Cost management for petroleum exploration part a

Cost Management and Performance Measurements for Petroleum Upstream Industry

Hamdy Rashed, CMA, CAPM Bsc of Accounting, E-mail: [email protected], Updated on February 15, 2013

Abstract

Cost control and management is not appropriate only for manufacturing and commercial industry; cost management is applied in upstream industry such as Petroleum exploration, development and production cost. Many Petroleum Companies don’t pay more attention to cost control and especially during exploration phase except if Companies face financial dilemma, declining production or if they see they cannot meet their planned schedule of Capital program that lead them to not meet their obligation, commitments and required return, therefore, they start considering cost reduction or control. This paper provide management accountant, cost controller, financial controller, financial manager, internal auditor and cost recovery auditor with brief of cost control, how cost is analyzed and managed and performance is measured in Petroleum upstream industry.

The technical information that is covered in this paper is useful for accountant and non-technical staff who are interested in understanding the cost behavior in petroleum upstream industry. Also, we don’t criticize or indicate to fishing period that stated in Standard Handbook of Petroleum and Natural Gas Engineering is wrong but we cover and adjust the fishing period formula and add new fishing period formulas in management accounting view only.

Keywords: Cost Management and analysis for petroleum exploration, Optimizing production, exploration and development programs, Project Cost Management and Analysis for Petroleum Upstream Industry, Procurement Cost Management, Drilling Cost Management, Production Cost Management, G&A Cost reduction.

It was noticed that few major oil companies hired management accountant and cost control accountant who are assigned to the correct tasks and duties that include measuring management, department and overall company’s performance, support management and provide with required financial and non-financial information that can help management to take a decision, participate in putting plan and strategy for the company.

Before discussing about the cost management and performance evaluation in oil and gas E&P companies, we like to draw our reader’s attention that this paper does not criticizing the drilling practices of oil and gas companies but it provides fundamental concepts for the possibility of managing costs in such industry. Accountant and internal auditor needs to understand what is the type of costs per function in oil and gas industry, to assign KPI of cost management to each functional department. The

Cost Management and analysis for performance evaluation

Hamdy Rashed; CMA, CAPM 2

costs that are assigned to each functional department shall be direct costs that are effected by cost drivers rather than decision-making such as barrels produced of petroleum, hours spend by staff, meters or days drilled, KM2 seismic run, processed or interpreted, meter square or cubic meter of space occupied.

1) Oligopolistic Market Oligopoly is created when there are few number of large firms in the industry that explore and produce somewhat similar commodities of oil and gas and there are many buyers because entering the market is not easily because it is too costly for exploring and producing oil and gas, the major part of such cost are fixed or sunk cost that increase the break-even output. The profit is maximized when the marginal cost equals marginal revenue. In summary, we assess the petroleum upstream producers market as oligopolistic market due to the following characteristics:

1- Small number of large firms 2- Somewhat similar commodities that

could be differentiated by its nature that is referred to the quality of oil and gas produced.

3- Natural barriers to entry that high set-up cost and exploration costs.

4- Elasticity of oil supply is relatively inelastic [Tom Konrad, Jan 26, 2012. The End of Elastic Oil. Forbes] & [John C.B Cooper. March 2003. Price Elasticity of demand for crude oil:estimates for 23 countries. Organization of Petroleum Exporting Countries]

Oligopolistic Company could take advantage of economics of scale that reduce production costs by reducing average fixed costs and take advantage of high price that is determined by setter who has price power. The disadvantage of

oligopolistic company can allocate the resources and produce inefficiently.

But many less experienced small or medium Oil and Gas Companies pay less attention to cost reduction in exploring and producing oil and gas because many of such companies thought that all costs incurred for exploration, development and production will be cost recovery, the finding and operating costs of one barrel or mscf does not reflect major part of oil and gas price. In other word, whatever it has been spend for finding and producing oil, the large recoverable reserves could payout the costs in very short time and such costs will be spread among the recovered reserves which lead to reduce the average costs to the level which make it immaterial. However, low finding cost and operating costs could lead to have more feasible well and attract companies to produce oil for such well.

2) Cost Analysis and Estimation All costs have not same behavior, there are costs are proportion to changes in volume range of production, other costs such as Labor hours and machine hours of production facility equipments. And there are costs that are not changed in responding to changes in volume range of production. Understanding Cost behavior enable Oil and Gas Companies to the following:

a) Identify the breakeven and Cost-volume-profit analysis

b) Evaluate organizational or departmental performance.

c) To make routine decisions d) To make non-routine decisions

Before identifying the direct or indirect costs. Management accountant should identify critical costs in petroleum upstream Companies. Then break the costs into elements and costs drivers to enable the management accountant to identify



and group the controllable costs from non-controllable costs and the responsibility centers.

2.1) Critical Costs Identification. Petroleum Company in Upstream Industry shall maintain detailed and accurate records if they are serious in cost control-orientation to enable Company to track the costs and to find ways for cost management improvements.

When Drilling Department or Exploration Manger finalized Project Management Plan and Work Breakdown Structure (WBS) they specify which materials and services they need to buy and what are the specifications of those materials and services. Also, Operation Department need to determine how much materials and what are the services they need to buy based on their Materials and Services Requirement Plan and based on their experimental judgments and historical data.

Responsibility centers, Program Manager or investment center manager should conduct with management accountant or cost controller to understand the critical costs and cost behaviors and identify the controllable costs.

All Oil and Gas Exploration and Production Companies financially categorize the costs into five major category as follow:

2.1.1) Pre-acquisition and Acquisition Cost Management accountant should help program manager or investment center manager to get and analyze the acquisition costs to enable the program manager to get in very good negotiation with government or third party to acquire license at lower costs. The Pre-acquisition and acquisition costs include cost of purchasing seismic data, cost of G&G analysis for this data, cost of license bonuses and signature bonuses,

broker’s fees and legal costs for acquiring the licenses.

Before taking decisions for acquiring the licenses and signing the related contracts with host government. Management accountant should prepare Contract cash flow projection and understanding the effect of the Contract terms to the cash flow projection and providing recommendation to program or exploration manager to have good negotiation with host government. The contract terms that could impact on the Production Sharing Contracts cash flow projection are as follow:

a) Royalties b) Profit Oil Split c) Work commitments d) Non-recoverable Costs

1. Annual Bonuses 2. Signature Bonuses 3. Acquisition Costs, If any.

e) Cost Recovery ceiling

Also, management accountant should consider other variable inputs for PSC cash flow projection such as

a) Petroleum Price b) Required Rate of Return c) Estimated Finding (Exploration,

development and facility) Costs d) Preliminary chance of success e) Preliminary potential Petroleum reserves f) Corporate Income Tax g) Estimated Operating Costs

If there is no attractive potential reserves or the preliminary chance of success is very low due to new discovery area, the Company can get into good negotiation with host government and obtaining Production Sharing Contract with good terms but if the expected rate of return of the cash flow projection does not encourage company to acquire the license



2.1.2) Exploration Cost Exploration costs are costs incurred after acquiring the license and before decision is made for developing the license. Such costs include the following:

- Geological and Geophysical studies that covers - Seismic Acquisition cost - Seismic processing/reprocessing - Seismic interpretation - Velocity modeling - Other G&G study - Cost of holding the undeveloped licenses - Cost of drilling and testing exploratory wells

Cost Management or Cost Controller should estimate the exploration costs that be used in Cash flow projection and viability analysis of discovering petroleum. Program manager or exploration manager should understand that the higher Capital Costs that represents exploration and development costs, the higher minimum target size of reserves will be, and the lower expected monetary value and higher opportunity loss may occur. Cost Controller or Management Accountant should analyze the service contracts that are related to seismic acquisition, processing, drilling contracts and others and investigating for higher costs and find the best alternative way to manage the costs without reducing the quality of service, materials or the performance of subcontractor’s in HSES.

Management Accountant or Exploration Manager need to know when to use 2D, 3D or 4D seismic, the quality of providing seismic acquisition and management accountant should consider the costs of high quality seismic in comparison of cost of drilling dry well. Also, exploration manager may not expect that petroleum will not be discovered in geological formation that its thickness will be less than 3 meters, therefore, exploration manager may contract with Seismic Compmany to use less frequency of seismic waves that include the less

than 3 meter formation into prior or consecutive thicker formation which going to be neglected in the seismic processing and the costs will be reduced, but exploration manager might be wrong, and Company may carry higher costs for drilling wrong well or for not having accurate seismic mapping. Any decision for having some specification in contracts should be reviewed by cost controller to check the cost and benefit of such quality or specifications.

Even the cost of exploratory or development wells, such costs are combined into drilling contract, cementing, logging and fluid contracts. Cost Controller or contract specialists, management accountant and exploration manager should not looking for only the lower cost of tender, they must consider the technical performance of such subcontractors. The lower performance the higher costs could be incurred in late time.

2.1.3) Development and Facility Cost Development costs are costs incurred after taking the decision for developing the license or reservoir that include:

- Cost of drilling and testing development well - Cost of completing and equipping production well - Cost of facilitating in producing oil or gas such as building facility equipments of separator, treator, storage, waste disposal system. - Cost of improved recovery equipments.

2.1.4) Operating Cost The third important activities that are performed for producing oil or gas which include:

- Labor costs engaged in operation of well and related facility equipments - Cost of repairs and maintenance of producing equipments - Cost of materials and fuel consumed and cost of services that are used in operations of wells and facility equipments.



2.1.5) Site restoration Cost It is costs of plugging and abandoning wells and dismantling all the surface equipments in accordance with production sharing agreement or local regulations.

3) Elements of Costs Whatever the type of costs or the functional activities that cause costs, the costs are contains three elements which are: - Materials - Labor - Other expense

And each of the above elements are either directly and completely assigned to specific units or charged to prime costs or indirectly elements that cannot be assigned to the specific unit or charged to prime costs the most appropriate example of indirect costs are overhead such as drilling overhead, exploration overhead, administrative overhead.

Exploration, development and production costs can be divided into materials and services, labor and overhead. Each of this costs can provide an opportunity for controlling and managing the costs.

3.1) Materials/Assets or services Cost Procurement Department and Drilling Manager shall ensure that they are obtaining the best prices with very good quality of materials and assets, check with variety of suppliers to find the best prices and materials via tenders and based Procurement Management Plan.

3.1.a) Materials

Procurement Manager, Operation Manager, Drilling Manager, or Exploration Manager may intend to buy in large volume of drilling materials or operation materials to obtain purchasing discount, saving transportation cost, meet variations of drilling needs, but they may

neglect the following risks and the costs associated of buying high volume and building up stock.

- Obsolescence and selling the materials less than actual costs at late time

- High storage Cost - Opportunity costs of keeping high value

of surplus inventory. However, if such money invested in bank with free-risk interest, it can generate income to the Company by 4% or more annually depends on the interest rates prevailed at that time.

Building materials and supplies Inventory in oil and gas upstream industry is subject to the type of costing.

When Company enter in production phase, it applies costing process system for production process, therefore, they follow Materials Requirement Plan, but they apply job-order costing system for exploration and development drilling that allow to use Just-In Time Inventory. However, drilling wells in specific geological formation may vary from place to another, and availability of suppliers may vary from country to another, Many of Petroleum Companies intend to buy their drilling materials or assets (Casing and wellheads) based on their estimated requirements of proposed wells to be drilled plus 10% - 20% as contingency.

