Oil and Gas Industry Overview PDF

BM2110 OIL AND GAS Industry Overview The oil and gas (O&G) industry is composed of entities that extract, refine, and sell oil and gas, refined products, and related products. It is the major industry in the energy market, and it plays an in...

BM2110 OIL AND GAS Industry Overview The oil and gas (O&G) industry is composed of entities that extract, refine, and sell oil and gas, refined products, and related products. It is the major industry in the energy market, and it plays an influential role in the global economy as the world's primary source of fuel. The objective of oil and gas operations is to find, extract, refine, and sell oil and gas, refined products, and related products. Entities in the O&G industry require substantial capital investment and long lead times to find and extract the hydrocarbons in challenging environmental conditions with uncertain outcomes. Exploration, development, and production often occur in joint ventures or joint activities to share the substantial capital costs. The outputs often need to be transported in significant distances through pipelines and tankers; gas volumes are increasingly liquefied, transported by special carriers, and then “regasified” on arrival at destination. Gas remains challenging to transport; thus, many producers and utilities look for long-term contracts to support the infrastructure required to develop a major field, particularly off-shore. The industry is exposed significantly to macroeconomic factors such as commodity prices, currency fluctuations, interest rate risk, and political developments. The assessment of commercial viability and technical feasibility to extract hydrocarbons is complex and includes several significant variables. Moreover, the industry significantly impacts the environment consequential to its operations; thus, entities are often obligated to remediate any resulting damage. Despite all of these challenges, taxation of oil and gas extractive activity and the resultant profits is a major source of revenue for many governments. Governments are also increasingly sophisticated and looking to secure a significant share of any oil and gas produced on their sovereign territory (PricewaterhouseCoopers [PWC], 2017). Sectors of Oil and Gas Industry There are three (3) sectors of the oil and gas industry (Aavos International, 2021): Source: https://www.elandcables.com/ Upstream. It includes entities that search for potential underground or underwater crude oil and natural gas fields, drilling exploratory wells, and subsequently drilling and operating the wells that recover and bring the crude oil and/or raw natural gas to the surface. 05 Handout 1 *Property of STI  [email protected] Page 1 of 6  BM2110 Midstream. It includes entities that transport (by pipeline, rail, barge, or truck) and store crude or refined petroleum products. These entities used pipelines and other transport systems to move crude oil from production sites to refineries and deliver the various refined products to downstream distributors. Downstream. It includes entities that refine petroleum crude oil and process and purify raw natural gas. It also refers to those companies that market and distributes products derived from crude oil and natural gas. The downstream sector touches consumers through gasoline or petrol, kerosene, jet fuel, diesel oil, heating oil, fuel oils, lubricants, waxes, asphalt, natural gas, and liquefied petroleum gas (LPG), as well as hundreds of petrochemicals. A company can operate in one sector of the industry. However, an integrated oil company can operate across the sectors. One example is the Philippine National Oil Company (PNOC), a government-owned and controlled corporation (GOCC). It has both upstream and downstream operations. Regulators of Philippine Oil and Gas Industry The Department of Energy (DOE) is the lead agency that regulates the oil and gas industries. The agency was created through Republic Act (R.A.) No. 7638, otherwise known as the Department of Energy Act of 1992. There are various bureaus and divisions under the DOE, and some of them that are relevant to the oil and gas industries are the following (Department of Energy [DOE], 2021): Oil Industry Management Bureau. It formulates and implements policies, plans, programs, and regulations on the downstream oil industry, including the importation, exportation, stockpiling, storage, shipping, transportation, refining, processing, marketing, and distribution of crude petroleum oils, products, and by-products. It also monitors developments in the downstream oil industry. Energy Resource Development Bureau. It assists in formulating and implementing policies to develop and increase the domestic supply of local energy resources like fossil fuels, nuclear fuels, and geothermal resources. Moreover, it conducts energy research and studies supporting the activities above and provides consultative training and advisory services to practitioners and institutions in regulated activities. Natural Gas Management Division. It formulates and implements policies, plans, programs, and regulations on developing and promoting downstream natural gas. It also undertakes product and market development activities for downstream natural gas. Moreover, there are various laws and issuances that entities in the oil and gas industry in the Philippines must observe. Examples of them are the following (Department of Energy [DOE], 2021): Oil Exploration and Development Act of 1972. It provides the legal basis for exploring and developing indigenous petroleum resources authorizing the grant of service contracts entered into through public bidding or negotiations. Presidential Decree 1857. This law amends certain sections of the Oil and Exploration Development Act of 1972, offering improved fiscal and contractual terms to service contractors with special reference to deep- water oil exploration. DOE Circular No. 2003-05-005. It establishes the procedures for the Philippine contracting round in petroleum prospective areas. 