Appendix 7-B

ANALYSIS OF OIL AND GAS DISCLOSURES

INTRODUCTION
The two acceptable accounting methods used for oil and gas exploration: the successful efforts method (SE) and full cost method (FC)1 are illustrated in Exhibit 7-1. The choice between these methods has signicant effects on reported nancial statements. These differences can be summarized as follows:
SE rms, by expensing dry hole costs, have lower carrying costs of oil and gas re-

serves than FC rms. SE rms have lower earnings than FC rms when exploration efforts are rising. SE rms have lower cash from operations than FC rms (unless explicitly adjusted for, as in the case of Texaco).

APPENDIX OBJECTIVES
1. Examine the motivation for use of the successful efforts and full cost methods. 2. Describe the motivation and effects of changes between the two accounting methods. 3. Analyze the supplementary disclosures regarding oil and gas reserves, showing how they can be used to gain insight into the: changes in reserve quantities over time. cost of nding new reserves. level and trend of present value of reserves, a proxy for the fair value of oil and gas reserves. 4. Show how to adjust present values for subsequent price changes. 5. Adjust stockholders equity and the debt-to-equity ratio for the difference between the carrying cost and present value of oil and gas reserves.

Motivations for Accounting Choice

The differential effects on nancial statements demonstrated in Exhibit 7-1 as well as the illustration in Box 7-1 help explain why some rms prefer the SE method and others the FC method. Empirical evidence as to these preferences is provided in Box 7B-1. Small rms generally prefer the FC method; large rms tend to be indifferent. For larger rms, with relatively stable exploration budgets and relatively constant success ratios (productive to total expenditures) across a portfolio of exploration projects, the year-to-year variability of dry hole expense is low. Amortization of past expenditures is large, reecting a large reserve base. As a result, the difference between the two methods is small. Additionally, larger oil companies are often diversied into the rening and distribution segments of the oil business. Income from these sources dampens the variability of exploration

Both methods are described on pages 244246.

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W22
BOX 7B-1 SE Versus FC Choice of Methods: Empirical Evidence
A number of research studies* have examined characteristics of rms using SE versus FC accounting. Malmquist (1990) tested the relationship between the following characteristics and rm choice. 1. Size The larger the rm, the less likely it will choose FC for several reasons. First, large rms prefer income-reducing alternatives such as SE to avoid earning windfall prots, especially when prices are rising, given the political sensitivity of energy prices. Second, large rms have more drilling activities occurring simultaneously, creating a portfolio effect and thereby decreasing income variability. Third, in addition to the risks associated with exploration, oil companies are subject to the risks associated with marketing and rening. The larger the proportion of the rms activities in marketing and rening, the lower the impact of SE because its effect is limited to the income associated with exploration. As large rms tend to be more diversied, they have less incentive to opt for FC. Using sales as a proxy for size (political costs) and the ratio of exploration costs to market value as well as the ratio of production costs to market value to measure the various aspects related to size, Malmquist found them all to be signicant in explaining the accounting choice. Higher sales and a larger proportion of production costs made the rm more likely to choose SE. Conversely, the larger the exploration cost proportion, the more likely the rm was to choose FC. 2. Difculty of Raising Capital in the Equity and Debt Markets SE companies report lower assets than FC companies. Therefore, securities underwriters may be hesitant (or find it difficult) to sell the securities of firms having low or negative net book value (equity) levels. Borrowing may also be more difficult for firms with high and variable debt/equity ratios. Moreover, for debt already in existence, there is a higher probability

APPENDIX 7-B

ANALYSIS OF OIL AND GAS DISCLOSURES

of technical violation of debt/equity-related debt covenants. Malmquists study confirmed that firms with higher debt/equity ratios are less likely to choose SE. 3. Management Compensation Contracts Earnings-based management compensation contracts are affected by the choice of accounting method. Opportunistic managers may choose full costing to increase the level of their compensation and decrease its variability. Malmquist notes there are strong disincentives and limits placed on such behavior by the managerial labor market. No apparent relationship between the choice of accounting method and the presence of an earnings-based compensation contract was observed. These results are consistent with some (but not all) of Deakins (1989) ndings. Analyzing rms that lobbied for FC and the reasons given by those rms for lobbying, Deakin found that, on average, they had characteristics consistent with the stated reasons. The reasons given by the rms were: 1. The expected impact on cost of capital and access to capital markets 2. The potential of the proposed elimination of the FC method to affect accounting income-based management incentive contracts 3. The perceived effect on future drilling activity 4. The effect of rate regulation To some extent, generalizing from Deakins sample of companies, which lobbied for a particular accounting method, to the general population of rms, is fraught with danger as the sample may be biased. Taking the time and effort to lobby can be an indication that these rms are the ones most likely to be affected by the choice. Thus, Deakins nding that the presence of management incentive contracts was associated with rms that lobbied for FC in contrast to Malmquist, who did not nd such a relationship, may reect their different samples.

*See, for example, Steven Lilien and Victor Pastena, Determinants of Intra-Method Choice in the Oil and Gas Industry, Journal of Accounting and Economics, 1982, pp. 145170 and Edward B. Deakin III, An Analysis of Differences Between Non-Major Oil Firms Using Successful Efforts and Full Cost Methods, The Accounting Review, Oct. 1979, pp. 722734. Edward B. Deakin III, Rational Economic Behavior and Lobbying on Accounting Issues: Evidence from the Oil and Gas Industry, The Accounting Review, Jan. 1989, pp. 137151. The last reason applied primarily to regulated companies that were required by rate-making authorities to use FC accounting procedures.

income. Large oil companies tend to use the SE method as well because it is perceived to be more conservative.2 For smaller companies, however, the differential impact of these two accounting methods can be considerable. Year-to-year variations in spending and success ratios mean that dry hole expense can vary greatly. Under SE accounting, this variability is transmitted directly to the income statement. Further, smaller companies (especially if growing rapidly) have small reserve bases and low amortization of past capitalized costs. Dry hole costs from current drilling activities often exceed the amortization of the capitalized costs of past drilling.
2

A more detailed analysis of the nancial reporting effects of SE versus FC on rms under different environments is provided by Sunder (1976).

