FEDERAL UNIVERSITY GUSAU

FACULTY OF MANAGEMENT SOCIAL SCIENCES

DEPARTMENT OF ACCOUNTING AND FINANCE
COURSE: ACC 408 (Oil and Gas Accounting)

A.COURSE DESCRIPTION
This course is designed to introduce students to the accounting system in use in the petroleum
industry of the Nigerian economy, with particular emphasis on the system in the upstream sector
of the industry. Students will also be exposed to the various types of operating contracts in the
industry and how they are being accounted for. The nature and relevance of the Nigeria
Petroleum industry, the differences between downstream and upstream sectors of the industry,
accounting principles, practices and procedures relevant to various phases of oil and gas
operations, petroleum products pricing and marketing, types of operating contracts in the
Nigerian petroleum industry – JV, PSC and SC, financial and fiscal monitoring mechanism,
accounting standards and auditing in the petroleum industry.
B. COURSE OBJECTIVES
The Objectives of this course are to:
i) expose students to the nature and historical development of oil and gas accounting;
ii) develop an understanding of the basic characteristics and differences between the
downstream and the upstream sectors and their activities;
iii) develop an understanding of accounting principles, practices and procedures relevant
to various phases of oil and gas operations;
iv) develop an understanding of accounting for exploration, ditching, and development
costs;
v) develop an understanding of petroleum products pricing, accounting standards and
financial statement disclosures in the oil and gas industry;
vi) develop an understanding of the various types of operating contracts in the petroleum
industry and how they are being accounted for;
vii) develop an understanding of petroleum products pricing and marketing; and
viii) Develop an understanding of financial and fiscal monitoring mechanism, accounting
standards and auditing in the petroleum industry.

1
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 The Upstream and the Downstream Sectors of the Nigerian Oil industry
1.6 NNPC and DPR and Their Roles
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
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

2
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 earth’s 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, and 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

3
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 theories the inorganic theory and the organic theory have 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,
hydrogenation 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.
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

4
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.

5
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. 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. Crude oil refining involves the breaking down of hydrocarbon
mixture into useful products, through distillations, cracking, reforming and extraction process.
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% propane- C3
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.

6
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, DanKano Petroleum, etc) and
part-time marketers.
1.3 The History of the Nigerian Oil and Gas Industry
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 was 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
came 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
company’s efforts were unsuccessful and with outbreak of the First World War, its operations

7
were disrupted. Two decades later, Shell D’Arcy (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 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 Nigeria’s 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 OPEC—the
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.
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 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, (i) the Niger Delta,
(ii) the Anambra Basin, (iii) the Benue Trough, (iv) the Chad Basin and (v) 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

8
the ministry of petroleum created Nigerian National Petroleum Corporation (NNPC). This was to
combine the ministry’s regulatory role and NNOC’s 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. 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. 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 was recently (i.e. in
2012) discovered in Anambra Basin, which is now to join the league of oil producing states.
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 owns 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

9
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
installment 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 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.

10
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 as an asset 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 D’Arcy 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 license to another party) 40 per cent of their interest to foreign companies,

11
mainly for financial and technological back-up (the foreign companies who acquire interest in a
license from another party, are said to have farm-in in indigenous companies mining 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 Nigeria’s 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.
Nigeria’s expertise in the upstream sector in the African Sub region, 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.
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 Nigeria’s oil and gas resources in all segments of the

12
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:

13
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 country‘s 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.
1.7.2 THE DEPARTMENT OF PETROLEUM RESOURCES (DPR)

14
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:
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, licenses 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, this
may have impact on the administration and control of petroleum;
6. processing all applications for licenses 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.
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 equipment and erection of field
offices, and increasing permeability through fracturing, acidizing and thermal process.

15
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
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

16
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).

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.

17
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.
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 company’s 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).

18
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
(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

19
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
(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.
3. Arrangements, Agreements and Contracts in the Nigerian Petroleum Industry
The 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 international
politics of oil and gas, as well as, 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 D’Arey which was the first
oil company to discover oil in commercial quantity in Nigeria operated under a concession
arrangement 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

20
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. 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.
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
Nigeria’s crude oil production. The largest JV operated by Shell Petroleum Development
Company of Nigeria Ltd and NNPC, produces nearly half of Nigeria’s crude oil, with average
daily production of approximately 1.1 million bpd.
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):
In PSC, host government (through its agent) engages a competent contractor to carry out
petroleum operations Government’s 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 Government’s behalf. The residual oil is the profit oil, if any, and the company
shares with the concession holder in some agreed percentage.
This form of contract which originates from Indonesia 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 company’s 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
Government’s percentage share of profit oil to increase to 70 percent when production reaches

21
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.
The main law which regulates the operation of PSCs in Nigeria is the deep Offshore and Inland
Basin Product Sharing contracts Act No.9, LFN, 1999. 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 nontransferability 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 if 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 contractor’s
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 Service Contract (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,
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.