05 Handout 1 *Property of STI  [email protected] Page 2 of 6  BM2110 DOE Circular No. 2003-05-006. It provides the guidelines for the financial and technical capabilities of a viable petroleum exploration and production company. Executive Order No. 66. This order designates the Department of Energy as the lead agency in developing the natural gas industry. DOE Circular No. 2002-08-005. It sets the interim rules and regulations governing the transmission, distribution, and supply of natural gas. Philippine Environmental Policy Act (Presidential Decree 1151). It requires the government and the private sector to undertake environmental impact assessments of their project activities which may significantly affect the quality of the environment. Philippine Environmental Code (P.D. 1152). It provides a detailed prescription on the management of air quality, water quality, land use, natural resources, and waste. Environmental Impact Statement System (P.D. 1586). It provides details on Environmental Impact Statement (EIS) System. National Integrated Protected Areas System (NIPAS) Act of 1992. It provides for establishing and managing a national integrated protected areas system, defining its scope and coverage. Section 14 of the NIPAS Act specifies the survey of energy resources in protected areas solely for data gathering. Any exploitation and utilization of energy resources found within NIPAS areas shall be allowed only thru the passage of a law by Congress. The Indigenous People's Rights Act of 1997. It establishes implementing mechanisms to protect and promote the rights of indigenous cultural communities/indigenous peoples. Key Audit Considerations There are certain key considerations in auditing the financial statements of the oil and gas industry that an auditor must understand. Given below are some of them (PricewaterhouseCoopers [PWC], 2017): Some private oil and gas entities choose to use a special purpose framework to prepare financial statements. If a special purpose framework is used, it is typically the income tax basis. One of the unique aspects of oil and gas accounting stems from the fact that each owner of an oil and gas mineral interest owns an undivided interest in the underlying minerals; that is, each party owns a proportionate share in the asset and is proportionately liable for related liabilities. Oil and gas reserves are a critical component in the calculation of depreciation, depletion, and amortization of oil and gas property costs, as well as the assessment of any impairment. The industry is exposed significantly to macroeconomic factors such as commodity prices, currency fluctuations, interest rate risk, and political developments. The oil and gas producing properties are accounted for using the full cost method or the successful efforts method. 05 Handout 1 *Property of STI  [email protected] Page 3 of 6  BM2110 Declining revenue and a corresponding reduction in the value of proved reserves can have an exponentially negative effect on oil and gas producers, and some entities may not be agile enough to respond to the related operational challenges. Oil and gas entities are required to record asset retirement obligations (ARO) in the period incurred. Auditors need to perform procedures to determine whether the obligations are properly recorded and disclosed in the financial statements. When oil and gas entities are adversely affected by falling prices, so are their counterparts. As a result, the collectability of receivables from interest owners and purchasers can often become an issue. Risk-Based Audit Process Generally, the risk-based audit process in each industry is the same. They only vary on the accounts or transactions that the audit shall be focused on. The auditor may focus on the following accounts/transactions for each sector: a. Upstream Sector (Thomson Reuters, 2014): Exploration and evaluation (E&E) expenditures. Auditing the exploration and evaluation expenditures of the entities in the upstream sector is ordinarily the most significant oil and gas audit area. Exploration and evaluation expenditures are expenditures incurred in connection with the exploration and evaluation of mineral resources before the technical feasibility and commercial viability of extracting a mineral resource is demonstrable. There are several important activities related to accounting and auditing of E&E expenditures, including the following: o Recording and categorizing property additions and acquisitions. o Calculating depreciation, depletion, and amortization (DD&A) of oil and gas properties. o Assessing properties for impairment. o Evaluating oil and gas reserves. o Recording dry hole costs, wells in progress, and workover costs. o Disposing of oil and gas properties. Philippine Financial Reporting Standard (PFRS 6) - Exploration for and Evaluation of Mineral Resources provides that E&E expenditures are accounted for using either the full cost method or the successful efforts method. Under the full cost method, all property acquisition, exploration, and development costs are capitalized when incurred, amortized, and periodically subjected to a ceiling test. On the other hand, only exploration and development costs related to proving reserves are capitalized and amortized under the successful efforts method. They are subject to impairment assessments similar to other types of assets under the generally accepted accounting principles (GAAP). In conducting an oil and gas audit, the auditor must check that the items in the E&E expenditures are properly valued and classified. Moreover, the auditor must check if the company fully disclosed in its notes to the financial statements which of the two methods it used in accounting for its E&E expenditures. Mineral interest. One of the unique aspects of oil and gas accounting is that each owner of an oil and gas mineral interest owns an undivided interest in the underlying minerals. Each party owns a proportionate share in the asset and is proportionately liable for related liabilities. As a result, every 05 Handout 1 *Property of STI  [email protected] Page 4 of 6  BM2110 oil and gas transaction must be allocated to reflect each interest owner’s proportionate share of the transaction to be appropriately recorded and accounted for by the owner. To further complicate matters, an individual property often has different revenue ownership interests and working (cost) ownership interests. To accommodate the complexity, oil and gas accounting systems maintain an automated division of interest master files, which are used to perform the proportionate allocation of transactions by property and interest owners based on division orders and other legal documents. Given the pervasiveness of working interest and revenue