Depletion and the units of production method

What is the units of production method?

Depletion for a period = cost to be depleted x production in the period / reserves at the start of the period. The cost to be depleted is the field's net book value, plus future development costs if the reserves base includes reserves not yet developed. Because the charge follows production, a field that is shut in for maintenance has little depletion that month, and one producing at plateau has a lot.

Which reserves base should be used?

IFRS does not prescribe one. Companies choose, as a policy applied consistently, between proved developed reserves, total proved reserves (1P), and proved plus probable reserves (2P). Proved developed reserves can be produced from existing wells and facilities, so they pair naturally with costs already incurred. Wider bases are acceptable only if the cost includes what it will take to produce them: matching costs incurred with reserves that still need billions of further spending would understate depletion.

Units of production: one field, three reserve bases

A field has cost CU 400 million to develop. Proved developed reserves are 50 million barrels; proved plus probable reserves are 100 million barrels, but producing the extra 50 million barrels needs further wells costing 100 million. The field produces 8 million barrels in year 1.

The first two are consistent policies, matching reserves with the cost of producing them. The third spreads today's cost over barrels that need another 100 million to reach, so it understates depletion. Under the proved developed basis, the new wells will be added to the cost and to the reserves base when they are drilled.

How are reserve revisions handled?

A change in reserves is a change in estimate under IAS 8, applied prospectively. Suppose at the start of year 2 the 2P reserves are revised to 80 million barrels. On the 2P basis, the cost to be depleted is the net book value of 360 million plus future development costs of 100 million, so the new rate is (360 + 100) / 80 = 5.75 a barrel, and year 2 depletion on 8 million barrels is 46.0 million. Nothing already charged is restated. Companies set a policy for when revisions take effect, commonly from the start of the period in which the new reserves report is approved.

Which assets are depleted on units of production?

• Field-specific wells and facilities: over the field's reserves.
• Licence acquisition costs: usually over total reserves, since they give access to all of them.
• Shared infrastructure, such as a pipeline serving several fields: over the combined reserves it will carry.
• Assets with shorter lives than the field, such as vehicles, IT and some leased equipment: straight-line over their own lives. Significant components are depreciated separately; see component depreciation.

Can depletion be based on revenue instead of volumes?

No. IAS 16 prohibits depreciation methods based on revenue, because revenue reflects prices and sales volumes, not the consumption of the asset. Units of production uses physical quantities. Where a field produces both oil and gas, companies convert them to a common unit, barrels of oil equivalent, usually on energy content, at about 6,000 cubic feet of gas to one barrel. See IAS 16 depreciation methods.

What about fields under production sharing contracts?

Under a production sharing contract, a company depletes its assets over its entitlement reserves, the barrels it will receive, and uses its entitlement production for the period, so that numerator and denominator are consistent. Entitlement reserves fall when prices rise, which can increase the depletion rate. See production sharing contracts.

How does US GAAP compare?

US GAAP is more prescriptive. Under successful efforts, acquisition costs of proved properties are depleted over total proved reserves, and wells and facilities over proved developed reserves. Under full cost, the whole country pool, plus estimated future development costs, is depleted over total proved reserves. See successful efforts vs full cost and oil and gas accounting. Mines use the same method over ore reserves; see mining accounting and stripping costs under IFRIC 20.

This guide is general information. It is not tax or legal advice for your situation.