SFAS 69: DISCLOSURES REGARDING OIL AND GAS RESERVES

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Smaller companies are also less diversied as they concentrate on exploration. Widely uctuating patterns of earnings growth are considered a drawback for rms attempting to obtain external (equity or debt) nancing. This problem is further exacerbated because, under successful efforts, the balance sheet shows lower assets and equity, thus hurting reported solvency ratios. As a result, smaller companies tend to use the FC method of accounting.

Changing Accounting Methods

The FC method has one drawback, however. When the price of oil causes the value of the reserves to fall below book value, the SEC requires that companies using the FC method write down properties whose carrying cost exceeds the present value of future cash ows of the proved reserves attributable to that property.3 Companies using the SE method are required to use the less stringent measure of undiscounted future cash ows.4 In the 1980s, when the price of oil fell drastically, some companies that had previously chosen FC accounting (presumably to report higher income) were forced to take large write-offs, reducing reported income. One method of avoiding such large write-offs was to change reporting methods from FC to SE, reducing the carrying amount of reserves. The change to or from the FC method is one of those cases where retroactive adjustment for accounting changes is mandatory; all prior years presented must be restated and the cumulative effect reported as an adjustment to the beginning retained earnings. Note that this does not change the value of the reserves; it only changes the carrying amount on the balance sheet. Sonat changed its accounting method several times, reecting changing industry conditions (see Problem 7B-1). Adoption of the SE method of accounting requires the expensing of capitalized dry hole costs, lowering reported income. On the other hand, the amortization of previously capitalized costs is also reduced, increasing reported earnings. The balance between increased expensing of current year expenditures and reduced amortization of past expenditures determines the net effect on earnings for any given year. What is the effect of the accounting change on cash ow? There is no effect on actual cash ow as the change to the successful efforts method merely reallocates cash ows for nancial reporting purposes. (For income tax purposes, oil and gas companies expense the maximum allowable; the accounting change has no impact on tax return income.) However, components of reported cash ows may be affected by the accounting change. Lower reported capital expenditures are offset over time by lower reported operating cash ows. Once again, we see how the classication of cash ow components is affected by accounting choice.

SFAS 69: DISCLOSURES REGARDING OIL AND GAS RESERVES

A major drawback of both accounting methods is the lack of correspondence between the reported cost of a producing oil or gas eld and its economic value. Although this is true of virtually all xed assets, it is especially true of oil- and gas-producing assets because, even at the time of drilling, there may be little relationship between the expenditures and results. An expenditure of millions of dollars can result in a dry hole. Alternatively, a small expenditure can result in a discovery of oil or gas worth many times its cost. Neither method provides truly relevant data as to the value of reserves. This shortcoming is addressed by the disclosure requirements of SFAS 69 (1982), which requires extensive information about the results of operations for oil and gas activities and disclosure of a standardized measure of proved oil and gas reserves. Additional summary disclosures of these activities by equity method investees and minority interests are also required.

The comparison of the carrying value of reserves with their present value is sometimes referred to as the ceiling test. 4 See David B. Pariser and Pierre L. Titard, Impairment of Oil and Gas Properties, Journal of Accountancy, Dec. 1991, pp. 5262.

W24 Disclosure of Physical Reserve Quantities

APPENDIX 7-B

ANALYSIS OF OIL AND GAS DISCLOSURES

Texacos 1999 nancial statements (included in the website and CD that accompany the text) contain a section entitled, Supplemental Oil and Gas Information. Table I provides data on the physical quantities of Texacos proved oil and gas reserves, including: 1. 2. 3. 4. 5. Separate disclosure of oil and gas reserves Separate disclosure by geographic area Separate disclosure of the reserves of equity afliates5 Reconciliation of the year-to-year change in proved reserves Disclosure of proved developed reserves

These data describe the companys physical reserves at each balance sheet date. The rst two features listed help the user understand the nature of the reserves. For example, oil reserves in the United States have different economic characteristics than gas reserves in Africa. Separate disclosure of the reserves of equity method afliates aids the evaluation of the investment in such companies. The reconciliation is one of the most signicant features as it enables us to understand how estimated reserves change from year to year as a result of: 1. 2. 3. 4. 5. Production, which reduces reserves Discoveries, which increase reserves Purchases and sales of reserves Revisions of estimates Price changes, which can make reserves economically feasible to produce, or not6

Each of these disclosures provides useful data because physical quantities can be related to cash ows. For example, the cost of nding reserves can be derived by comparing exploration expenditures with reserves discovered. This is considered an important measure of management ability. Revisions, as noted by Clinch and Magliolo (1992),7 are important indicators of the quality of management estimates. Companies reporting predominantly downward revisions are viewed with some skepticism, reecting the apparent overoptimism of past estimates. Investors prefer positive surprises, that is, upward revisions of estimated reserves. Texacos disclosures show that worldwide oil reserves increased over the three-year period, from 2,704 million barrels at December 31, 1996 to 3,480 million barrels at December 31, 1999. Most of the increase was in the United States and Other East geographic areas. Gas reserves also rose, with the United States and Other East (the largest percentage increase) again accounting for the gain.
5 6

