Decommissioning provisions in oil and gas

When is a decommissioning provision recognised?

When the company has a present obligation from a past event and an outflow is probable. The obligation usually comes from law or the licence, and sometimes from a published policy that creates a valid expectation. The past event is the damage or installation itself: drilling a well, installing a platform or laying a pipeline. The provision therefore builds up as facilities are added, not as oil is produced, and each new well adds its own layer. See IAS 37 provisions explained.

How is the provision measured?

At the best estimate of the cost to settle the obligation, based on current technology, current legislation and any changes that are virtually certain, with costs inflated to the expected date of the work and discounted at a pre-tax rate reflecting the time value of money and the risks specific to the liability, unless those risks are already in the cash flows. Many companies use a risk-free rate for the currency of the costs. The discount rate matters enormously for obligations decades away: a small change in rate moves the provision by a large amount.

Decommissioning provisions: a platform over twenty years

A company installs a platform. It expects removal to cost CU 300 million in 20 years, in money of that time, and uses a discount rate of 5%. The provision is 300 / 1.05²⁰ = 113.1 million, added to the cost of the platform. In year 1 the unwinding of the discount is 5.65 million, charged to finance costs. By the end of year 5, with 15 years to go, the provision has grown to 144.3 million. At that point new engineering studies raise the estimated cost to 360 million, and the provision becomes 173.2 million.

The decommissioning cost in the asset is depleted with the field, usually on a units of production basis, so it reaches profit as oil is produced. The increase from the new estimate is depleted over the remaining reserves from the date of the change. See decommissioning costs under IAS 16.

How are changes in the estimate handled?

IFRIC 1 applies to changes in the estimated cost, its timing and the discount rate. Under the cost model, the change is added to or deducted from the asset's cost. A decrease cannot take the asset below zero: any excess goes to profit or loss. An increase may be a sign that the asset is impaired, so the company considers whether to test it. Once the field has reached the end of its life, all later changes go straight to profit or loss. The unwinding of the discount is always a finance cost and is never capitalised as a borrowing cost.

Is deferred tax recognised on decommissioning?

Yes, since amendments to IAS 12 effective from 2023. Decommissioning costs are usually deductible only when paid, so on day one the provision creates a deductible temporary difference and the asset a taxable one of the same amount. The initial recognition exemption no longer applies to such transactions, so the company recognises both a deferred tax asset, subject to recoverability, and a deferred tax liability. See temporary differences.

How do partners and funds affect the provision?

In a joint operation, each partner recognises its share of the decommissioning obligation, unless it is liable for more, for example if partners are jointly and severally liable and another partner is likely to default. Money set aside in a decommissioning fund is a separate asset, a right to reimbursement, and is not offset against the provision. In some jurisdictions, such as the UK North Sea, the government can require former owners of a field to pay if the current owners cannot, so sellers assess whether a residual liability remains after a sale. See joint operating agreements.

How does US GAAP differ?

ASC 410-20 measures asset retirement obligations at fair value, discounted at a credit-adjusted risk-free rate. Each layer keeps the rate at which it was first recognised: an upward revision is a new layer at the current rate, and changes in market rates alone do not remeasure the liability. IFRS remeasures the whole provision at the current rate each period. The accretion of the discount is usually an operating expense under US GAAP. See IAS 37 vs ASC 450 and oil and gas accounting. Mine closure and rehabilitation follow the same rules; see mine rehabilitation provisions and decommissioning wind and solar farms.

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