Many PSAs require to pass title of drilling materials or assets to the host government at the termination of PSAs, which lead Company to bear the loss of disposed assets. To mitigate such loss, Petroleum Companies are supposed to have very clear and practical drilling schedules in foreign Companies and high experienced technical and drilling staff to have the best estimate of actual needs of drilling materials/assets that will be bought.



In Petroleum upstream Companies, the followings are the major materials costs that could be controlled and managed properly.

- Tanigble Drilling cost such as o Casing o Tubing o Wellhead

- Operating materials such as o Treating chemicals o Small tools & supplies

- Furniture’s and equipments - Facilities Assets such as

o Pumper o Generators o Gathering compression o Flowlines o Treater, Sperator

3.1.b) Services

After preparing the WBS, Drilling Department and Procurement Department will outline the requirements for services in Contract Statement of work (SOW) after identifying the type of contract and the risks, Company and Contractor will bear them. Most of the Petroleum service contracts is fixed price contracts with economic price adjustments.

Drilling and Procurement Departments defines the technical, functional, and performance specification and the exact works that are needed from Contractor in enough detail to mitigate the disputes between the Company and Contractor.

SOW and contract must clearly define the parameters for acceptable performance and timeline for each section of work based on the nature of the work.

Drilling Department, Procurement Departments or Exploration Management may be trapped themselves unknowingly by increasing the specification and wrong assumption that may increase the unnecessary costs. Specification

must not be very open or loose with missing important details.

Drilling and Procurement Manager shall have open meeting with all suppliers and reply to their inquiries equally, provide adequate and accurate information of specification equally ‘cause missed details may lead ineffective suppliers purposely providing lower bidding price to win the contract and they know the contract price will be changed then by issuing variations or purchase orders. And this action will lead to increasing the costs.

Drilling Department and procurement shall define the evaluation criteria if there is no Corporate policy that define them. Internal auditor shall review the objectivity of evaluation criteria and if they are properly updated and applied by concerning staff. Internal auditor shall review the SOW and contracts either before it has been signed to mitigate the potential risks or after it was signed and implemented, for lessons learned and avoid the same mistakes or risks in future. Also, management accountant, cost controller or contract specialists can review the activities and terms of contracts after the implementation for lessons learned if the Control-Self Assessment (CSA) program is applied.

The major and most common services requested by Petroleum Company are as follow.

- Drilling service - Cementing service - Drilling Fluids service - Logging and Testing service

3.2) Labor Cost Labor costs in oil & gas Companies represent high part of total costs after materials/assets and services costs, even services costs contains materials and labor costs but it is not practically to determine such costs from services



contractors’ invoices except for Consultancy services that does not contain materials cost.

Labor costs that we need to indicate to, is the cost of employees that have a direct contracts with an Oil and Gas Company.

Oil and Gas Company should be look for the ways to improve labor efficiency. In production/operation Department, Petroleum Company shall keep track of how much oil or gas produced during specific period of time per labor hour and look for variables and correlate that can increase the productivity, such as direct labor cost, and labor costs of home office. Even in Drilling and Exploration Department, Petroleum Company shall keep track of how much proved reserves of oil or gas discovered per labor hours, and how much unproductive hours (Unproductive drilling hours include the time spent for lost circulation, stuck pipe, fishing) to total drilling hours per well, cost center and overall.

Petroleum Company should know their employees’ strengths, weakness and skills, determine suitable training for them, schedule them for the positions that allow Company to make optimum use of their abilities. Petroleum Company that are seriously seeking for cost control may replace high cost of their expatriates by the lower costs of high technical skilled labor after train them managerially.

Petroleum Company shall have incentive and salaries payments that are more reasonable and relating to performance of labor and managers that can change the slope of learning curves of labor to higher and reducing the unproductive time. Also, Petroleum Company shall review and update their performance measurements systems and payments system frequently to consider all the necessary appropriate combined factors that determine the payments systems for salaries, bonuses or incentives for low level of

employees to high level of management. For example, Oil & Gas Company that face annual loss or will face difficulty in availability of cash and need to reduce its costs shall give more weight for factor of finding oil and commercial oil and factor of reducing costs more than other factors such as HSES factor to enable management and employee to focus on maximizing their productivity by lower costs, but if the opposite is happened. If Company pays more attention to HSES than any other factors, management and employee will focus on spending more money for HSES that its cost may exceed the benefit because it will be easily achievable for management and employee and distract management attention and energy from generating profit from normal course of business and reducing costs, that will lead Company to generate its profit and cash flow from abnormal course of business such as selling working interests which could have been potentially and significantly profitable for the company in future. HSES is important but should be combined with other important factors and be weighted based on the strategy that company want to follow.

Also, clear promotion and recruitment policy and procedures help company to control labor costs and increase labor efficiency.

3.3) Overhead Cost Overhead costs are costs that cannot traced to particular object of costing. Most of such overhead are fixed over time but such cost cannot be indirect for all cases, it can be traced to specific cost center but cannot be traced to specific project or production. The most likely costs that are considered overhead are Headquarter’s expenses that are considered as an overhead costs. And many of PSAs does allow to recover part of foreign Headquarter’s costs as cost oil but not all overhead expenses. Therefore, many Petroleum Companies are seeking to cut such costs by using their facilities



and capabilities as fully as possible. However, those PSAs allow to recover all direct overhead of offices allocated in the host countries but they need to use either appropriate basis or equal basis for allocating such costs to the licenses obtained. Therefore, the part of allocated overhead to exploration block may lead Petroleum Company to reduce such this overhead cost.

4) Cost Drivers Identification The costs that cannot be measured, it cannot be managed but may be cut or void. The costs that can be measured are costs that varied based on independent variables and can be stated or estimated in a formula by identifying the unit of activity that causes the changes in prime activity costs and the price of unit activity. Developing cost drivers in formula is as follow.

Total Cost = Variable Cost + Fixed Cost

Variable Cost = Cost per unit x quantity used

Petroleum Company should prepare Cause and Effect Analysis to know how different factors and variables relate together and can effect the costs of particular object.

4.1) Direct Cost Direct costs can be charged to particular object of costing, either project, cost centers or production. Most of direct costs are variable costs that are vary in total to changes or activity of project, cost center or production. labor cost formula and materials formula.

Labor Cost = Labor rate x Labor hours + Constant labor cost when labor hours is 0

Cost of Materials = Unit cost of materials x quantities of materials consumed + Constant cost of materials when consumption of materials is 0

Cost of Services = [Labor rate x Labor hours + Constant labor cost when labor hours is 0] + [Unit cost of materials/equipment x quantities of materials/equipment

consumed x period of time to be used + Constant cost of equipment when equipments are not used or in standby]

4.2) Fixed and Indirect Cost Fixed costs are stay constant regardless of activity or throughout the production level, life of a project, depth of drilling well, time spend to use equipments or materials

4.3) Sunk Costs Sunk costs are irrelevant costs that cannot be varied by obtaining different decision and need not to be considered in decision analysis. The historical costs and fixed costs are most likely considered as sunk costs.

5) Cost Control Techniques Cost control techniques can help Petroleum Companies achieve good financial results and overcome difficulties they face. Cost control can allow Company to know if they are really spend more than it should be for petroleum exploration, development and production. The below techniques will give our accountant more information about how to manage such costs.

5.1) Cost and Contract Analysis Petroleum Company shall breaking down the cost and classifies them by management function and nature to enable to assign responsibility of cost to appropriate management or department and should track them and record them in proper cost accounts.

Management accountant, cost analyst or cost controller should develop Worksheet of actual costs and applying statistical analysis to determine the correlation between cost and variable factors.

Management accountant, cost analyst or cost controller should conduct with technical staff to know the appropriate relationship between variables and costs formulas.



Petroleum Company should authorize management accountant, cost analyst or cost controller to analyze service contracts and measure the hidden (implicit) costs of Contractors due to inefficiency, missed details of Statement of Work (SOW), inappropriate evaluation criteria, inappropriate applying tender and procurement process.

For example, Petroleum Company can calculate the total costs incurred by its drilling service contractor. Contract Analyst should consider the efficiency of drilling wells and experience of driller by computing the hours that it is taken for trip time for changing bits. The lower hours the higher efficiency of contractor is and lower costs can incurred. Also, the higher experience drilling engineer, the lower probability of lost circulation and stuck pipe that are due to lack of knowledge and experience of personnel or drillers then the lower costs can be achieved. The higher technological which driller use, the lower costs can be achieved by avoiding lost circulation and stuck pipe. Also, the experience of drillers or drilling personnel or management to drill in different type of drilling such as horizontal drilling or deviated drilling that can reduce the total costs by saving the cost of site construction.

Missed Contract details that describe the SOW, open contract, providing information unequally to suppliers with knowing that changes will be incurred after winning the business can cause higher services costs.

5.2) Reporting and Accounting System. Management accountant or cost controller shall realize that different companies use different financial and cost accounting system.

Petroleum Company shall combine between financial and cost accounting and determine which cost accounting system is the best to help several level of decision makers. Also, cost and

financial reporting is important to know the profitability and measure the performance of Petroleum business segments.

Financial accounting is different from cost or project accounting, Company’s system should be designed in manner that can provide relevant, reliable, consistent and comparable information to several stakeholders. The financial information is most likely used by investors, creditors, analysts, stock brokers, government, management and employees but the cost or project accounting information is most likely used internally by different level of management and employees.

Financial and cost accounting system should categorize, group and consolidate transactions or events by designing accounts codes that determine the transactions that can be categorized, grouped and consolidated and reported in specific manner to meet the financial requirements which is ruled by GAAP or IFRS, and that could be categorized, grouped and reported in specific manner to meet the cost or project requirements which is ruled by prevailing industry’s practices, stakeholders’ needs and company policy.

We will assumed that how the costs of two vehicles hire, one is leased for supporting seismic acquisition activities and it is non-recoverable and another is leased for supporting development activities for drilling Well A, how these costs should be recorded in the financial and cost accounting system. Company’s system include chart of accounts that contains the financial accounts, project and cost accounts, cost recovery accounts. Let’s assume that seismic acquisition compaigne was approved by AFE300 and it is categorized under sub-account No. 10 that is assigned for G&G expenses and G&G is expensed but intermediated by second head account no. 70 and first head account No. 02 which is assigned for exploration and



evaluation and element cost no. 6000 is assigned for vehicle hire. Also, the AFE200 for well A campaign was approved by partners, which is categorized under sub-account no. 25 that is assigned for drilling cost which is under second head account no. 20 that is assigned under development costs and first head account no. 02. And R is assigned for the recoverable costs code and N is assigned for the non-recoverable costs code. The coding will be lined as follow:

02.70.10.AFE300.6000.N 02.20.25.AFE200.6000.R

Based on the above coding line. The coding contains Financial accounting codes that represents exploration and evaluation code (02), exploration (70) or development (20) codes and financial activities coding that determine if it is seismic or drilling the seismic acquisition code is (10) and drilling code is (25) + Projects accounting codes which is flexible codes that is established based on AFE for example (seismic acquisition AFE300 and AFE200 for drilling Well A) + cost accounting code that represents the detailed type of costs and assigning code 6000 for vehicle hire+ Recovery accounting codes.

Based on appropriate accounts coding, the Company will be able to generate the appropriate reporting for several purposes. And based on the above example, the company can generate financial statements by grouping all the amounts of transactions that contains exploration code (70) in the income statements under exploration expenses and development cost that contains code 20 under capital expenditures of exploration and evaluation balance. Also, can generate cost reports that grouped the costs by function (exploration, development), activity (G&G, seismic acquisition or drilling) and by detailed type of costs elements, and can generate a cost recovery report to the government by

grouping the transactions that contains recovery code.

