high experiencedtechnical and drilling staff to have the bestestimate of actual needs of drillingmaterials/assets that will be bought.In Petroleum upstream Companies, thefollowings are the major materials costs thatcould be controlled and managed properly.- Tanigble Drilling cost such aso Casingo Tubingo Wellhead- Operating materials such aso Treating chemicalso Small tools & supplies- Furniture’s and equipments- Facilities Assets such aso Pumpero Generators
  • 6. Cost Management and analysis for performance evaluation Hamdy Rashed; CMA, CAPM    6 o Gathering compressiono Flowlineso Treater, Sperator3.1.b) ServicesAfter preparing the WBS, Drilling Departmentand Procurement Department will outline therequirements for services in Contract Statementof work (SOW) after identifying the type ofcontract and the risks, Company and Contractorwill bear them. Most of the Petroleum servicecontracts is fixed price contracts with economicprice adjustments.Drilling and Procurement Departments definesthe technical, functional, and performancespecification and the exact works that are neededfrom Contractor in enough detail to mitigate thedisputes between the Company and Contractor.SOW and contract must clearly define theparameters for acceptable performance andtimeline for each section of work based on thenature of the work.Drilling Department, Procurement Departmentsor Exploration Management may be trappedthemselves unknowingly by increasing thespecification and wrong assumption that mayincrease the unnecessary costs. Specificationmust not be very open or loose with missingimportant details.Drilling and Procurement Manager shall haveopen meeting with all suppliers and reply totheir inquiries equally, provide adequate andaccurate information of specification equally‘cause missed details may lead ineffectivesuppliers purposely providing lower biddingprice to win the contract and they know thecontract price will be changed then by issuingvariations or purchase orders. And this actionwill lead to increasing the costs.Drilling Department and procurement shalldefine the evaluation criteria if there is noCorporate policy that define them. Internalauditor shall review the objectivity of evaluationcriteria and if they are properly updated andapplied by concerning staff. Internal auditorshall review the SOW and contracts eitherbefore it has been signed to mitigate thepotential risks or after it was signed andimplemented, for lessons learned and avoid thesame mistakes or risks in future. Also,management accountant, cost controller orcontract specialists can review the activities andterms of contracts after the implementation forlessons learned if the Control-Self Assessment(CSA) program is applied.The major and most common services requestedby Petroleum Company are as follow.- Drilling service- Cementing service- Drilling Fluids service- Logging and Testing service3.2) Labor CostLabor costs in oil & gas Companies representhigh part of total costs after materials/assets andservices costs, even services costs containsmaterials and labor costs but it is not practicallyto determine such costs from servicescontractors’ invoices except for Consultancyservices that does not contain materials cost.Labor costs that we need to indicate to, is thecost of employees that have a direct contractswith an Oil and Gas Company.Oil and Gas Company should be look for theways to improve labor efficiency. Inproduction/operation Department, PetroleumCompany shall keep track of how much oil orgas produced during specific period of time perlabor hour and look for variables and correlatethat can increase the productivity, such as directlabor cost, and labor costs of home office. Even
  • 7. Cost Management and analysis for performance evaluation Hamdy Rashed; CMA, CAPM    7 in Drilling and Exploration Department,Petroleum Company shall keep track of howmuch proved reserves of oil or gas discoveredper labor hours, and how much unproductivehours (Unproductive drilling hours include thetime spent for lost circulation, stuck pipe,fishing) to total drilling hours per well, costcenter and overall.Petroleum Company should know theiremployees’ strengths, weakness and skills,determine suitable training for them, schedulethem for the positions that allow Company tomake optimum use of their abilities. PetroleumCompany that are seriously seeking for costcontrol may replace high cost of their expatriatesby the lower costs of high technical skilled laborafter train them managerially.Petroleum Company shall have incentive andsalaries payments that are more reasonable andrelating to performance of labor and managersthat can change the slope of