See Chapter 13 for a discussion of the equity method. For example, in 1985, Atlantic Richeld removed 8.3 trillion cubic feet (trillion billion MCF) of natural gas reserves located in northern Alaska from its estimate of proved reserves, reducing its domestic gas reserves by more than 50%. The company explained that this change was prompted by a review of economic factors, especially the signicant drop in oil and gas prices in that year. In its 1999 10-K, the company stated that:

ARCO is actively evaluating various technical options for commercializing North Slope gas. . . . Signicant technical uncertainties and existing market conditions still preclude gas from such potential projects being included in ARCOs reserves. 7 Clinch and Magliolo argue that the value-relevance (informativeness) of the SFAS 69 data depends on the reliability investors attach to it. As data are subject to constant revision, reliability suffers. They found that although the market did not nd reserve data to be value-relevant, production data were found to be informative. Production data, they argue, are more objective as they reect actual actions taken by management rather than just estimates. Further, they found, for the subset of rms whose quantity estimates appeared more reliable (less revision of estimates), that proved reserve data were also value-relevant. (Greg Clinch and Joseph Magliolo, Market Perceptions of Reserve Disclosures Under SFAS No. 69, The Accounting Review, Oct. 1992, pp. 843861.)

SFAS 69: DISCLOSURES REGARDING OIL AND GAS RESERVES

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The reconciliations give us additional insights regarding the reserve increases:

Revisions have generally been positive.8 Improved recovery estimates also consistently made positive contributions to esti-

mated reserve quantities. These gains may reect newer technologies that permit higher recovery from existing oil and gas wells. Texaco purchased oil reserves in the U.S. in 1997 (Monterey Resources) and gas reserves in the Other East in 1998 and 1999. Discoveries and extensions, however, were below production levels in all three years for oil and all but 1997 for gas The data can also be used to measure the reserve life (end-of-year reserves divided by production) of Texacos reserves, by type and geographic segment. The computations below indicate that Texacos reserve lives increased over the period as U.S. oil production and worldwide gas production failed to increase with reserves. Reserve lives in the United States are higher that in other areas for oil, but lower for gas. Reserve Lives in Years United States 1997 Oil reserves Production Ratio Gas reserves Production Ratio 1,767 157 11.25 4,022 643 6.26 1998 1,824 144 12.67 4,105 633 6.48 1999 1,782 144 12.38 4,205 550 7.65 1997 3,267 317 10.31 6,242 839 7.44 Worldwide 1998 3,573 351 10.18 6,517 879 7.41 1999 3,480 336 10.36 8.108 786 10.32

Data from Table I; oil in millions of barrels, gas in billions of cubic feet

Disclosure of Capitalized Costs

Table IV reports the balance sheet carrying cost of the disclosed reserves and Table V the current year costs incurred. When reviewing Table IV (Capitalized Costs), note that:
Capitalized costs depend on the accounting method followed: Companies using the

FC method will capitalize more exploration cost than companies employing the SE method. Notice that the capitalized costs of equity afliates are disclosed separately, just as their reserve quantities are disclosed separately. Costs are net of accumulated depreciation, amortization, and valuation allowances; different accounting choices in these areas will affect the net carrying cost. Costs of unproved properties and support facilities are separately disclosed. Capitalized costs are aggregated for oil and gas, unlike reserve quantities. These data give analysts a balance sheet cost to match against the physical reserves with all oil and gas reserves combined into one measure, usually termed barrel of oil equivalent (BOE). Quantities (of oil and gas reserves disclosed in Table I) can be combined into units of

There is a typographic error in the 1999 gas reserve change data. The worldwide revisions should be 915 and the total changes 1,591; the negative signs are in error.

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APPENDIX 7-B

ANALYSIS OF OIL AND GAS DISCLOSURES

BOE based on either energy equivalence (1 barrel of oil 6 MCF of gas)9 or the basis of relative price.10 Once this has been done, the balance sheet cost per BOE can be computed. At December 31, 1999, the calculation for Texacos reserves is (in millions of barrels): No. of BOE No. of Barrels of Oil 3,480 3,480 4,831 The capitalized cost per BOE is $ BOE $13,038 4,831 $2.70 BOE Equivalent of Gas Reserves

8,108 BCF (billion cubic feet) 6 1,351

Note that part of the capitalized cost represents outows for unproved properties (for which no reserves have yet been estimated) and for support facilities. This calculation, therefore, overstates the capitalized cost per BOE. With two years of data, we can look at the trend of capitalized cost per BOE as well as variations by geographic area: Capitalized Cost per BOE Equivalent December 31 United States Europe 1998 Oil reserves Gas reserves BOE Capitalized costs Costs per BOE 1,824 4,105 2,508 $8,086 3.22 419 964 580 $1,436 2.48 1999 Oil reserves Gas reserves BOE Capitalized costs Costs per BOE 1,782 4,205 2,483 $7,933 3.20 427 962 587 $1,459 2.48 670 1,866 981 $2,056 2.10 546 134 568 $1,178 2.07 3,480 8,108 4,831 $13,038 2.70 598 477 678 $1,278 1.89 684 151 709 $1,072 1.51 3,573 6,517 4,659 $12,190 2.62 Other East Equity Worldwide

Data from Tables I and IV. Oil reserves and BOE in millions of barrels, gas reserves in billion cubic feet, capitalized costs in $millions

This table indicates that Texacos unit carrying costs are below even the cyclical low points of recent oil prices (approximately $10 per barrel). Low capitalized costs are expected, given the use of successful efforts accounting. These amounts represent the costs that Texaco must amortize as oil and gas reserves are produced; low capitalized costs equate to low amortization and higher operating earnings. Low capitalized costs also indicate that the risk of impairment write-downs is minimal.