Also, the financial, project and cost accounting systems must be integrated, the system should be designed smartly to enable to enter non-financial input data in the project systems and cost accounting system such as volume of reserves, volume of production, depth of well, area that run seismic based on service requisition or technical reports on frequently basis to enable the cost accounting system to calculate the cost of production, and cost at completion for projects and completion percentage for managerial purposes and determine the DD&A and accrued expenses for financial purpose.

5.3) Budgeting Budget is tool for planning at the beginning of the period and can be used as tool of control at the end of the period to help management to measure the performance against plan of sales, capital expenditures, production cost. Therefore, Petroleum Company prepares comprehensive Master budget by using computer software to enable Company to compare the actual figures to estimated figures easily.

Petroleum Company may use one or all of the below type of budget processing.

5.3.a) Traditional Budget

Traditional budget is adding and subtracting a percentages in comparison to last period to find new budget for the coming year. This is more appropriate to be used for utilities expenses, sales budgets and specific production costs items.

5.3.b) Zero-Based Budget (ZBB) and Activity-Based Budget (ABB)

ZBB and ABB examine costs and benefit for all activities, ZBB start from scratch but ABB not. These techniques help Company to measure the



performance of management’s effectiveness but preparation of ZBB consume lot of time to be prepared. Many Oil and gas companies use project budget which is more similar to ABB.

Theoretically budget can be used for identifying standard costs for all cost elements, but practically standard costs cannot be used in petroleum upstream industry for all cost elements, it might be used to time writing costs to monitor and plan for the cost of expatriates but it is difficult and impractical to apply standard costing system for all costs elements.

6) Breakeven and Cost-Volume-Profit (CVP) Analysis CVP and breakeven analysis help management accountant to perform useful analysis. breakeven is branch of CVP analysis that determine the sales which matches the costs and generate zero profit.

Petroleum Company can use CVP and breakeven analysis to know the following

a) Daily production and sales volume that is required to breakeven

b) Daily production and sales required to earn a desired profit.

c) How the changes in oil/gas price, variable operating costs and fixed Finding & Development costs.

However, the oil/gas price is less to be controlled, but Major oil producers and consumers in the world participate in determine the oil/gas price in world market. Therefore, rise of breakdeven price is mainly caused by increasing in operating costs and increasing in F&D costs. The below formulas compute the breakeven point (BEP) and CVP in units.

Where: Variable Cost per unit = Direct Production cost ÷ Volume of production in barrels

Where: Operating Profit before tax = Net profit ÷ (1-Tax rate)

7) Leverage

Leverage is common techniques is used in Petroleum upstream industry, it calculates the operating leverage and financial leverage which shows how much an sales increase/decrease by 1% can expect Company’s Earning Per Share (EPS) to increase or decrease by percentage. The high degree of leverage is, the high risk the Company would face if the production or commodity price is declined.

The high oil/gas price enable inefficient producers to continue exist and enables to produce from inefficient wells which it was infeasible before increase of oil/gas price and become feasible after rising price of oil.

8) Performance Measurement and Scorecards Performance is measured through Key Performance Indicators (KPIs) which are essential tools used by management to understand how far their business is successful.

The KPIs are grouped together and presented in dashboard which is called scorecard to enable the management to take a glance over the view of how the Company is performing its business. Most of Scorecards grouped such KPIs into four perspectives or more as follow:

Financial perspective measures the performance of for-profit organizations whichever they are



public or private. Financial perspective includes the following KPIs

- Operating Profit Margin

Operating Profit Margin can provide an indication of the operating efficiency of a company. Operating profit is calculated by deducting the operating costs from revenue generated from normal course of business, the revenue generated from extraordinary items or discontinued operations is not considered, and divided by the operating revenue to get operating profit margin:

Operating Profit Margin = (Revenue – Operating Cost) ÷ Revenue

The information of the above formula is obtained from the financial statements and periodical financial or accounting reports of a system. Company can monitor this indicator on monthly, quarterly and annual basis.

If a company faces difficulty to generate revenue from normal course of business activity and operating profit margin is reasonably high, it can give an indication to cost leadership strategy that company may follow and the ability of managing operating cost well, otherwise, the company may seek to sell part of its working interests to generate revenue and recover part of its costs.

- Net Profit Margin

Net Profit Margin can provide an indication of the overall business efficiency of a company. Net profit is calculated by deducting the operating costs, financing cost, general and administrative cost, cost of extraordinary or discontinued operations from all revenues that are generated from normal course of business, or extraordinary and discontinued operations, and divided by the operating revenue to get operating profit margin:

Net Profit Margin = (Revenue – Operating Cost + Other Income – Finance, G&A & Other expense) ÷ Revenue of normal course of business

The information of the above formula is obtained from the financial statements and periodical financial or accounting reports of a system. too Company can oversea this indicator periodically.

If Company faces low operating profit margin and high net profit margin, it gives strong indication that Company generate revenue from not main business activity e.g. sell part of its working interests in some licenses

- Total Shareholder Return/ Return On Equity

Return on ordinary Shareholder’s Equity (ROE) measures the profitability exclusively the return on the real owners’ funds. Stockholders are primarily interested in the relationship between net income and their investment in the company. This is probably the single most important ratio to judge whether the firm has earned a satisfactory return for its equity-holders or not. Its adequacy can be judged by comparing it with the past record of the same firm, inter-firm comparison and comparisons with the overall industry average. The higher rate is, the more efficiency in utilizing the owners’ funds.

ROE = (Net income-Preference dividend)/Average Ordinary Shareholder’s Equity

The information of the above formula is obtained from the financial statements and periodical financial or accounting reports of a system. Company can measure its profitability frequently.

The more costs are decreased, the higher ROE ratio will be. The high ROE gives an indication



that company does not need to depend on loan to finance its projects.

- Capital Expenditures to Revenue Ratio

Oil and Gas Companies intend to acquire new property, develop current proved property, or even explore unproved property to generate future benefits. This ratio is comparing the capital expenditures to sales or revenue (Capex for specific period ÷ Revenue for the same specific period) which gives us impression of how much Company is investing for future benefit. Lower ratio is not always good indication and vice versa for higher ratio. To know how better the Company invest for future, the ration should be compared with the average industry or other peers’. Also, Company should consider that much investing in petroleum acquisition, exploration, development without producing enough oil or gas can give bad indicator about the technical management performance of Company.

Information for calculating the above ratio is obtained from accounting or financial systems. But different accounting method can lead us to different results and misstate this ratio, but many companies prefer to charge all the exploration cost to Capex then to take it off to expenses to give total capital expenditures for the current period.

- Price/Earning Ratios

Many companies use price/earnings ratio to know how their stocks (shares) are attractive in stock market for potential investors. This ratio searches for the relationship between the stock price and company’s profit.

P/E Ratio = Current stock price ÷ (Net profits per share)

Also, this ratio can express the time for recovering back the initial investment in buying

Company’s stock. In cost management, P/E ratio can be increased if the cost managed to be reasonably decreased. Therefore, the higher P/E ratio is, the more stock is attractive for potential investors who pay more for each dollar (unit of currency) of net income, and the more expensive the stock is.

- Finding & Development Cost Ratio

It can be used for evaluating the efficiency of a company in adding new reserves. If we want to measure the performance of technical performance of companies or managements the finding cost ratio which include only exploration costs the reserves extensions and discoveries can reflect how efficient they are, the high ratio, the more efficient they are. To know how the overall efficiency or experience of company’s management, we can consider all the costs and all reserves additions into your considerations. [Charlotte J. Wright and Rebecaa A. Gallun, 5th Edition, 2008,Fundamentals of OIL & GAS Accounting, PennWell Corporation, Tulsa, Oklahoma, USA. Page 711-713]

- Success Rate

This rate is calculated by dividing the cost of drilling successful well to total cost of investment in drilling wells, that shows the performance of exploration and drilling departments. The higher rate is, the higher technical performance Company has and good indication that Company is managing its Capital expenditures well.

- Present Value of expected cash flow for proved and probable reserves per share

McDep LLC is independent researchers focused on stocks of oil and gas Companies, which originate McDep ratio that measures Company’s ability to generate discounted cash flow in future from oil/gas or other business for covering its market capitalization at current stock price and



debt. The Company that is low Market Capitalization and debt to present value of oil/gas reserves and other business is performed better and more profitable than Company’s stock is high capitalization and debt to present value ratio.

Internal process perspective include the following KPIs

- Capacity Utilization Rate

Capacity utilization is good measure that provides management with oversight how the production facility units are utilized and are their appropriateness to the production when they are purchased.

Capacity Utilization Rate = Actual production per day ÷ maximum quantities is produced per day for the facility equipments.

The lower rate is, the more slacks are, and higher inefficiency is in the process. And can give strong indication that Cost of facility equipments is high too because Company purchased assets has much higher capacity than the wells can produce. Which can increase the finding cost, DD&A, decrease the operating profit and net profit that may lead Company to face difficulty in profitability in future.

Information for calculating the above rate is obtained from technical internal process system and capacity of facility equipments can be estimated and obtained from equipment data that is provided by manufacturer.

- Earned Value or Budget Cost of Work Performed (EV or BCWP)

Earned Value is one of operational processes that used as a tool for combining costs, schedule, performance and risk managements. It measures how much the value of actual work performed during period of time

BCWP = Percent work complete x Initial Budget Cost (BAC)

Where: Percent Complete = BCWP ÷ BAC

- Cost Variance (CV) and CV%

It computes the difference between actual cost and what it is expected to spend.

CV = Budgeted costs for work performed (BCWP) – Actual costs for work performed (ACWP)

Positive CV gives better indication of doing better on costs than it is planned.

- Schedule Variance (SV) and SV%

It computes the difference between where the project is and where the project is planned to be in the schedule.

SV = Budgeted costs for work performed (BCWP) – Budgeted costs for work scheduled (BCWS)

Positive amount indicates that project is a head of schedule and negative variance reflects to beyond schedule

- Cost Performance Index (CPI)

It is the rate at which project performance is meeting cost expectations during a period of time or from beginning up to a point in time.

CPI =

If the CPI is equal or greater than 1, it is favorable value that indicates cost performance is perfect or physical progress is accomplishing at less than forecasted costs. and vice versa

- Schedule Performance Index (SPI)

It is rate which project performance is meeting schedule expectations up to point in



a time. The performance Indices measure the efficiency as percentage.

If the SPI is equal or greater than 1, it is favorable value that indicates schedule performance is perfect or physical progress is accomplishing at faster than planned schedule. and vice versa and vice versa

- Estimate At Completion (EAC)

Is the amount which the project is expected to cost at its completion.

or

EAC is frequent evaluation of project status. The revised EAC does not mean that corrective action is taken. Company should know the factors that cause the increase in EAC to know where is the overrun activities that occur high cost? It is preferred to identify the EAC by group of activities to consider the actual or revised of work packages not yet begun into the calculation of EAC.

Also, Time at completion (TAC) is useful to now the new length of the project, the longer the project is the longer time and higher costs it needs to be completed.

- Estimate To Completion (ETC)

It is the expected cost that is required to spend from the current point of time to the end of the project.

- Variance At Completion (VAC)

It measures the difference between the original budget and what we expect to spend at completion. If the result is positive amount it indicates that Project team is doing better than projected and negative indicates to project is run over on costs.

