Wednesday, December 16, 2015

Bloomberg: Billions of Barrels of Oil Vanish in a Puff of Accounting Smoke

So how do Billions of Barrels of oil vanish as this Bloomberg article states? This is a question I can answer having worked as an accountant in the oil industry for many years. It really doesn't matter how many actual physical barrels of oil may be below the surface in an oil resevoir. What does matter is whether or not they can be produced at a profit. If they can't, they will stay below the surface. Below are some quotes from the Bloomberg article and then a few added comments.




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My added comments: Years ago at my previous employer I actually worked on the calculation done at the end of each year to determine how many barrels of oil reserves could be reported. This is how that works. Engineers produce a reserve report each year that takes into account all the costs to produce the oil reserves and the current market price the oil can be sold for. If the price drops too much, many of the actual physical oil reserves underground cannot be produced without losing money so you must "write off" those barrels even though they still exist physically (accounting rules make this mandatory) . From an accounting point of view, they "vanish."

This causes the accounting for oil and gas companies to be somewhat different from other industries. While oil and gas companies produce a balance sheet like everyone else that lists the assets and liabilities of the company, it does not really give you any idea what the true "net worth" of the company is at any given time. The true "net worth" of the company is the net present value of all the reserves in the ground that can be produced at a profit. This net worth goes up and down constantly even though the assets listed on a balance sheet may stay fairly stable (reserves are not carried on a balance sheet directly as an asset, the costs to find or buy the reserves are the asset on the balance sheet). Oil companies take a double hit when prices fall, they lose cash flow from the oil produced in the present and they have to write off the value of future barrels that will no longer be produced.

Simplistic Example: A company owns oil reserves expected to last 10 years at an oil price of $75 per barrel. This is based on the discounted net present value of all those barrels using the best estimate for what it will cost to produce them. At $75, the engineers may estimate that the company has 1 million barrels of oil that can be produced and sold profitably. But some of those barrels will cost more than others to produce. So if the price falls to $50 per barrel, all the barrels that cost $50 or more are no longer are counted as reserves. In this example we will say that is 250,000 barrels. Suddenly those 250,000 barrels of oil "vanish" as Bloomberg says in this article. Now the company only has 750,000 barrels of reserves. The only way the oil can "reappear" is for the price to go back above $50 per barrel.

This is why a relatively stable price for oil really benefits everyone so long as the price is high enough to make money and not too high to hurt low income users. Eventually the world will gradually transition away from oil for energy, but it will take a long time to do that. In the meantime, we need a price that works for everyone if possible. The problem tends to self correct over time. Right now the price is too low so a lot of oil will "vanish". This will lower supply and cause the price to correct back up enough to generate more supply. 

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