22
3.1.6 NNPC’s 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 committee’s chairman, the operator appoints the secretary. The
committee is responsible for creating subcommittees to take care of finance, budget monitoring
and other similar issues.
(ii) Book-keeping, Financial Reports and Returns:

23
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 without a written
approval of the management committee and its relevant sub-committee(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 operator’s financial statements with respect to the operations must be audited by the
operator’s 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.

24
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.
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.

25
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:
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.

26
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.
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 1960’s 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

27
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 FASB’s 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
company’s 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 prove 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.
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.

28
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 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. Uche’s 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 adopted IFRS in financial reporting, the
reverse is the case. In other words, with effect from first January, 2012, IAS/IFRS was adopted
in Nigeria, and SAS will only be applicable where no IAS or IFRS is issued on the same item.
Sequel to this, IFRS 6 (and some aspects of SAS 14) and 17 are now applicable in Nigeria.
ACCOUNTING FOR E&E COSTS
Expenditures incurred in exploration activities are expensed unless they meet the definition of an
asset (see the IASB Framework, paragraphs 53–59). An entity should recognize an asset when it
is probable that economic benefits will flow to the entity as a result of the expenditure.
Expenditures on an exploration property are expensed until the capitalization point. The
capitalization point is the earlier of either (1) when the fair value less cost to sell of the property
can be reliably determined as higher than the total of the expenses incurred; or (2) when an
assessment of the property demonstrates that commercially viable reserves are present and
therefore, there are probable future economic benefits from the continued development and
production of the resource.

29
IFRS 6, paragraph 9, gives examples of expenditures incurred for E&E assets (the list is not
exhaustive):
(i) Acquisition of rights to explore;
(ii) Topographical, geological, geochemical and geophysical studies;
(iii) Exploratory drilling;
(iv) Trenching;
(v) Sampling; and
(vi) Activities in relation to evaluating the technical feasibility and commercial viability
of extracting a mineral resource.
Expenditures related to the development of mineral resources do not relate to E&E assets.
These are covered under development assets. An entity has to take guidance from the IASB
Framework and IAS 38 for recognizing and measuring development assets. While
recognizing E&E assets, it becomes necessary to recognize any obligations for removal and
restoration that are incurred during a particular period as a consequence of having undertaken
the exploration for and evaluation of mineral resources under IAS 37, Provisions, Contingent
Liabilities and Contingent Assets.
Prior to the adoption of IFRS, a number of companies in the oil and gas industry used the full
cost method of accounting for E&E expenditure. Under this method all E&E expenditure is
capitalized within cost pools. Costs are then considered for impairment or depreciated on
commencement of production as cost pools rather than on the basis of an individual field.
Applying full cost method, a “dry” well may be capitalized as part of the cost pool, but the
lack of associated reserves will be taken into account through an increased depletion charge
or through the impairment testing performed on the overall pool.
Successful efforts is an alternative method of accounting for E&E that is favored by many
larger companies. Under this method, the E&E expenditure is initially capitalized pending
the determination of reserves on the basis of an individual field. As companies opt to change
from a full cost method to a successful efforts method on adoption of IFRS, there will be
generally a reduction in opening net assets; however, this will result in lower amounts
recognized through the statement of comprehensive income going forward in respect of these
assets by way of reduced depletion. In fact, IFRS 6 does not specify the full cost or
successful efforts method. It requires an entity to adopt an appropriate accounting policy
within the broad principles stated in IAS 8, paragraph 6. However, only expenses specified in
IFRS 6, paragraph 9, can be capitalized and the IASB Framework definition of an asset may
not permit capitalization of some expenses as E&E assets.
Measurement after Initial Recognition and Presentation Subsequent to the initial recognition
of E&E at cost, an entity shall apply either the cost model or revaluation model. For the
purpose of applying revaluation, the entity should follow the principles set out in IAS 16
(Property, Plant and Equipment) or IAS 38 (Intangible Assets). An entity may change its
accounting policies relating to E&E assets. While doing so, it is necessary to judge the
principles of reliability and relevance in accordance with IAS 8. A change in accounting
policy should make the financial statements more relevant for the users’ decision making and
should not be less reliable. It is possible to present E&E assets either as tangible assets or
intangibles depending on the nature of the assets. For example, a drilling right is classified as