Natural gas is measured in MCF (thousand cubic feet). In recent years, in the United States, gas has usually sold at a lower relative price than its energy equivalent would suggest. The relationship changes over time. In 2000, natural gas prices rose more rapidly than oil prices. While some analysts combine oil and gas reserves based on relative price, such calculations may require frequent revision.
10

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The geographic differences are revealing. Capitalized costs per BOE are signicantly lower in the Other East segment and for Texacos equity afliate (also Other East). Higher nding costs in the United States and Europe have driven exploration efforts for companies such as Texaco increasingly to areas with lower costs. These data also reect historical costs, well below the cost of nding new reserves. The capitalized cost per BOE, moreover, is only a crude means of comparing the cost of reserves for different companies. It reects both the accounting method used and the efciency in nding oil (the nding cost per BOE). Companies that use the SE method and have low nding costs have a low capitalized cost per BOE. Companies using the FC method or recording higher nding costs have higher capitalized cost per BOE. The capitalized cost per BOE can also be compared with the market value of oil and gas reserves, as revealed by market transactions. If the capitalized cost is higher than transaction prices, this indicates that the balance sheet amount is overstated; if transaction prices are higher, the reverse is true. However, using the capitalized cost per BOE is, at best, only an approximation of the value of reserves. It is decient because it fails to recognize the following factors: 1. Reserves in different geographic markets vary in value. 2. Oil reserves have different values from natural gas reserves of equivalent energy content. 3. The cost of producing reserves (bringing them to the surface) may vary with location. 4. A barrel of oil produced today is more valuable (assuming constant pricing) than one produced in ve years because of the time value of money. 5. Tax rates vary by jurisdiction and, within jurisdictions, may vary by location and type of resource. For these reasons, the aggregation of all reserves by physical quantities does not capture the market value of reserves. Fortunately, better data are available. Analysis of Finding Costs Table V, Costs Incurred, reports Texacos exploration costs. This table includes all expenditures, regardless of whether they are capitalized or expensed, making the data comparable among companies with different accounting methods. These expenditures can be compared with reserves found to compute the actual per unit nding cost. Although annual nding costs are volatile, over longer time periods they measure managements prociency in discovering reserves. Texacos 1999 nding cost was $4.37 per BOE,11 well above both the carrying cost of reserves and the nding costs over the ve-year period ending in 1999. Finding costs can be compared by geographic area and over time, although we have not done so here. Disclosure of Present Value Data Table II, Standardized Measure, reports the estimated future cash ows of the specic reserves owned by the rm. The following elements are presented: 1. Future cash inows. Based on a year-by-year schedule of planned unit production, multiplied by current price levels, that is, future gross revenues based on current prices. Companies are not permitted to assume price changes, unless provided for by a rm contract, which may then be incorporated in the computation. These calculations use proved developed reserves only. 2. Future production costs. Also based on current prices. Production costs include all expenditures required to bring the oil or gas to market.

11

Reported in Table V of Texacos 1999 Supplemental Oil and Gas Information.

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APPENDIX 7-B

ANALYSIS OF OIL AND GAS DISCLOSURES

3. Future development costs. Include the cost at current price levels of additional wells and other production facilities that may be required to produce the reserves. 4. Future income tax expense. The estimated tax liabilities assuming that the forecast cash ows actually take place. The net of these amounts, net future cash ows before discount, is a forecast of net cash ows from existing oil and gas reserves. These data must also be adjusted to reect the time value of money by discounting to present value. SFAS 69 requires that all rms use a discount rate of 10%. The objective is comparability; the correct discount rate will vary over time and, perhaps, from rm to rm. The result is a net present value of the after-tax12 cash ows expected from the rms reserves. Note that these data are provided separately for reserves in different geographic areas, but with oil and gas combined. Companies providing these data routinely state that the standardized measure is not market value and suggest that the data have limited usefulness. Nonetheless, the data are widely used in the analysis of companies with oil and gas reserves and, in practice, are a useful approximation of market value. Despite some limitations, the data are far more representative of market values than the cost shown on the balance sheet, regardless of the accounting method used.13 Using Present Value Disclosures How can the data be used? One simple adjustment is to replace the capitalized cost of reserves with the net present value (standardized measure). This is one step in preparing a current value balance sheet (see Chapter 17) or computing adjusted net worth. Before making this adjustment, the following issues should be considered: 1. Have prices changed since the balance sheet date? If so, the present value data must be adjusted to current prices, for example, a 10% increase in oil prices increases future cash ows by 10%. (Because oil and gas prices do not always move together, use a weighted-average based on the composition of reserves.) 2. Costs may also be adjusted. Although hard data are difcult to come by, industry sources can provide a rough guide as to changes in production and development costs. 3. Do economic or other factors suggest a need for assumptions of future price changes? Some analysts construct their own price scenarios and make their own computations of future cash ows. 4. Is 10% the right discount rate? The discount rate is a function of the general level of interest rates and the relative riskiness of the rms reserves. Adjustments may be required. A higher discount rate, of course, reduces the net present value calculation; a lower rate increases the present value. 5. Should pretax or after-tax net present values be used? The answer depends on the tax status of the rm and purpose of the analysis.14 In a liquidation analysis, for example,