Project Manager or Cost controller should not only monitor the costs, they should manage the costs. Cost controller should prepare Project Reports to the executives and internal auditor that contain the following information:

- Performance that show the progress to date such as PV, EVand AC, and material procurement and usage if there is no any Materials Report issued by Materials and Logistics.

- Status that identify where the project is today and shows CV and SV.

- Projection that calculate the EAC, ETC, SPI and CPI.

- Exceptions that justifying the variances and identify the problems, causes and situations. o Indication of drilling problems such

as the flow out and flow in, mud return rate, mud pit volume, cannot pickup pipe.

o Causes of drilling problems such as high formation permeability, low formation pore pressure, using



wrong drilling fluid or mud weight. Carving, differential pressure.

o The results of drilling problems such as Cost of mud used, cost of fishing, loss of hole.

- The lessons that are learned from drilling programs. Such as Lack of experience and knowledge of personnel, and needs of crew education, and study wells in area, using centralizers, drill collars.

Learning and Growth perspective this perspective focus on employees. Nowdays and in future the employees represent significant assets. However, such assets are not accountingly recordable in ledgers. This perspective include the following KPIs

- Human capital value added (HCVA)

Human capital value added is calculated by adding the employment costs to operating profit and dividing the results by number of full time employees. The bigger the ratio overtime, the better profitability per employee goes.

- Average employment and training costs by skills

The average employment and training costs by level of skilled employees provide management the cost rate of different level of skilled employees which can be used for cost allocation or to enable the company to know how much they spend for each level of worker in salary or training and whether the cost

- Employee satisfaction index (ESI)

To measure employee satisfaction, the company needs to have survey, ask few questions and ranking the optional answer, the survey questions needs to cover the style

of leadership, communication, culture or work environment and staff development opportunities. Scoring the answers and give high rate for positive answer and low rate for negative answer, then compute the percentage of total scores to total questions. The higher index the better indication of higher satisfaction.

- Employees Turnover and average employee tenure

Recruiting and developing employees take long time and more cost. Employee retention save such time and costs. Also, replacing employees or promoting inappropriate people can cost company a lot.. Therefore, oil and gas companies intended to recruit and retain talented staff specially in technical and finance or accounting departments. The company can monitor the employees turnover by tracking the such ratio overtime and in different type of job. The employees turnover is calculated by dividing the Total number of leavers in specific job over specific period by average total number of employees during the same period. The lower ratio the more employment settlement is, indication of less problems in management practices, philosophy and leadership style and less costs and time incurred in recruiting new employees

Average employee tenure ration enable Company to know how long its employee stay in the organization on average by total, gender, level of management, type of job or departments. The longer tenure the lower costs incurred for recruiting and training staff. Also, the longer tenure indicates to high employee satisfaction and loyalty to the Company. Average employee tenure ration (AET) is calculated as follow:



∑(Years of service x (Number of employees) ÷ Total number of employees

- Salary Competitiveness Ratio

Company needs to know how much they pay to their employees in comparison to competitor’s pay or market price to employees in similar position and job area to enable Company to know if it is potential employer and if payment is a reason to leave the company. This ratio can be calculated as follow and for specific job and position and by industry.

Salary competitiveness ratio = Salary offered by the Company ÷ Salary offered by the competitor or market

Company should consider the efficiency, effectiveness and proficiency of employee too before paying more than competitors or above industry average because paying salaries to inefficient and ineffective or low proficient employees costs a company a lot for low quality of work.

Corporate Social Responsibility Perspective

Health, Safety, Environment and Security (HSES) issues have criminal and civil effects. The criminal law imposes on natural or in-kind personnel for protecting another natural or in-kind personnel. Criminal court may allocate the punishment among the personnel who commits the offences. Court can award compensation to victims or injured party. Civil Law concerns about the disputes between personnels. Plaintiff may bring complaint to court to get compensation and defendant try to reduce the compensation through involving the plaintiff in contributory negligence. Civil courts is looking for liability of two parties rather than for guilty and non-guilty that are concerned by criminal

court. HSES cases always have civil disputes that caused by accidents, illness, breach of law or contractual terms and negligence.

The employers should reasonably and practicably ensure they achieve minimum legal and ethical requirements of HSES and welfare of all employees that can include the following:

a. Safe System or Work b. Training and Supervision c. Safe place of work d. Written Safety policies and procedures e. Insure for work accident and fidelity f. Safeguard materials and people who are

not in their employments but affected by employers’ activities

Employees should take reasonable care of themselves and others who are affected by their activities, and should follow Company’s HSES policy to enable Company to achieve their legal obligations and reducing potential risks.

Suppliers or contractors must follow Company’s HSES policies or their own policies whichever is better for eliminating or reducing risks of HSES.

As we indicate to employer’s responsibilities that HSES policy should be maintained and monitoring its application. The HSES policy should be clearly and simply stated to be understandable by different level of skills. The policy should include the following:

a. Names and position of HSES people who are in charge and HSES advisors

b. Duties toward each others (employers, employees, suppliers, customers, community)

c. Short-term and long term objective

The HSES’s objectives and performance targets could be mentioned in brief as follow:

a. Reducing number of accidents



b. Reducing number and period of absenteeism.

c. Reducing criminal and civil claims d. Achieving international or national

Safety requirements and obligations

Company shall frequently assess the risks of HSES by determining the volume and costs of severity and the likelihood of occurrence. Then to determine the proper and urgency of actions.

However, HSES is new and important issues, Companies should not exaggerate its care of HSES on other accounts of successful factors. Company should always look for cost and benefit of HSES controls.

Corporate Social Responsibilities include the following KPIs:

- Injury/Incident Index

Health and Safety issues could cause increasing costs that represents compensation to injured party, violation of regulations, cost of losing opportunity for hiring skilled employees, attracting new long-term and ethical investors or contracting with high quality-experienced suppliers and paying high insurance premium.

Company should measure injury/incident to total working hours ratio which reflects the reduction of criminal/civil claims, reduction of number of accidents/injury and reduction in costs.

The Injury/accident Ratio is calculated as follow:

Injury/Accident Index = Number of injury or accident ÷ Total working hours * specific numbers

- Pollution mission rate

Environment pollution is one of most serious challenges that our planet is encountered. Most of Oil and Gas Companies play important role to mitigate the environment pollution, the most effective index that measure the pollution rate is “Carbon/gas mission rate”, “waste reduction rate”. Many countries adopt legislation for environment protection. Also, some oil and gas companies might be granted ISO 14001 that cover the environment protection requirements. The lower pollution rate that caused by Company, the less long-term costs may be incurred and higher image the company can create for itself among community. For calculating the carbon or gas emission rate, the following factors should be considered:

o Number of business travel o Energy consumed by company o Transportation of materials and

commodity o Waste generated.

- Gender Work Participation

Woman and Man are working to improve their community. After activating the international organization for woman rights and claiming for equality with man in obtaining equal opportunity for working and conducting managerial duties. Oil Companies’ social responsibilities are to enhance gender work participation. Therefore, some oil companies announce in their sustainability report the gender work participation in different level of managements.

Female employees Percent

Number of Females in CompanyTotal Number of employees



The higher female employee percent encourage the high skilled woman to join working in such companies. Also, to reduce number of claims that are related to gender discrimination if companies take such target seriously.

9) Cost management by nature The below formulas are basic formulas for calculating, drilling costs per day, cementing costs services, mud services, casing and wellheads costs and production costs. Those formula are very easy to understand by non-technical professional, however, complex calculation for cementing, mudlogging, drilling fluids and others are not easy to be done by hand of non-technical professional due to complexity that need technical staff to use specialized program to solve the problems.

Those basic formulas can help management accountant, cost controller who are not engineer to understand the variables of drilling and production costs in Petroleum upstream industry.

9.1) Drilling Cost To know how to control and manage drilling costs, we need to know the main cost drivers of drilling costs. The Below formula can help us to compute drilling costs which are effected by variables that could be controlled and managed:

Drilling Cost = (Bit Cost + Rig Cost x (Drilling Time + Trip Time)) ÷ (Length Drilled) Drilling Cost => drilling cost $ per length unit ($/ft, $/m) Bit Cost => bit cost, $ Rig Cost => rig cost per hour, $ / hour, cost of hiring rig may represents 25% of total drilling costs. Rig rate is time-based drilling cost Drilling Time => total drilling time, hour Trip Time => trip time taken to change bit, hour Length Drilled => total length drilled by drill bit, ft or m

Using inappropriate bit and drilling fluids or mud during drilling, may lead to reducing the penetration rate, increasing drilling problems ,expanding drilling length time and increasing the total costs. However, using heavier bit weight in harder formation, increase rotary speed, and using light mud weight are good alternatives to increase the penetration rate and reducing the drilling costs, problems may be occurred during the drilling such as failing to lift rock cuttings to surface and results stuck pipe or fails to keep high-pressure formation under control that results in gas kicks or blowout.

The above formula is the preliminary calculation of drilling cost. However, there many factors that could indirectly participate in cost reduction. There are many other drilling costs that may has significant relative amounts specially if there is drilling problems such as stuck pipe and lost circulation problems.

Also, there are other costs that are not covered by above formula that are related to the following activities and materials.

a) Cementing and fluids materials b) Cementing and drilling fluids Engineers c) Casing and tubing d) Testing and logging e) Completion cost

Petroleum Company shall perform cost analysis and determine, categorized the causes of increasing costs objectively and find out the appropriate resolutions to reduce such costs.

For example, if the higher costs is due to human errors, Company may need to train current staff or find replacing current technical staff with higher experienced skilled staff. And if they are refer to inefficient and effective contractor, Company may updating evaluation criteria to stop dealing with such Contractor.



9.2) Petroleum Services Petroleum services may represents about 20% of total well costs, Petroleum services cover, mud, cementing, mud and testing. Cementing and Mud, logging is depth-based drilling costs.

9.2.1) Cementing

Cementing is used during drilling operations to support casing and stop moving fluid outside the casing, and to protect casing from corrosion.

To determine the required total sacks of lead or trail cements, we need to know how many sacks are required in annulus and in casing or yield quantities of lead cement.

Number of sacks of lead cement required = Feet to be cemented * annular capacity ft3/ft * excess ÷ yield ft3/sk lead cement.

Number of sacks of Trail cement required = Sacks required in annulus + sacks required in casing.

Sacks required in annulus = ft to be cemented * annular capacity ft3/ft * excess ÷ yield, ft3/sk Tail cement

Sacks required casing = no. of feet between float collar & shoe * casing capacity ft3/ft ÷ yield ft3/sk Tail cement

Casing Capacity, bbl = Casing capacity, bbl/ft * feet of casing to float collar.

Cements are should be used with slurry and other additives. The additives should be added in specific percentages to enable the cements to be binded fast. The more lost circulation is, the faster binding particles is needed for cementing materials.

Per the above formula the volume in casing is measured in sacks and additives can be measured in bbl, where 1 bbl equal 42 US gallon. Company can estimate the cost of cementing and additives costs by multiplying the quantities in sack, bbl or gallon by unit price.

9.2.2) Volume of Mud

To determine the volume of mud to fill up the inner of the cylindrical objects, it can be computed by the following equation.