30
an intangible asset, whereas vehicles and drilling rigs are classified as tangible assets. E&E
assets are no longer classified as such when technical feasibility and commercial viability of
extracting minerals is demonstrable. When an entity incurs obligations for removal and
restoration these must be recognized in accordance with IAS 37 (Provisions, Contingent
Liabilities and Contingent Assets).
Impairment E&E assets are tested for impairment when the facts and circumstances suggest
that the carrying amount is more than the recoverable amount. In such a case, the entity
should apply IAS 36 and measure the impairment loss, if any. Then E&E assets should be
presented net of such impairment loss. IFRS 6, paragraph 20, explains those facts and
circumstances that should be evaluated for assessing if there is any impairment loss for E&E
assets. IAS 36, paragraphs 8–17, are not applied for the identification purpose. IFRS 6,
paragraph 20, illustrates four indicators or ‘facts and circumstances’ which may indicate that
impairment testing is required ((this list is not exhaustive) (i) period of ‘ right to explore ’ has
expired and not expected to be renewed; (ii) substantive expenditure on future exploration is
neither budgeted nor planned; (iii)exploration for and evaluation has not led to discovery of
commercially viable quantities of mineral resources and entity is discontinuing its activities
in a specific area; (iv) although development likely to proceed, the carrying amount is
unlikely to be recovered in full from successful development or by sale.
Disclosures
An entity shall disclose information that identifies and explains the amounts recognized in its
financial statements arising from the exploration for and evaluation of mineral resources.
This requires: (i) disclosures of accounting policies for exploration and evaluation
expenditures including the recognition of exploration and evaluation assets, and (ii) the
amounts of assets, liabilities, income and expense and operating and investing cash flows
arising from the exploration for and evaluation of mineral resources. An entity is required to
treat E&E assets as a separate class of assets, either under IAS 16 (classification as tangible
assets) or IAS 38 (intangible assets), and make the disclosures required by either IAS 16 or
IAS 38, consistent with how the assets are classified.
Recent amendments to IFRS 1 (effective for annual periods beginning on or after January 1,
2010, with early application permitted) allow a first-time adopter using full cost method of
accounting under its previous GAAP to elect to measure oil and gas assets at the date of
transition to IFRS on the following basis: (i) E&E assets at the amount determined under
previous GAAP (ii) Assets in the development or production phases at the amount
determined under previous GAAP, allocated to the underlying assets pro rata using reserve
volumes or reserve values as of that date
Upon measuring oil and gas assets on this basis, the E&E assets and those assets in the
development and production phases are required to be tested for impairment at the date of
transition to IFRS in accordance with the provisions of this standard and those of IAS 36,
Impairment of Assets, to determine that the assets are not stated at more than their
recoverable amount. For the purpose of these exemptions, oil and gas assets comprise only
those assets used in the exploration, evaluation, development, or production of oil and gas. If
the exemption for oil and gas assets in the development or production phases accounted for
using the full cost method under previous GAAP is elected, a first-time adopter is required to

31
disclose that fact and the basis in which carrying amounts determined under previous GAAP
were allocated.
Entity must classify exploration and evaluation expenditure assets as tangible or intangible
according to their nature. Examples of tangible assets include vehicles and drilling rigs and
intangible assets include drilling rights. Once technical feasibility and commercial viability
become demonstrable any previously recognized exploration and evaluation assets fall
outside the scope of IFRS 6 and is reclassified in accordance with other standards but they
should be assessed for impairment first.
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.

32
33
5.3 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, implying 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.

34
Examples of Intangible Drilling Costs are: i. Drilling contractors’ charges ii. Site preparation,
roads, pits iii. Bits, reamers, tools iv. Labour Fuel, power and water v. Drill stem tests vi.
Coring analysis vii. Electric surveys and logs viii. Geological and engineering ix. Cementation
x. Completion, fracturing, acidizing, perforating xi. Rig transportation, erection and removal
xii. Overhead xiii. Other services
Examples of Tangible Drilling Costs are: i. Casing (production and surface) ii. Tubing Well
head and subsurface iii. Pumping units iv. Tanks Separators v. Heater-treaters vi. Engines and
automotives vii. Flow line viii. Installation costs of equipment ix. Sundry equipment.
5.4 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.
5.4.1 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:

Illustration 1
35
Sabongida 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

Solution

5.4.2 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.
Illustration II
Damba 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

36
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.

5.4.3 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.
Illustration III
Assume the following data are in respect of the entire leases owned by FUG Oil Company in
Nigeria. You are required to calculate the DD&A for the year Ended 31st December, 2011 on
(i)property-byproperty basis and (ii) countrywide basis.

Computation of DD&A for FUG Oil Company

For the Year Ended 31st December, 2011

37
5.4.4 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 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.

5.4.5 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.

ILLUSTRATION IV
(i) Calculate DD&A for New-Site Oil and Gas Nigeria Limited, a “full cost” company,
assuming the following:
38
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
Capitalized costs: Wells and equipments N 20,000,000
Acquisition costs N 10,000,000
Proved reserves 5,000,000 bbls
Proved developed reserves 3,000,000 bbls
Production 500,000 bbls

SOLUTION

5.5 Accounting for Exploration and Drilling Costs

39
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.

5.5.1 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 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.

5.5.2 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.

5.6 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.
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
40
 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 drilled to find and produce oil in an unproved area,
to find a new reservoir in a field previously found to be productive.

ILLUSTRATION I
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.

41
(b) Entry for full cost company is the same as for successful efforts company above.
(c) 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.

5.7 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
non-hydrocarbon 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.

The key drivers of profitability of refineries are:

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.

5.7.1 Types of Refineries

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.

42
5.7.2 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 post-production 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

5.7.3 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.

43