Texaco deducts tax payments from net cash ows (both undiscounted) and then discounts the after-tax cash ows. We can estimate the discounted income taxes by using the ratio of the discounted pretax cash ows to the undiscounted cash ows. (This assumes a constant tax rate.) Some rms deduct the present value of tax payments from the net present value of pretax cash ows. The result is the same, but this latter case permits more accurate calculation of the pretax net present value.
13

12

Surprisingly, early empirical studies did not seem to bear this out. Harris and Ohlson (1987) and Shaw and Wier (1993), for example, found that SFAS 69 disclosures had weak explanatory power for stock prices and that book value measures outperformed the standardized present value measure. More recently, however, Boone (2002) demonstrated that the valuation models used in the previous studies were misspecied and, for the valuation model used in his study, the present value measure exhibited signicantly more explanatory power than the historical cost measure. 14 Disclosures for rms with signicant reserves outside of North America and Europe frequently show very high income tax rates for these reserves. These high rates reect the fact that royalties in many countries are a percentage of the gross value of the oil or gas produced. Accounting for these royalties as income taxes obtained better income tax treatment in the United States. This suggests that net present value data for such reserves should always be used on an after-tax basis. Texacos Other East clearly ts the category just described, with an estimated tax rate of 64% in 1999 [$7,665/($7,665 $4,323)].

SFAS 69: DISCLOSURES REGARDING OIL AND GAS RESERVES

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when all cash ows are evaluated on a pretax basis, pretax present values would be used for consistency. Example: Texaco To illustrate, we use the data provided by Texaco and the following assumptions: 1. No change in prices or costs 2. A 10% discount rate 3. Pretax net present values for U.S. reserves but after-tax present values for foreign reserves.15 The data provided can be used to adjust Texacos equity at December 31, 1998 and 1999, for the difference between the present value of its oil and gas reserves and the carrying amount: Years Ended December 31 Standardized Measure United States* Europe Other areas** Total Carrying amount Excess Reported equity Adjusted equity % change Total debt Debt-to-equity ratio Reported Adjusted 1998 $ 4,879 1,382 $ (1,116 $ 9,375 $12,190 $ (2,815) $11,833 $ 9,018 24% $ 7,291 0.62 0.81 1999 $15,604 4,990 $23,909 $26,502 $13,038 $13,464 $12,042 $25,506 112% $ 7,647 0.64 0.30

*Using United States 1999 as an example, $15,604 was calculated as the net present value ($11,352) plus the estimated present value of income tax payments ($4,252). The later is estimated by applying the ratio, ($11,352/$22,168) ($8,304) and assuming a constant rate. **Sum of Other West, Other East, and Afliate (after-tax) present values.

This adjustment more than doubles Texacos equity at December 31, 1999; for 1998 the adjustment reduces equity by 24% because of low oil and gas prices on that date. The adjustment sharply reduces Texacos debt-to-equity ratio in 1999. Varying the discount rate or making assumptions about changes in prices or costs would also lead to different adjustments. The adjustment of net worth is not an end in itself, but one step in the analysis of a rm. Although equity after adjustment is not a precise measure of the market value of Texacos net assets, it is a better measure than the historical cost of those assets. Chapter 17 discusses the usefulness of equity adjustments in greater detail. Adjustments for Subsequent Price Changes In 2000, natural gas prices rose sharply from the year-end 1999 levels. As a result the December 31, 1999 present value data no longer reected the economic value of Texacos reserves. Exhibit 7B-1 shows the assumptions and calculations required to adjust the 1999 standardized value of U.S. reserves for subsequent price changes.

15

See footnote 14.

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APPENDIX 7-B

ANALYSIS OF OIL AND GAS DISCLOSURES

EXHIBIT 7B-1. TEXACOUNITED STATES Adjustments to Present Values for Subsequent Price Changes Amounts in $ millions except for reserve quantities (oil in millions of barrels, gas in billions of cubic feet) A. Future Cash Inows Quantity December 31, 1999 Crude oil and natural gas liquids Natural gas December 31, 2000 Estimated Crude oil and natural gas liquids Natural gas 1,361 3,388 B. Standardized Measure Reported Future cash inows Future production costs Future development costs Pretax net cash ow Future income tax expense Net future cash ows Discount (10% rate) Standardized measure $ 45,281 (10,956) $1(3,853) $ 30,472 $1(8,304) $ 22,168 $(10,816) $ 11,352 C. Discussion The objective is to recompute the standardized measure using price changes at a later period. In part A, we estimate the future cash ows associated with Texacos U.S. reserves, using reserve quantities from Table I of the 1999 supplementary data and prices obtained from the futures market at December 31, 1999. Our computed future cash ows of $42.7 billion is nearly 6% below the $45.3 billion shown in Table II. The difference must be due to different prices as the standardized measure must use proved reserves. We estimate future cash ows at December 31, 2000 using the same reserve quantities but with prices at December 31, 2000. These calculations produce future cash ows of $69.6 billion, 63% higher than the December 31, 1999 level. In part B, we adjust each component of the standardized measure to estimated levels at December 31, 2000. The future cash inows come from part A. We assume 20% increases in both future production costs and future development costs, on the assumption that the cost of drilling equipment and services rises with higher oil and gas prices. We assume the same tax rate (27.25%). We also assume the same production time pattern so that the % discount is unchanged. These calculations produce a 75% increase in the standardized measure for U.S. oil and gas reserves, to $19.8 billion. The actual standardized value (see Exhibit 7BP-1) at December 31, 2000 was just under $18 billion. The major reason for the difference was that reserves declined during 2000, reducing future cash ows to the following amounts: December 31, 2000 Actual Crude oil and natural gas liquids Natural gas Quantity 1,202 3,299 Unit Price $ 26.80 9.77 Cash Flows $ 32,214 $332,231 $ 64,445 Adjusted $ 69,576 (12,052) $1(4,238) $ 53,286 $(14,521) $ 38,765 $(18,914) $ 19,851 Explanation Part A 20% higher 20% higher Same rate Same rate $26.80 9.77 $36,475 $33,101 $69,576 1,361 3,388 Unit Price $25.60 2.33 Cash Flows $34,842 $47,894 $42,736

Lower reserves reduces future cash ows and, therefore, lowers the standardized value.