Inner Volume, bbl = Inner Capacity, bbl/ft x Length, ft

Drilling Engineer can compute the volume of mud, cementing any many drilling costs that is supposed to be occurred in specific well based on the several well information that is obtained from contractors and company’s representative in the field. The project cost system should segregate the duties between the Company’s representative in the field site and drilling engineer in the office to verify the information that is obtained from Company’s representative in the field site to drilling logs readings. Project Cost System or Cost accounting System need to be designed to ensure the existence, accuracy and completeness of vendor’s billings with the technical information and Report any exceptions noted to be adjusted or solved manually for flexibility characteristic of the system.

9.2.3) Well planning, Site Construction/Civil Works and Rig Move .

Mobilization/Demobilization, Rig move, site construction and well planning represents about 10% of total well costs and they are considered



as fixed costs regardless the depth of well or days lasts for drilling. But they are varied from well to another except for mobilization and demobilization they are fixed in total but they can be varied in average based on the number of wells that are drilled. Rig move is fixed in total and average regardless the number of wells drilled.

For well planning, the Company can reduce drilling costs by appropriately design well plan and considering the mistakes that were made in the past to predict the future. Also, Company should properly determine the proper labor needs of skill and experience. Well Planning costs might be high if the Company prepare well study for new basin that it does not have adequate technical information but when the Company purchase several data, make and process seismic, consider the information of previous wells drilled, the well planning does not take time to be completed and get more accurate information.

Civil work costs can be high if the Company does not plan for it feasibly, oil companies may spend a lot of money for asset protection and civil works that are unnecessary and inappropriate ways e.g. pay much money in cash to local community people that can be questionable for type of fraud or illegal acts. Also, such practice of paying cash money to local community people make the Company to carry high costs, and this cash money can be misused by local community people which threatens the interests of Company and host government instead of obtaining benefit. The more civilian activities (e.g. building school, clinic, drilling water well, and others) that are performed by Company, the more benefit the Company will take from local community by reducing the future community affairs and security costs in long-term.

However, Site construction costs can be high too based on the ecological features of the location, Company can reduce the site construction costs by awarding the contracts to the best vendor and by transparent tender invitation and by eliminating the duplicated or unnecessary civil activities but locating one civil camp in near all the sites to serve all wells and the entire property efficiently.

9.2.4) Testing and Long-term Production Tests

Testing costs can be the major part of well costs. And the well test is made by well logs and drill stem test that will be explained below in brief.

Litholigical Log is sampling and coring test that helps engineer to lists the depth by geological rocks and describe the rock to note the rock textures, color, grain size, cementation, porosity, microfossil. The source of such information is from samples of rock cuttings that are flow out to the surface during the drilling

Mud Log is chemical analysis of drilling mud and well cuttings that determine the rocks which bear oil or gas. The abnormal expected information in this log is called “show”

Wireline Well Logs are a readings obtain either during drilling well or after drilling well but after cleaning well by circulating drilling mud and pulling drilling equipment. For knowing the main purpose or advantages of such logs. Please see the below table.

In drill stem test (DST), drillstring of perforated drillpipe which can be less than 5” run into the target formation in the well. Two packers are installed between the upper and lower level of probable productive formation to enable the oil gas to flow into the well and if the oil or gas is adequate to be flowed up to surface the pressure gauge and valves measure the flow. The valve is opened and closed on several times to record the pressure and to calculate the formation



permeability and reservoir pressure. The longer test is, the more accurate information is and more costs occurred. The hydrocarbons that are located in porous formation can be tested within 30 days and get accurate information of gas or oil but for the hydrocarbons that located in the fractures of basements take more than 30 days and might be reach to two years for adequate testing. In this case the testing is called Long-term production testing.

The questions are whose is the title of production tests? And how the costs and revenue of long-term production testing is accounted for?

The title of the production tests is depend on the host government and PSCs. If the PSCs or host government’s regulations gives the Company right to share the specific percentage of long-term production tests. The revenue of sold production testing petroleum should be offset against development costs in accordance IAS 16.17.e. For entering long-term production testing phase, Company should determine the costs and benefits of taking such decision and ensure that the revenue from production test will exceed the incremental costs of obtaining such decision.

Development and drilling department and exploration program manager needs to reduce testing costs to the minimum level. Drilling manager needs to not request tests in formation that does not show good show during mud log or in formation location which hydrocarbon may be migrated from since very long time ago. Also, Drilling manager should not request different well logs that gives almost the same results, or asking for running a well log that its result might not be used or considered. Not merely, Drilling or exploration manager should not request equipment for specific well log and using different log which lead company to pay standby rate of unnecessary well log or the formation or type of drilling may not need such type of

logging. And extending the period of tests for less potential formation can lead to increase unnecessary costs too. All the above points need to be considered and the drilling manager or exploration manager should think and plan appropriately before determining the well log, period of test and target formation that will be tested.

Also, Engineers should to detect their seismic processing mistakes and interpreting the seismic processing based on their readings of well logs and revise their seismic mapping based on the well logs and to have more comprehensive and deep knowledge of the geological formations in basin to reduce the probability of dry wells and reduce the costs, or reduce the probability of facing lost circulation or stuck pipe during the next drilling wells

9.3) Management and Supervision Studies, drilling management and supervision may represents about 5% of total well costs but such costs could be more than 10% for less efficient supervision and management if the company does not have effective performance measurements method.

9.4) Casing, tubing & Wellhead Wells costs contains the cost of wellhead, casing and tubing and several accessories costs. Casing costs is determined based on the following formula.

Casing/tubing cost = cost per meter * meter of casing/tubing required for drilling well.

The technical engineers should determine the depth that needs to be cased in their well plan and based on their understanding and experience of the formations.

Procurement management shall buy casing and wellheads via tender process, obtain the supplier that can provide good price and good characteristics of materials and with good terms



delivery and payment and in good time. The procurement management should procure the suitable quantities of casing, tubing and wellhead based on drilling plans and should consider variance between plan and actual. Drilling and exploration manager should know preparing plan on early time enable procurement department to contract with third party to provide the casing, tubing and wellhead on proper time before drilling start. Procurement department and exploration management should not exaggerate in purchasing bulk of casing, tubing and wellhead for not facing rigid capital due to surplus in drilling materials and selling those equipments and materials at price less than original costs later on. Also, Drilling and exploration management should coordinate with higher management and treasury department for availability of funds, because unrealistic drilling plan can cause huge of unnecessary purchases.

Casing Hanger, Oil and gas companies could use casing hanger to assemble to different sizes of casing lines instead of running casing from the surface to the bottom hole and to reduce the costs but casing hanger might be used or not depend on the drilling method, characteristics of rocks of formation and experience of engineers.

9.5) Drilling Problem

8.5.1) Lost Circulation and Kick

Drilling problem can increase the well costs rapidly within days or weeks. It can exceed the actual drilling costs if there is lack of knowledge and experience among technical management.

Lost Circulation is a reduction or absence of fluid flow up the annulus when it is travelled through drillstring. Lost circulation consume time and costs without drilling the well that is either due to mechanical malfunction of formation or lack of experience and knowledge of personnel.

Losses divided into two categories.

1) Minor Loss which it is less than 500 barrels (80m3) or can be controlled within two days by increasing viscosity of fluid such as Bentonite or Polymers with additives

2) Severe loss that is more than 500 barrels (80m3) or takes more than two days to be controlled. And this type may lead the Company to stop drilling the well and try to move few kilometers to drill near the first well.

The main causes of lost circulation are as follow:



There are several causes of kick (Wellbore Influx) that can be listed below

1- Lack of Knowledge and Experience of personnel who has no ideas what can causes well control problem e.g. personnel may pump lighter fluid into wellbore which reserves pressure may overcome hydrostatic pressure.

2- Light density fluid in wellbore a. Light pills, sweep, spacer in

hole b. Gas cut mud

3- High abnormal Pressure of zone that is over current mud weight in the well can cause kick.

4- Unable to keep the hole full all the time while drilling and tripping.

9.5.2) Stuck Pipe

Stuck pipe is more common problem in Oil and Gas Industry that causes serious drilling problems and cost Company by loss of drillstring and complete loss of well and can be caused by mechanical malfunction or lack of knowledge and experience of personnel. The causes of stuck pipe that we can stated them are:

1) Mechnical sticking that is caused by physical obstructed or restriction such as

a. Settled Cuttings b. Cementing sticking or Junk in

the hole c. Mobile formation d. Casing failures e. Hole packoff and bridges

2) Differential sticking that is caused by differential pressure forces from overbalanced mud column acting on drillstring against filter cake deposited on permeable formation, such as

a. High overbalance pressure b. Thick Filter cake c. High-solids or density of muds

Those causes of stuck pipe has warning signals and preventive actions which the Drilling Department should be aware of them.

9.5.3) Fishing Junk or stuck pipe

The consequent of stuck pipe and stuck junk can cost the company a lot. The costs of consequent of stuck pipe and junk may include the costs of unproductive drilling time during fishing and fishing costs, close well, sidetrack or restart well.

The number of days that allows for fishing before taking decision to sidetrack drilling/ restarting the well or milling of junk tools.

Number of days =

Where:

Cs: is the estimated cost of drilling sidetrack, milling of junk tool or restart well

R: is the replacement value of fished equipment

F: is the cost per day of fishing equipments and services

Cd: is the cost per day of drilling rig

The formula has been taken from the below reference (Standard Handbook of Petroleum and Natural Gas Engineering. By William C. Lyons, Ph.D., P.E., Gary J Plisga, BS. 2005. Elsevier Inc. UK. Page 4-378) but it has been revised by us by subtracting the replacement value of fished equipments from the estimated costs of drilling sidetrack, milling of junk tool or restart well. Our revision in the formula does not indicate that the formula was not correct, but as per our analysis in the below Figure 1: Fishing Cost shows the replacement value needs to be subtracted to get the costs of fishing that equal to the costs of sidetracking. If we add the replacement costs of fished equipment the



number of days will exceed the feasible period of fishing.

Also, the above formula can calculate the maximum period of fishing that management must not exceeds because the cost of fishing will equal the costs of the alternative decision of sidetrack. If the management decide to continue fishing after the maximum period, it will give very strong indication of the poor financial knowledge of management, more optimistic decision than it should be or will draw forensic accountant’s attention to something wrong.

In addition to the above formula, we like to add the financial formula that compute the maximum, minimum and optimal number of days for fishing. We assumed that initial costs of fishing and sidetracking can be determined, and daily costs of alternative decision can be determined too.

The minimum number of days for fishing

Minimum number of days = ∆

∆

Where:

∆ Initial costs is incremental costs for sidetrack, start well or milling of junk tool e.g. cementing and cementing plugin costs and replacement value of fishing equipment

∆ Daily Costs is the incremental daily costs for side track, start well or milling of tools.

The minimum period of fishing enable technical management to take the decision when the cumulative daily fishing costs exceeds the expected cumulative daily sidetracking costs. As long as the marginal costs of fishing is less than marginal costs of sidetracking, the fishing decision is in the safe margin and fishing process is still valid and management hope to get the junk out to save costs that could be occurred by sidetrack activity. This period is very pessimistic.

Period of fishing can be optimum if the management consider the cost of risk that could be carried. Means, management will accept specific amount of cumulative marginal fishing that exceeds the expected cumulative sidetrack costs or to be in compliance with fishing budget that management should not exceed it.

The optimal number of days for fishing

Optimum period of fishing =

Or

∆ ∆

Where:

RT is the risk tolerance or the positive cumulative marginal costs between fishing and sidetracking/restart well costs

The reasons of junk or stuck pipe has been briefly discussed previously under stuck pipe and due to careless during drilling operations and other reasons that drilling engineer can take preventive action before it happens.