learning curves oflabor to higher and reducing the unproductivetime. Also, Petroleum Company shall reviewand update their performance measurementssystems and payments system frequently toconsider all the necessary appropriate combinedfactors that determine the payments systems forsalaries, bonuses or incentives for low level ofemployees to high level of management. Forexample, Oil & Gas Company that face annualloss or will face difficulty in availability of cashand need to reduce its costs shall give moreweight for factor of finding oil and commercialoil and factor of reducing costs more than otherfactors such as HSES factor to enablemanagement and employee to focus onmaximizing their productivity by lower costs,but if the opposite is happened. If Company paysmore attention to HSES than any other factors,management and employee will focus onspending more money for HSES that its costmay exceed the benefit because it will be easilyachievable for management and employee anddistract management attention and energy fromgenerating profit from normal course of businessand reducing costs, that will lead Company togenerate its profit and cash flow from abnormalcourse of business such as selling workinginterests which could have been potentially andsignificantly profitable for the company infuture. HSES is important but should becombined with other important factors and beweighted based on the strategy that companywant to follow.Also, clear promotion and recruitment policyand procedures help company to control laborcosts and increase labor efficiency.3.3) Overhead CostOverhead costs are costs that cannot traced toparticular object of costing. Most of suchoverhead are fixed over time but such costcannot be indirect for all cases, it can be tracedto specific cost center but cannot be traced tospecific project or production. The most likelycosts that are considered overhead areHeadquarter’s expenses that are considered as anoverhead costs. And many of PSAs does allowto recover part of foreign Headquarter’s costs ascost oil but not all overhead expenses.Therefore, many Petroleum Companies areseeking to cut such costs by using their facilitiesand capabilities as fully as possible. However,those PSAs allow to recover all direct overheadof offices allocated in the host countries but theyneed to use either appropriate basis or equalbasis for allocating such costs to the licensesobtained. Therefore, the part of allocatedoverhead to exploration block may leadPetroleum Company to reduce such thisoverhead cost.4) Cost Drivers IdentificationThe costs that cannot be measured, it cannot bemanaged but may be cut or void. The costs thatcan be measured are costs that varied based on
  • 8. Cost Management and analysis for performance evaluation Hamdy Rashed; CMA, CAPM    8 independent variables and can be stated orestimated in a formula by identifying the unit ofactivity that causes the changes in prime activitycosts and the price of unit activity. Developingcost drivers in formula is as follow.Total Cost = Variable Cost + Fixed CostVariable Cost = Cost per unit x quantity usedPetroleum Company should prepare Cause andEffect Analysis to know how different factorsand variables relate together and can effect thecosts of particular object.4.1) Direct CostDirect costs can be charged to particular objectof costing, either project, cost centers orproduction. Most of direct costs are variablecosts that are vary in total to changes or activityof project, cost center or production. labor costformula and materials formula.Labor Cost = Labor rate x Labor hours + Constant laborcost when labor hours is 0Cost of Materials = Unit cost of materials x quantities ofmaterials consumed + Constant cost of materials whenconsumption of materials is 0Cost of Services = [Labor rate x Labor hours + Constantlabor cost when labor hours is 0] + [Unit cost ofmaterials/equipment x quantities of materials/equipmentconsumed x period of time to be used + Constant cost ofequipment when equipments are not used or in standby]4.2) Fixed and Indirect CostFixed costs are stay constant regardless ofactivity or throughout the production level, lifeof a project, depth of drilling well, time spend touse equipments or materials4.3) Sunk CostsSunk costs are irrelevant costs that cannot bevaried by obtaining different decision and neednot to be considered in decision analysis. Thehistorical costs and fixed costs are most likelyconsidered as sunk costs.References‐ Tom Konrad, Jan 26, 2012. The End ofElastic Oil. Forbes] & [John C.B Cooper.March 2003. Price Elasticity of demand forcrude oil:estimates for 23 countries.Organization of Petroleum ExportingCountries