PROBLEMS

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Changes in Present Values Table III is a reconciliation of changes in the standardized measure, akin to the reconciliation of reserve quantities. But these data are richer as they include the impact of such factors as:
Changes in prices and costs Accretion of discount (the passage of time reduces the discount period) Expenditures that reduce future required cash ows Changes in estimates Purchases and sales of reserves Effect of production

The standardized measure of Texacos oil and gas reserves declined by nearly one-third in 1997 and more than half in 1998, but soared to a higher level at December 31, 1999. The reconciliation provides the following insights: 1. Changing prices and costs were the major factor accounting for the sharp decline in the standardized measure in 1997 and 1998 and its recovery in 1999. Over the three-year period, the price effect was slightly negative. 2. Texacos quantity revisions were positive each year, suggesting that the companys estimates have been conservative. 3. Timing effects were negative each year, suggesting that Texacos production rate was below previous forecasts.16 Summary and Conclusion While the supplemental oil and gas data mandated by SFAS 69 must be used with care, they provide considerable useful information regarding the firms exploratory activities and the value of its reserves. These data are far more comparable among firms than reported financial data as most are unaffected by accounting methods.

PROBLEMS
7B-1. [Changes between full cost and successful efforts methods] Sonat [SNT], a diversied energy company, announced the following accounting change when it reported its results for the third quarter of 1998:
Sonat Exploration Company [Sonat subsidiary] changed from successful efforts to full cost accounting because its future capital spending will be focused signicantly more on exploration activity than in the past. Full cost accounting, which amortizes rather than expenses dry-hole exploration and other related costs, provides a more appropriate method of matching revenues and expenses. Exploration activity has increased from 6 percent of 1995 capital spending, or $27 million, to an estimated 33 percent of 1998 capital spending, or approximately $175 million. . . . The adoption of the full cost method is expected to increase 1998 and 1999 normalized earnings from levels that would have been reported under successful efforts accounting and, more important, will reduce earnings volatility from quarter-to-quarter and year-to-year going forward. . . . The change to full cost accounting will not materially affect the companys cash ow from operations. Sonat has restated all prior period statements . . . all previous charges related to the impairment of Sonat Explorations assets . . . were reversed, which significantly raised the book value of those properties as well as Sonats stockholders equity. The full cost method, however, requires quarterly ceiling tests17 to insure that the carrying value of assets on the balance sheet is not overstated. . . . The end result of the full cost conversion

16 17

Postponing production reduces the net present value by increasing the discount factor. Authors note: see footnote 3 to this appendix and the related text.

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APPENDIX 7-B

ANALYSIS OF OIL AND GAS DISCLOSURES

is that both the book value of Sonat Explorations properties and Sonats stockholders equity are at higher levels than if it had continued with the successful efforts method of accounting.18

Note 2 to Sonats annual report for the year ended December 31, 1998 reports the following effects of the accounting change and restatement of prior periods: Effect on Net income ($thousands) Earnings per share, fully diluted 1996 18,006 .16 1997 130,584 1.17 1998 (258,351) (2.35)

The 1998 income statement reports ceiling test charges of $1,035,178 thousand. Retained earnings at January 1, 1996 were increased by $199,196 thousand for the accounting change. A. Explain each of the following benets from the accounting change stated in the Sonat press release: (i) Increased normalized earnings (ii) Reduced earnings volatility (iii) Higher book value of exploration properties (iv) Higher stockholders equity B. Compute the effect of the accounting change on Sonats stockholders equity at December 31, 1998. C. Describe the effect of the accounting change on each of the following Sonat ratios for 1998: (i) Debt-to-equity ratio (ii) Asset turnover (iii) Book value per share D. Explain why the accounting change was not expected to materially affect Sonats cash from operations. E. Given your answers to parts A through D, evaluate Sonats decision to change accounting method. F. The accounting change took place during a period of declining energy prices. Describe the risk of making the accounting change and illustrate that risk using the data provided. G. Sonat had changed from the full cost method to successful efforts in 1991, a previous period of energy price declines. Describe the effect of that fact on your view of the 1998 accounting change. 7B-2. [Analysis of Supplementary Oil and Gas Data] Exhibit 7BP-1 contains the supplemental oil and gas data from Texacos 2000 annual report. Use this exhibit, and the data for 1999 and prior years from Texacos 1999 annual report, to answer the following questions. A. Compute Texacos reserve lives in years for 2000, for both oil and gas: (i) In the United States (ii) Worldwide B. Discuss whether production trends mirror the reserve trends over the four years ended December 31, 2000. C. Compute Texacos capitalized cost per BOE for 2000: (i) In the United States (ii) Worldwide

18

Sonat press release, October 22, 1998.