9.6) Facility Cost Facility cost includes tanks, storage, treaters, heater, meter run, separators, flow-line pipes, Vapor recovery, circulating pump, Injection pump. All those items have specifications and capacity. The procurement department and development management can manage costs by reducing the procurement costs via good negotiation and not trapping themselves unknowingly with unnecessary specifications. For example, Company should consider the capacity of the well, initial formation pressure and formation pressure decline over period of time, the power that is supplied by electrical motor to select the appropriate centrifugal pumps because the capacity of Horizontal Centrifugal End Suction Pumps is wide range from about 2100 barrels per day to 100,000 barrels per day and it is not logically to select



pump that can produce 50,000 bpd for well that its maximum production is 3000 bpd. Not merely, even the specification of heating and treating equipments and piplelines should be properly determined.

Even purchasing vehicle hires and building camps, Company should consider the requirement of the production sharing contracts and applicable laws that may require to buy such materials for building camps from local market. Procurement department and development manager should consider the price and specification of materials that can be obtained from local market and international market. Many Oil and gas Companies may prefer to buy from international market with very high costs of such materials and equipments that can exceed three times of local price and with few difference in quality which can be tolerated. Not merely, Company should take care of buying any equipments and materials that might not be used. However, Company might find itself compelled to hire vehicle from locals for mitigating security risks or hire unnecessary building or vehicle at high price specially in the countries that has high Corruption Perceptions Index (CPI) that is published by Transparency International (TI). In this case, Company management should consider their country’s anti-corruption law and not try to violate terms of FCPA, criminal code or any anti-corruption regulations. Also, it should consult legal advisor for any suspicious transactions.

9.7) Overhead and Joint Cost Overhead and common costs are a disputed expense item and draws attention of joint venture and cost recovery auditors.

9.7.1) Facility Cost Often support equipment and facilities equipments are not tied to one single field or license. If they support one field or license, the costs of such equipments will be directly

charged to the license costs, but in practice such equipments can serve several fields such as oil plants, pipelines, vehicles and in country offices. Paragraph 26 and 36 of SFAS 19 are specifically addressed the depreciation of support equipment and facilities that are not tied to a particular field.

As we indicate above, the support equipment and facilities that support production operations frequently serve more than one cost center or multiple activities or multiple licenses that are owned by different partners often results disputes in charging such costs to the cost center or license that are in tied to the same equipment and facilities. Therefore, Such costs and the costs that are associated in operating facilities equipments should be allocated to several cost category, multiple license based on the appropriate and fair allocation method of fee base. We will discuss few of such support equipments and facilities as below.

- For example, well testing equipment and rig may be used on one location that is in the exploration phase and also on another location that is in the development phase. In these situations, the equipment or rig is being used in both exploration and development activities. And fee base should be used that include the depreciation cost of rig or testing equipments, idle costs of such equipment, and associated direct costs and overhead to compute the daily fee or rental in condition of not including any elements of profit.

- The pipelines can serve multiple licenses that each are owned by different partners, the costs of usage of pipelines are allocated to appropriate license based on fee base that is organized by Facility Agreements.

- truck, for example, is being used for multiple activities and in multiple cost



centers, The depreciation of vehicle should be allocated based on kilometers driven or some other method. The depreciation and operating costs would then be allocated to the activities being served in the different cost centers.

The portion allocated to production activities would be written off as operating expense. The portion allocated to development costs would be ultimately capitalized to the wells and related equipment and facilities accounts in each cost center that the support equipment serves. That cost would then be amortized along with the other capitalized costs for the cost center using the unit-of-production method. The portion allocated to the exploration would either be expensed as G&G expense or capitalized to drilling-in-progress. The drilling in-progress accounts would subsequently be cleared to dry hole expense if the associated well is dry hole expense if the associated well is dry, or wells and related equipment and facilities if the associated well is successful.

Theoretically, the portion of depreciation relating to the support equipment and facilities and the operating cost of the support equipment and facilities should be allocated to exploration and appraisal, development or production as appropriate given usage of the support equipment and facilities or production as appropriate given the usage of the support equipment and facilities

9.7.2) Field or Host country office costs Field or host country office that supports operations covering a large area serves multiple licenses and activities of operations, exploration development. Since some of the costs attributed to each of these activities or phases may be capitalized while other costs are expenses, it is necessary to allocate a portion of offices costs to

the particular activities being served. This treatment is also required in many operations governed by Production Sharing Contracts (PSCs) and Joint Operating Contracts (JOCs) where the licenses needs to be charged by the cost of such offices equally or using appropriate General and Administrative allocation. It is appropriate to group the same office activities into cost pool then allocate the costs pools to multiple licenses or activities based on level of appropriate usage method.

9.7.4) Joint costs Joint products or by-products in petroleum upstream Industry are, crude oil, natural gas and condensate.

The criteria that differentiates the joint product and by-product are ;

- The value sales to the total sales of all products or profit of specific product to total profit. The sales value or profit of joint product represents at least 10% of total sales or total profits of all products which is presented in the financial statements as business segment (IFRS 8), whereas, the by-product’s represents less than 10%

- The business and marketing purpose. Company does not intend to produce and generate profit the by-product as the same as main product and by-product are produced in very limited quantity.

How to allocate joint costs to several petroleum upstream products?

Allocating the joint costs is necessary to compute the cost petroleum, tax and sharing profit petroleum and it is useful for determining the cost of sales by product segment. There are many allocation method for allocating the joint costs between crude oil, natural gas and condensate, and we can list and explain them in brief as follow:



1- Allocation based on physical measure. After unifying the physical measure of different commodity (crude oil and gas) either to convert oil to cf or convert cf to equivalent oil barrel, and the net realizable value of products are most likely to be the same.

2- Allocation based on Sales Value/net realizable value at split-off point, is computing by deducting the separable costs from sales value

The accounting that is used for by-product depends on

‐ There is market for by-product ‐ The by-product can be used as an energy

source ‐ The by product can be used for

reinjection

The accounting treatment of by-product can be either of the following:

1- Income generated from by-product is reported as “Other Income”

2- Income generated from by-product is credited the joint costs.

If the by-product is used internally as energy source or for reinjection to produce main product, it needs to be valued at net realizable value of replacement cost at split-off point and the joint costs of main product can be reduced by the value of by-product.

9.7.3) Corporate overhead Corporate personnel and equipments support multiple licenses and the costs should be allocated fairly among the licenses.

Corporate overhead may not wholly be recovered from cost oil, Most of international PSCs allow the contractor to recover part of it only. Also, international JOCs allow operator to recover part of its corporate overhead. But how

the Corporate overhead is allocated between license. Some Companies may prefer to allocate it equally or based on profit, sales or total costs of each license such allocation it is not fair enough but it might be accepted by PSC or JOC in condition of not exceeding the allowed amount.

The each costs pool may require different allocation base. The below Table shows the cost pool and allocation base as follow:

Table: Examples of Cost Pool and allocation Base

Cost Pool/Dept Allocation Sequence

Allocation Base

Payroll Costs Level 2 Hours spent or amount of salaries

Purchase Dept Level 2 Number of Shipments or amount of purchases

Accounts Payable Dept

Level 2 Number of Invoices paid to license payables

Accounts Receivables Dept

Level 2 Number of invoices raised for license customers

General Ledger Dept Level 2 Number of Transactions line

HR Dept Level 2 Number of employees Admin Dept Level 2 Number of orders Internal Audit Dept Level 2 Time spent for each

assignment of each license

Fixed Assets assigned for each dept

Level 1 Depreciation is charged to department based on assets assigned to dept

Rent Level 1 Rent is charged to department based on square meter

Maintenance and repairs in office

Level 1 Maintenance and repairs is charged to department based on square meter

Electricity Level 1 Electricity is charged to Dept based on total watt of equipments of each dept

10) Cost Analysis for Petroleum decisions Not all costs and revenue are useful in Cost analysis for petroleum decisions, only relevant costs and revenue that should be considered in



petroleum decision analysis. The Petroleum decision has the following steps

1- Gather all costs and revenue of each alternative

2- Take the sunk costs or revenue off (Sunk costs are the past or historical costs)

3- Select the best alternative that maximize the revenue and profit or minimize the costs

10.1) Buy against Lease (Cars, rig, building) For selecting the best decision of buy or lease vehicle, rig, equipments, materials or building, the present value of both alternative of buy and lease should be computed, and select the lowest present value of alternative costs.

10.2) Further Processing (Natural gas or LNG) or (selling from wellhead or export port) The company that may take a decision for further processing or selling from wellhead or export port needs to compute the preliminary incremental earnings of further processing and get the preliminary approval for making investment analysis. A company may need to make decision analysis for process natural gas to produce Liquefied Natural Gas (LNG) that is more marketable and profitable than selling natural gas. To prepare the decision analysis for such case, Company needs to do the following steps

1- Compute the sales value and costs at split-off of natural gas

2- Compute the sales and costs of further processing for LNG

3- Compute the incremental revenue and costs by obtaining the difference of step 1 and 2 above

4- Obtain the incremental earnings by subtracting the incremental costs from incremental revenue.

If the incremental revenue is greater than incremental costs, the further processing is preliminary feasible. If not, the Company should not take a decision of further processing. We intend to say preliminary feasible because Company still needs to prepare more detailed feasible study and investment analysis for further processing to get the expected net present value of further processing.

10.3) Selling below Normal or International Market Price If Company likes to sign sell and purchase agreement for natural sources that is under the normal market price or sell commodity at significant discount and idle capacity of assets exists, Company needs to compare the contribution margin for the special order, if the contribution margin is positive after providing the lower price or significant discount because it is still increase Company’s profitability and vice versa. If there is no idle capacity, it is not prefer to sell the commodity at lower price than market price.

10.4) Acquiring or Relinquishing Acreage For acquiring new license or not or relinquishing existent license or not depends on investment analysis for petroleum exploration that is covered by our paper. The Company should select the license that has higher expected monetary value and continue maintaining the license as long as the contribution margin exceed the direct fixed costs of license even if it is less than total fixed costs (direct fixed costs + allocated fixed costs). If the direct fixed costs exceeds the contribution margin, relinquishing license will be necessary if there is no potential profit in the license.

10.5) Determine the maximum costs of running seismic acquisition. Determining how much the maximum amount of seismic acquisition that Company should pay depends on computing the expected value of



perfect information (EVOPI). The expected value of perfect information is obtained by subtracting the maximum amount of expected monetary value of alternative strategies from the expected payoff with perfect information that equal maximum amount of expected monetary value of successful strategies. The Seismic acquisition, processing and interpretation costs may equal the expected value of perfect information and +/-10% in most likely cases.

10.6) Drilling or not For taking decisions to drill or not, Company should take the probability of different cases as follow: Dry hole as probability of lose and different probabilities of success for different oil or gas commodity and different size of reserves, small, medium and large. And each case has present value and should be multiplied by the probability to obtain the expected monetary value of each scenario than summing all the results to get the expected monetary value (EMV) of drilling a well. The higher EMV of planned well, is the well that will be drilled first and the less EMV will not be drilled.