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EXHIBIT 7BP-1. TEXACO 2000 Supplemental Oil And Gas Information Note: These disclosures omit text and tables that duplicate the 1999 disclosures. Table INet Proved Reserves Net Proved Reserves of Crude Oil and Natural Gas Liquids (millions of barrels) Consolidated Subsidiaries Afliate Other West 374 374 374 374 Equity Afliate Other East 546 14 37 (52) (1) 282 263 545

United States As of December 31, 1999* Discoveries & extensions Improved recovery Revisions Net purchases (sales) Production Total changes Developed reserves Undeveloped reserves As of December 31, 2000* *Includes net proved NGL reserves As of December 31, 1998 As of December 31, 1999 As of December 31, 2000 1,782 39 25 (21) (135) (130) (222) 1,202 358 1,560

Other West 55 (52) (3) (55)

Europe 427 21 9 (44) (44) (58) 219 150 369

Other East 670 9 39 30 (78) 559 111 670

Total 2,934 69 64 18 (231) (255) (335) 1,980 619 2,599

Total 546 374 14 37 (52) 373 282 637 919

Worldwide 3,480 443 78 55 (231) (307) 38 2,262 1,256 3,518

250 250 219

68 74 67

22 134 162

340 458 448

6 1 1

6 1 1

346 459 449

Net Proved Reserves of Natural Gas (billions of cubic feet) Consolidated Subsidiaries Afliate Other West 33 33 33 33 Equity Afliate Other East 134 4 8 (24) (12) 121 1 122

United States As of December 31, 1999 Discoveries & extensions Improved recovery Revisions Net purchases (sales) Production Total changes Developed reserves Undeveloped reserves As of December 31, 2000 4,205 585 5 121 8 (494) 225 3,299 1,131 4,430

Other West 941 12 (58) (95) (141) 738 62 800) *

Europe 962 43 (11) (81) (49) 573 340 913

Other East 1,866 164 (36) 128 977 1,017 1,994

Total 7,974 585 5 340 (61) (706) 163 5,587 2,550 8,137) *

Total 134 37 8 (24) 21 121 34 155

Worldwide 8,108 622 5 348 (61) (730) 184 5,708 2,584 8,292) *

*Additionally, there are approximately 302 BCF of natural gas in Other West which will be available from production during the period 20052016 under a long-term purchase associated with a service agreement.

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EXHIBIT 7BP-1 (continued)

APPENDIX 7-B

ANALYSIS OF OIL AND GAS DISCLOSURES

The following chart summarizes our experience in nding new quantities of oil and gas to replace our production. Our reserve replacement performance is calculated by dividing our reserve additions by our production. Our additions relate to new discoveries, existing reserve extensions, improved recoveries, and revisions to previous reserve estimates. The chart excludes oil and gas quantities from purchases and sales. Worldwide Year 2000 Year 1999 Year 1998 3-year average 5-year average Table IIStandardized Measure Consolidated Subsidiaries United States Other West Other East 172% 111% 166% 150% 146% United States 76% 99% 144% 109% 108% International 267% 124% 191% 192% 189%

(Millions of Dollars) As of December 31, 2000 Future cash inows from sale of oil & gas, and service fee revenue Future production costs Future development costs Future income tax expense Net future cash ows before discount 10% discount for timing of future cash ows Standardized measure of discounted future net cash ows

Europe

Total

$ 67,115 (13,107) (3,588) (17,024) 33,396 (15,407)

$ 1,559 (252) (30) (612) 665 (259)

$ 10,549 (2,074) (1,244) (2,238) 4,993 (1,778)

$ 15,512 (2,768) (1,280) (6,681) 4,783 (2,239)

$ 94,735 (18,201) (6,142) (26,555) 43,837 (19,683)

$ 17,989

$ 406 Equity

$ 3,215

$ 2,544

$ 24,154

(Millions of Dollars) As of December 31, 2000 Future cash inows from sale of oil & gas, and service fee revenue Future production costs Future development costs Future income tax expense Net future cash ows before discount 10% discount for timing of future cash ows Standardized measure of discounted future net cash ows

Afliate Other West

Afliate Other East

Total

Worldwide

$ 3,917 (273) (406) (1,101) 2,137 (1,431)

$ 7,873 (2,853) (694) (2,189) 2,137 (809)

$ 11,790 (3,126) (1,100) (3,290) 4,274 (2,240)

$ 106,525 (21,327) (7,242) (29,845) 48,111 (21,923)

$ 706

$ 1,328

$ 2,034

$ 26,188

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EXHIBIT 7BP-1 (continued) Table IIIChanges in the Standardized Measure Worldwide Including Equity in Afliates (Millions of Dollars) Standardized measure beginning of year Sales of minerals-in-place 2000 $ 18,710 (3,990) 14,720 Changes in ongoing oil and gas operations: Sales and transfers of produced oil and gas, net of production costs during the period Net changes in prices, production, and development costs Discoveries and extensions and improved recovery, less related costs Development costs incurred during the period Timing of production and other changes Revisions of previous quantity estimates Purchases of minerals-in-place Accretion of discount Net change in discounted future income taxes Standardized measureend of year Table IVCapitalized Costs Consolidated Subsidiaries Afliate Other West* Equity Afliate Other East 1999 $ 5,487 (352) 5,135 1998 $ 12,057 (160) 11,897

(7,345) 11,389 4,543 2,043 670 668 901 3,120 (4,521) $ 26,188

(4,276) 22,036 1,821 1,598 (517) 301 895 881 (9,164) $ 18,710

(3,129) (11,205) 728 1,770 (1,170) 852 48 1,916 3,780 $ 5,487

(Millions of Dollars) As of December 31, 2000 Proved properties Unproved properties Support equipment and facilities Gross capitalized costs Accumulated depreciation, depletion, and amortization Net capitalized costs

United States

Other West

Europe

Other East

Total

Total

Worldwide

$18,213 1,026 257 19,496 (12,084) $ 7,412

$137 98 81 316 (92) $224

$3,295 58 28 3,381 (1,821) $1,560

$3,699 655 135 4,489 (1,508) $2,981

$25,344 1,837 501 27,682 (15,505) $12,177

$ 66 68 42 176 (1) $175

$1,370 265 906 2,541 (1,349) $1,192

$1,436 333 948 2,717

$26,780 2,170 1,449 30,399

(1,350) (16,855) $1,367 $13,544

*Existing costs were transferred from a consolidated subsidiary to an afliate at year-end 2000.