10.7) Optimizing Production Production optimization in petroleum upstream industry is more appropriate to be analyzed by petroleum production engineers because it uses complicated technical formula of optimizing the production and equipments which some of them are mentioned in the below link http://www.elsevierdirect.com/v2/companion.jsp?ISBN=9780750682701

But the production optimization concepts are the same in any industry and we can cover it in accounting or economical view. The production is optimized by the following method

- Liner programming and decision rule can be used as optimization technique

- Theory of Constraint is one of the most famous and common technique, it focuses on the following steps

1- Identify production process system constraint

2- Decide how to use the constraints by getting the most out of the constraint

3- Subordinate everything else to the decision taken in step 2 above by aligning whole system to support decision made above.

4- Elevate system’s constraint by making significant changes needed to increase the capacity of constraint.

5- If a constraint is broken, engineer should go to step 1 but should not allow to cause new constraint.

Constraints that we mentioned above are anything prevent the production process system from achieving the goals or from obtaining the optimum point of production. Constraints can be either internal or external to the system;

a. Internal constraints are categorizes as follow: i. Limits of equipments, hours and

ability to produce ii. Limits of people in skills, experience,

hours iii. Written or unwritten policy that

prevent to get more production b. External constraints when the system

can produce more than the market demand. And when there is legislation or contractual terms that limit production.

10.8) Support Facilities Utilization and Throughput accounting In the presence of the constraints, Company can maximize the profit by obtaining highest or increasing the contribution margin per unit of



constraints measurement. Company should focus on commodity that its contribution margin per constraint measurement unit is higher than other. We can use the throughput ratio instead of contribution margin. Throughput is calculated as the following formula:

Throughput = (Sales – Direct Materials cost)

Throughput accounting ration = Return per constraint measurement unit ÷ Cost per constraint measurement unit.

To optimize the production company should seek to increase the throughput, decrease the investment and reduce operating expense, and then consequently the net profit, return on investment and productivity will be increased.

Net profit = Throughput – operating expense

Return on investment = net profit / investment

Productivity = Throughput / operating expense



Table 2: Drilling practices and Cost effect and management

Drilling Techniques

Characteristics of drilling tools

Penetration rate Formation Total Cost trend Potential Risks

Select Proper bit HTC Low Increase PDC High Decrease Heavy weight High Hardstone Decrease Light weight Low Sandstone Increase Rotary speed High with heavy

bit High Hardstone Decrease Poor Hole Cleanings and

stuck pipe Tooling wears out faster

Slow with light bit Low Sandstone Increase Will not hurt except if the in case of very small drill bits that very slower than recommended RPM that will be difficult to know the resistance from formation and very difficult to penetrate it.

Mud Heavy weight Low Pressure in Borehole is greater than the pressure onto the bottom.

Increase Fails to lift rock cuttings to surface, resulting stuck pipe Excessive high mud pressure can factures the formation and cause lost circulation or kill the well

Light weight High Pressure in Borehole is less than the pressure onto the bottom.

Decrease Fails to lift rock cuttings to surface, resulting stuck pipe Fails to keep high-pressure formations under controls and results in gas kicks or blowouts

Viscosity High Low Increase - Fluid which is too



Drilling Techniques

Characteristics of drilling tools

Penetration rate Formation Total Cost trend Potential Risks

Low High Decrease viscous will wear out the mud pump - If the mud is very less viscous, cuttings will not be brought to the surface and the stuck pipe can be caused in the borehole

Trip time Short N/A N/A Decrease Increase safety risk but this risk could be at the minimum acceptable level if it is done with trained, high experienced and efficient team.

Long N/A N/A Increase Increase Non-productive time

Table 3: Drilling Problems, risks, causes, signs, results and preventive control

Drilling Problem

Causes Results Signs/Indicators Prevention Remedial Practices

Lost Circulation

- High Formation Permeability - Low Formation Pore Pressure - Poor Drilling Fluid Characteristics

- Costly Mud usage - Loss of Production - Unproductive drill time

- Flow out < Flow in - Drop in mud Return Rate - Drop in Mud Pit Volume

-Crew Education -Good Mud Program -Study Wells in Area

-Decrease Mud Weight -Use Lost Circulation Material as Mud Additive

Stuck Pipe -Cave -Keyseat - Crooked Hole -Differential Pressure Sticking -Filter Cake

-Fishing Operations -Loss of Hole

-Cannot Pick Up Pipe

-Use Minimum Mud Weight Required to Control Formation Pressures. -Use Special Drill

-Erode Mud Filter Cake - at High Fluid Velocity (speed up pumps) -Spot Special Fluid; Oil, Acid



Drilling Problem

Causes Results Signs/Indicators Prevention Remedial Practices

Collars -Use Centralizers on Casing

-Reduce Mud Weight as Far as Possible -Rotate Pipe - Keep Moving Pipe -Cut Pipe or Unscrew Joint-and Fish

Junk-In -Negligence of Crew -Fishing Operation -Crew Education -Run Junk Basket - Run Basket with Collapsible Teeth - Run Magnet

Blow out -Loss of Hydrostatic Head due to Lost Circulation -Poor drilling Fluid -Swabbing Effect while Pulling Drillpipe -Insufficient Mud Weight

-Possible Loss of Life and Property -Legal and Financial Problems

-Returns to Surface after Circulation is Stopped (KICK!) -Well Out of Control - Big Problem -Lost Circulation

- If on Bottom: -Use proper Mud Weight -Add Lost Circulation Materials - In Extreme Case of Blowout: -May Have to Directionally Drill a Relief Well

-Crew Education - Be Alert -Blowout Control Equipment on RIG including Pit Volume Indicators

Crooked Hole -Too much Weight on Bit -Dipping Formation -Anisotropic Formation -Too Small Drill Collars -No Stabilizers

-Uneven Spacing (on bottom) -Legal Problems -Production Problems -Cementing Problems

-Periodic Directional Surveys -Stuck Drill String -Casing Problems

-Avoid Buckling of Drill Pipe by using sufficient number of drill collars -Use “Oversize” Drill Collars -Use Reamers and Stabilizers -Start the Hole Vertically

-Plug Back and Sidetrack -Use Whipstock -Use Reamers in 3 Locations

Table 4: Types of Test logging and purposes



Test and Logging Purposes/Advantage Electrical & Induction Log 1- Determine elevation of formations

2- Identify pore fluid Gamma Ray Log 1- Measure natural radioactivity

2- Identify potential reservoir rocks 3- Correlate formations 4- Determine elevation of formations 5- Determine shale content of rock

Neutron Porosity Log 1- Determine formation porosity

Formation Density or Gamma-Gamma Log 1- Determine formation density and porosity

Sonic or Acoustic Log 1- Determine sound velocity 2- Calculate porosity 3- Determine Lithology

Caliper Log 1- Measure diameter of wellbore 2- Calculate wellbore volume

Figure 1: Fishing Cost Analysis



9) Balanced Scorecard (BSC) In the light of business developments of petroleum upstream industry, the integrated Enterprise Risk Management ERM can be achieved through main tools such as Strategic planning, Budgeting and Corporate Governance, and balanced scorecard.

Budgeting was covered in brief in the previous papers and it may occur to minds of many accountants and non-accountants that integrating ERM and measuring performance through balanced scorecard process is more appropriate to manufacturing sector. And some of you may wonder how the Balanced Scorecard can be suitable for Petroleum Upstream Industry. To answer this question, we need to know what is the balanced scorecard first.

Balanced scorecard is management system that enables the Company to track and achieve their main strategies and objectives through many perspectives depends on the industry that Company is operating in.

The Perspectives that we cover in this paper for Petroleum Upstream Industry are as follow:

- Financial perspective that track Company financial requirements and measure its financial performance.

- Internal Process that measures the whole process requirements from start point to sell commodities to customers

- Learning and Growth assesses how Company educate their employees

- Social Responsibilities perspective determines how the Company feel responsibilities toward the community and track the HSE requirements and measure Company’s contribution and responsive actions of the social responsibilities

We previously discussed about those four perspectives in brief. We removed customer perspective because, we believe that customer perspective may not be an important under the upstream industry due to uncontrollable for the quality of extracting oil and gas from ground, and reaching the final product to the best quality such as downstream industry.

If Company is ignoring one of those perspectives is like sitting on four-leg chair that has one broken leg.

How Balanced Scorecard can be applied in upstream Industry? and how those four perspectives can be measured, analyzed, and improved together continuously in petroleum exploration and production companies?

Firstly, we need to know if the balanced scorecard can be important for such industry, we need to answer the following few questions.

- Can the profitability of Oil and Gas commodity be improved?

- Can we improve the processes of exploring and producing Oil and gas?

- Are employees are motivated? And Are the level of our employees’ skills, knowledge and experience need to be improved?

If your answer of the above questions are “Yes”, that means, you need to have balanced scorecard tools that should be designed either by functional departments, whole Company, project/program or by all levels. If your answer is “No”, it means you can not apply such tool and you will think it is useless to apply it. Even if your answer is “No”, why balanced scorecard, corporate governance and performance measurements disclosures are required in Management Discussion & Analysis (MD&A) requirements.



10) Cost Management and Key Performance Indicators by function

Cost management shall be performed by doing the following steps.

- Specify list of activities or processes - Determine the cost of each activity or

processes - Select Critical Cost to be managed,

controlled or cut. - Search and think about the associated

risks and results of cost cut or cost management.

- Identify Cost Drivers. - Arrange the cost per their priority (From

highest costs to lowest cost) - Develop Models of “What costs should

be” by using Cost Worksheets. - Working with Technical staff and other

department to justify the differences between “Should cost” and the “actual cost” and discuss with them if there is any human errors during running seismic acquisition, processing and interpretation, drilling, producing, marketing and selling, financing or general management support.

The following are examples of cost by management function.

10.1) Exploration and Drilling managements

Drilling and Exploration Management should try to not pay much more attention that exceed the reasonable of boundries to unnecessary activities. Health, Safety and Security is important but Company shall not focus on Corporate Social Responsibilities on the account of Company’s financial performance, and its employees’ learning and growth, Company

managements should balance between several four perspectives.

If Company faces liquidity and profitability problem in short and middle term, Company should:

1- reduce its standards of HSES to reasonable boundaries to reduce their associated costs. Because the associated costs sacrifice the profit in the short and middle-term.

2- they should replace high costs of ineffective and inefficient staff (most likely foreign staff) with low cost of high efficient and effective staff (who can be local staff). In other word, Training lower cost employee to become master in their area and replacing expatriates because the middle payment of each expatriate could exceed US$ 35,000 per month. However, local staff in the Middle East or third world countries could not exceed US$ 6000 in average for each. And average costs of training for each efficient local staff to become master could not exceed US$300,000.

3- Decrease all employees’ welfare such as traveling in business or first class, living in very luxury palace.

4- Developing payment system to management to be based on their performance of finding proved reserves with low costs and less risk rather than payment based on HSE risk reduction only because finding Oil at low costs is the primary objective of Oil and Gas organization that seek for profit or currently face profitability problem.

5- Mitigating investment from high risks countries to lower risk countries.

6- Investigate and perform due diligence care about the operator partner, whether operator has high experienced technical



engineer and the Company’s performance is high technically or not in order to maintain joint venture interesting or cease investment by selling their working interests or entering Farmin/farmout agreement with efficient and effective operator to take the operation of the license.

The Departmental KPIs that can be measured to ensure if the drilling and exploration department is in alliance with Company’s strategy planning are as follow.

- Number and volume of proved formations correctly assessed to total formations were under study.

- Area of horizon studied during the period

- Number of dry wells to total wells drilled

- Number of lost circulations, junk, stuck pipe to total wells drilled.