Table VCosts Incurred On a worldwide basis, in 2000 we spent $3.62 for each BOE we added. Finding and development costs averaged $3.74 for the threeyear period 19982000 and $3.92 per BOE for the ve-year period 19962000. Consolidated Subsidiaries Afliate Other West Equity Afliate Other East

(Millions of Dollars)

United States

Other West

Europe

Other East

Total

Total

Worldwide

For the year ended December 31, 2000 Proved property acquisition $ 138 Unproved property acquisition 5 Exploration 227 Development 716 Total $1,086

$ 12 62 121 $195

$ 18 334 $352

$ 276 287 677 $1,240

$ 414 17 594 1,848 $2,873

$ 19 169 $188

$ 19 169 $188

$ 414 17 613 2,017 $3,061

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EXHIBIT 7BP-1 (continued) Table VIUnit Prices

APPENDIX 7-B

ANALYSIS OF OIL AND GAS DISCLOSURES

Average sales prices are calculated using the gross revenues in Table VII. Average lifting costs equal production costs and the depreciation, depletion, and amortization of support equipment and facilities, adjusted for inventory changes. Average Sales Prices Afliate Other West Afliate Other East

United States Crude oil (per barrel) 2000 1999 1998 Natural gas liquids (per barrel) 2000 1999 1998 Natural gas (per thousand cubic feet) 2000 1999 1998

Other West

Europe

Other East

$26.20 14.97 10.40 18.73 10.86 8.99 3.67 2.07 1.93

$22.74 14.12 9.65 1.13 .77 .92

$26.86 17.15 11.73 17.93 12.53 11.89 2.49 1.99 2.42

$22.81 15.33 9.61 1.23 .18 .38

$21.52 13.24 9.81

Average lifting costs (per barrel of oil equivalent) Afliate Other West $ Afliate Other East $5.06 3.95 2.68

United States 2000 1999 1998 Table VIIResults of Operations $5.05 4.01 4.07

Other West $2.94 2.87 1.86

Europe $5.08 6.15 5.24

Other East $3.03 3.45 3.65

Consolidated Subsidiaries United States Other West Other East

(Millions of Dollars) For the year ended December 31, 2000 Gross revenues from: Sales and transfers, including afliate sales Sales to unafliated entities Production costs Exploration costs Depreciation, depletion, and amortization Other expenses Results before estimated income taxes Estimated income taxes Net results

Europe

Total

$ 4,460 545 (1,070) (130) (723) (190) 2,892 (972) $ 1,920

$ 190 (46) (62) (18) (27) 37 (48) $ (11)

$ 869 591 (375) (18) (221) (2) 844 (269) $ 575

$ 1,440 315 (232) (152) (147) (88) 1,136 (945) $ 191

$ 6,769 1,641 (1,723) (362) (1,109) (307) 4,909 (2,234) $ 2,675

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EXHIBIT 7BP-1 (continued) Equity Afliate Other West Afliate Other East

(Millions of Dollars) For the year ended December 31, 2000 Gross revenues from: Sales and transfers, including afliate sales Sales to unafliated entities Production costs Exploration costs Depreciation, depletion, and amortization Other expenses Results before estimated income taxes Estimated income taxes Net results
Source: Texaco 2000 Annual Report

Total

Worldwide

$831 50 (223) (14) (129) (2) 513 (258) $255

$831 50 (223) (14) (129) (2) 513 (258) $255

$7,600 1,691 (1,946) (376) (1,238) (309) 5,422 (2,492) $2,930

D. Discuss the trend, over 19982000, in Texacos capitalized cost per BOE, and explain how changes in reserve quantities and capitalized costs may have affected that trend. E. Review the data in Tables II and III and discuss the effect of each of the following factors on the change in the standardized value over the four years ended December 31, 2000: (i) Price changes (ii) Revision of estimated reserve quantities (iii) Income taxes F. Discuss, based on your answers to part E, the extent to which Texaco replaced the economic value of its reserves over the four years ended December 31, 2000. G. Texacos reported debt at December 31, 2000 was $7,191 million with reported equity of $13,444. (i) Compute Texacos equity adjusted to replace the carrying cost of reserves with the standardized value. (ii) Compute Texacos debt-to-equity ratio using both reported and adjusted equity. (iii) Discuss the effect of the adjustment on the trend of Texacos debt-to-equity ratio over the period 1998 to 2000. (iv) Describe the effect of the adjustment on Texacos asset turnover ratio. H. The equity adjustment would appear to reduce Texacos return on equity. (i) Discuss how you could adjust income, using the standardized measure, to compute a current cost return on equity. (ii) Explain how current cost ROE would be superior to reported ROE as a performance measure. (iii) Describe one drawback to using current cost ROE as a performance measure.