- Cost of drilling problems to total drilling costs

- Total dry well costs to total investment in drilling.

- Number of Lessons not learnt from previous well.

- Number of litigations raised due to tender process or contract wordings.

- Total number and amounts of urgent services or items requested during the year.

- Total amount of variation exception payments.

- Total amounts paid for over specification or request of services or equipments or for unnecessary services and equipments.

- Drilling and G&G project cost and schedule variance and indices

- The expected monetary value of well, reservoirs, total productive block.

10.2) Procurement and Logistics management

Procurement Department can manage costs by reducing the following costs via good negotiation and not trapping themselves unknowingly with unnecessary specifications.

- Materials cost - Procurement Labor Cost - Transportation Cost - Storage Cost - Risk of procurement

o Obsolescence o Missing or damages during

transportation and in-transit o Stealth

The Departmental KPIs that can be measured to ensure if the department is in alliance with Company’s strategical goals

- Lead time o Time taken to order the item

from supplier o Time taken to received the item

to the requestor o Materials damage Issues solved

- Inventory Shortage/overage rate - Materials & Logistics Cost to Revenue - Number of incidents or injuries in

warehouse - Stock hold costs to total exploration

costs - Number and amount of finalizing the

governmental formalities for importing/exporting/consuming materials and services.

- Total number and amounts of urgent services or items requested during the year

10.3) Marketing and Sales management



Marketing and sales costs are not too high like CAPEX and production costs, but it must be managed as follow:

1- If the Company has depended on single or few customer(s), and has ability to produce and sell more. It shall find new customers, and encourage marketing staff by incentives and good payment to find new customers.

2- If the Company has depended on single or few customer(s), and has faced declining production and sales, it is preferred to reduce marketing and sales costs until Company find and produced from new reservoirs.

3- The company shall have Customers Analysis, and try to change their contract terms based on the results of analysis.

10.4) Finance and accounting

management

If the Company is small in comparison to its competitors or other peers in the industry, faced production declining, commodity price declining, has problem for financing future Capital program, Company may reduce G&A costs and doing the following:

1) Simplify its organizational structure remove the mid level management and may costs Company too much as Corporate overhead or expatriate costs.

2) Reduce the employees’ welfare 3) Review, update and change payment

system to executives to be more relevant to their actual and physical performance.

4) Merge the job duties if they can be done by one person but Company shall be care of removing unnecessary position or merge position, Company shall select the most efficient and effective person to occupy the merged positions.

5) Company shall review the level of salaries for each position and comparing to their duties, performance and potential skills they have.

6) Company shall reduce and cut costs that are unnecessary such as villas costs of expatriates and there are no expatriate have visited the villas for one year and there is no probability of residing these villas by expatriates in next years, then reducing the high salaries of ineffective and efficient individual, merge positions, and the last step is employment reduction or layoff.

The Departmental KPIs that can be measured to ensure if the department is in alliance with Company’s strategical goals

- Number of cancelled payments to total payments

- Number and amounts of debit/credit notes to total payments

- Number and amount of invoices paid after due date to total payments

- Amount of lost from not obtaining cash discount.

- Number and amount of invoices paid within due date to total payments

- Number and amount of unjustified audit queries

- Number and amount of audit adjustments

- Total non-recoverable costs detected during cost recovery and Joint Venture audit.

- Time of processing invoices - Cash shortage/overage rate and times of

bank account be overdue - Timely, Accurate and Transparent

information provided. - Number of reclassification entry to total

entries posted.



- Total payments that is not supported by Purchase Requisition and Orders (urgent payments)

10.5) IT management

IT management department ensure all IT activities, resources of hardwares, softwares and people are properly managed in alignment with Company’s strategic goals through the following:

- Reduce IT costs - Improved IT services and use best

practices processes - Improve productivity of IT

Therefore, The Departmental KPIs that can be measured to ensure if the IT department is in alliance with Company’s strategy goals

- Total numbers of helpdesk calls - Numbers of closed/open helpdesk calls

to total helpdesk calls. - First helpdesk call solved rate = Total

number of unsatisfactory resolution ÷ Total number of helpdesk calls.

- Average time to close IT support calls. - Numbers and costs of external

assistance to close IT issues. - Numbers and saved costs of closing

issues without referring to external assistance.

- IT Project Schedule Variance - IT Project Cost Variance - Total number and amounts of urgent

services or items requested during the year.

10.6) Human Resources (HR) management

Human Resources Department participate good role in adding value to long-term utilization of

staff by designing proper performance and measurements, promotion, and salary determination system. Human resources can achieve Company’s strategic goals by ensuring that Company recruit efficient and high skilled employee, train lower skilled employee, and maintain those experienced staff for longer time. Therefore, The Departmental KPIs that can be measured to ensure if the HR department is in alliance with Company’s strategy goals

- Employee turnover = Total number of leavers ÷ total number of employee over period

- Salary competitiveness ratio = Salary offered by your company ÷ Salary offered by your competitor.

- Time to hire = Time to start – Time of posting

- Average employee tenure = Sum of all tenures ÷ number of full time employees And it can be for particular job role

- Employee satisfaction index - Human Capital Value Added - New discoveries per training hour - Staff Costs by level of skills,

management, and gender. - Number of issues solved before

escalating them to management or court

The below Exhibit 1: General view of balanced scorecard (BSC), Table 5: Example of Balanced Scorecard and Table 6: Strategic Risk Management show how each department participate in achieving the strategic goals and how company can manage and mitigate the strategic risk through Balanced scorecard technique that track the objective and risks by all perspectives and by each departments.



Exhibit 1: General view of balanced scorecard (BSC)

Internal Process

Goals Measures Efficient Project Management Process

- Finding & Development Cost

- Replacement Ratio - Cycle time to produce - yield

Production Productivity

- Production and Engineering Efficiency

Increase sales - Customer Satisfaction/Image

- Products on time in minimum period

- Increase proved reserves - Increase production

stability Optimize operations and Procurements

- Capital Utilization Rate. - Lifting Cost per barrel

Financial Perspective

Goals Measures Create Value

- Increase Profit - Optimize assets

value - Increase ROE - Increase

Company’s market value of stocks and Improve Stakeholders’ satisfaction/image

Strategic Management range the first above two layers of pyramid. Operating Management start from Operational Planning by department and lower

Corporate Social Responsibility

Goals Measures Contribution in Social Responsibility efficiently

- Increase the positive results and decrease the negative results (Decrease pollution emissions, and work incident)

Optimizing the costs of corporate social responsibility

- Efficiently decrease the current and future costs

Learning and Growth

Goals Measures Knowledge Leadership

- Time to develop next generation

Develop Strategic skills/innovation

- Training time - New discoveries to

training time Information systems

- Ability to apply and adapt to new system.

- Able to innovate new system

Information System

Environment

Decision Support System (e.g. BSC)

Operational Planning and Management by

Department

Integrated System (Financial, Managment,Tax,

etc)



Table 5: Example of Balanced Scorecard

Strategic Goals

Perspective Measure KPIs and tactical goals by Functional Department Drilling & Exploration

Marketing and Commercial

Production Procurement & Logistics

Accounting & Finance

Administration & Human Resources

Information Technology

Increase Shareholders’ wealth

Financial Increase profit

Decrease the finding and development costs Decrease total dry well costs to total investment in drilling.

Increase oil and gas sales

Increase produced oil and gas

Decrease procurement and stock hold costs

Total non-recoverable costs detected before cost recovery and Joint Venture audit and find way to reduce such costs amounts of debit/credit notes to total payments Amount of lost from not obtaining cash discount.

Efficiently decrease personal costs by replacing the inefficient personnel with skilled personnel.

Decrease the costs of external assistance and increase the saved costs

Optimize Company’s assets value

Increase the proved reserves Increase the prospects. Decrease total dry well costs to total

Increase the production at lower costs

Decrease procurement and stock hold costs

amounts of debit/credit notes to total payments Amount of lost from not obtaining cash discount.

New discoveries to total exploration and drilling hours New discovery to total Training hours




Strategic Goals







investment in drilling.

Internal Process

Managing the operating costs efficiently

Improve the production process to decrease the operating costs per barrel to get the highest level of production

Improve procurement process to decrease procurement and stock hold costs

To improve the invoice process to decrease the cycle time of payments and receipts to get discount and pay invoices appropriately

Training and annual staff costs to costs of external source and total operating costs


Increase the replacement ratio

Number and volume of protective geological formations correctly assessed to total formations studied. Number of successful well to total wells drilled Increase proved reserves

Appropriate install/analyze /program technical system software

Learning & Decrease Number of Decrease the Detect wrong New discovery Numbers of



Strategic Goals







Grow project/operation pending issues and solving the issues from the first try or before the risk is occured

Lessons learned and not repeated again during the year Decrease number and Cost of drilling problems to total drilling costs

risks of incident, environmental damage and production decline.

amount, costs, accounting treatments and solve it before it is detected by auditors

to total Training hours

closed/open helpdesk calls to total helpdesk calls. First helpdesk call solved rate

Corporate Social Responsibility

Increase the stock price in market

Decrease incident and injuries during drilling and exploration campaign Decrease risks of blowout and oil spill.

Decrease air or water pollution

Decrease incident and injuries in warehouse

Participate in Health, Safety and Environmental culture





Table 6: Strategic Risk Management

Perspective Objective Risk Indicators Current practice/processes

Suggested Action/Control Processes

Focus Area Effectiveness Rating

Comments

Financial Increase Profit

High Loss may be occurred over time. Distract management from core tasks to branch tasks Liquidity solvency problem

High production decline

Bonuses paid to managers is mainly based on the HSE results rather than finding new discoveries.

Improve Management performance and rewards by combining several measures in different and appropriate weights such as level of profit, stock price, proved reserves and HSE.

Human Resources

10

No positive reserves replacement ratio over time

Continue hiring high expatriate costs with no positive results for long time

Improve training and recruitment process. Train the efficient expatriate Efficient expatriate pass knowledge and experience to local staff

Human Resources Drilling and Exploration

8

Negative operating cash flow and

Increase amounts of urgent payments

Preparing Cash Budget/Forecast by Treasury Dept.

Accounting & Finance Procurement

9






Comments

negative income results

Getting with good negotiation for extending payment period and shrinking the collection period Improve all the controls process

All Departments

No Drilling and exploration plan for the short and middle term and no appropriate coordination between all departments and levels of managements Unnecessary high specification of contractual service equipments Or Purchase unnecessary service and equipments

Develop plans and coordinate the plans with several level of management and departments. Coordinate or arrange with requesting department to select the appropriate customization standards for services or equipments. Mitigate the contractual specifications

Contract Administration of Drilling & Exploration Human Resouces IT Procurement

8






Comments

that are too open or loose.

References

‐ PMBOK, 3rd edition. ‐ The Purchasing and Supply Manager’s Guide to the C.P.M Exam,

Fred Sollish and John Semanik, Publisher: Neil Edde, 2005. ‐ Basic Drilling Technology, Developed by WCS-Well Control

School, 1998 ‐ Drilling Formula. Available at Website:

http://www.drillingformulas.com/

‐ Definition of Lost circulation at Website:http://en.wikipedia.org/wiki/Lost_circulation

‐ Website: http://www.forbes.com/sites/tomkonrad/2012/01/26/the-end-of-elastic-oil/

‐ Website:http://15961.pbworks.com/f/Cooper.2003.OPECReview.PriceElasticityofDemandforCrudeOil.pdf

Cost management for petroleum exploration part a

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