interest percentages in the audit of oil and gas properties, the auditor typically performs tests of the division of interest master files to verify the appropriateness and integrity of the ownership percentages. Oil and gas reserves. Oil and gas reserves are a critical component in the calculation of depreciation, depletion, and amortization of oil and gas property costs, as well as the assessment of any impairment. As the related oil and gas reserves are produced, capitalized acquisition costs of proved properties should be amortized or depleted using the unit-of-production method. Each unit of oil and gas produced is assigned a pro-rata portion of the unamortized acquisition costs. The unit-of- production amortization method requires that the total number of oil or gas reserves units in a property or group of properties be estimated and the number of units produced in the current period be determined. Evaluating oil and gas reserves is the most critical area in which oil and gas entities may involve a specialist. Generally accepted auditing standards (GAAS) state that the nature, timing, and extent of audit procedures performed in evaluating the work of a specialist is affected by whether the specialist is employed by the entity and the extent to which management can exercise control over the specialist. In auditing the valuated amounts of oil and gas reserves, the auditor will need to perform detailed testing of the reserve report to evaluate its appropriateness as audit evidence, particularly if the report is prepared internally. The auditor may use the “Standards Pertaining to the Estimating and Auditing of Oil and Gas Reserve Information” of the Society of Petroleum Engineers in determining whether the method used by the entity’s specialist to estimate oil and gas reserves is appropriate. b. Midstream and Downstream Sectors (Pilipinas Shell Petroleum Corporation, 2020): Inventories. Entities in the downstream sector maintain inventories such as lubricants, liquified petroleum gases (LPG), and merchandise. Such inventories shall be valued at lower between the cost and net realizable value (NRV) following Philippine Accounting Standard (PAS) 2 – Inventories. In auditing the inventories of entities in the downstream sector, the auditor must understand the company’s inventory valuation process and related controls. Moreover, he/she must obtain and review the management’s calculation of the inventories’ net realizable value (NRV). It can be done by testing the NRV of selected inventories. Testing the NRV may include obtaining the inventories’ prevailing market prices and historical selling costs then comparing them with their current cost. In doing so, the auditor will also determine if the allowance for inventory write-down is reasonable. However, inventories may be valued at cost if they are raw products that the entity intends to process to create a new product, e.g. refining crude oil, which is an exception to the requirement in PAS – 2. 05 Handout 1 *Property of STI  [email protected] Page 5 of 6  BM2110 Property, plant, and equipment (PPE). Entities in the downstream sectors have various PPE such as refineries, gas treatment installations, chemical plants, distribution networks, and other infrastructure. These assets are depreciated using a method that reflects the pattern in which their future economic benefits are expected to be consumed as provided by PAS 16 – Property, Plant, and Equipment. Some PPEs, such as refineries, are often depreciated on a straight-line basis over the expected useful lives of the assets. Other assets are depreciated using the throughput basis. For example, for pipelines used for transportation, depreciation can be calculated based on units transported during the period as a proportion of expected throughput over the life of the pipeline. In auditing the PPEs of entities in the downstream sector, the auditor may check the PPEs’ balances by testing and reviewing the fixed asset roll-forward of the company. The auditor may also perform a test of movements of the fixed assets, which involves determining their additions, reclassifications, and disposals. Also, the auditor may review the supporting documents used in determining the assets’ fair value less cost to sell, which represent the recoverable amount of the entity's PPEs. Moreover, the auditor may also review the company disclosures related to the impairment of the PPEs, including the manner of determining their recoverable amount. c. Sector-Wide (PricewaterhouseCoopers [PWC], 2017): Tax. Some entities in the oil and gas industries may avail certain tax benefits, especially when they act as service contractors on behalf of the government. In auditing the tax of an entity in the oil and gas industries, the auditor may discuss the status of their claims of benefits with the company’s management and internal legal counsel. Moreover, the auditor may also check the supporting documents about the tax benefits. Joint-Arrangements. An entity in the oil and gas industry may partner with the government. This kind of setup may require a joint agreement. In this case, the parties involved will need to consider the relevant provisions of PFRS 11 – Joint Arrangements. Joint ventures and other similar arrangements (joint arrangements) are frequently used by oil and gas companies as a way to share the higher risks and costs associated with the industry or as a way of bringing in specialist skills to a particular project. In auditing the joint arrangements, the auditor may review the contract of the entity and the other party. It is to determine if the arrangement is properly classified as a joint operation or joint venture. Decommissioning cost. By contract, local regulations, or environmental policies, most natural resource companies are required to provide for a decommissioning cost to restore the area to its natural state. The decommissioning effort can cost tens of millions of dollars for the upstream chain and involve well-plugging, pipe-cutting below the seabed and seabed restoration, subsea installation/equipment removal, platform removal, and others. Thus, the auditor must check whether the decommissioning cost of the company is properly recorded and is not accrued over the company's operations. References: Aavos International. (2021). Upstream, midstream, downstream (oil industry). Retrieved from Aavos International: https://aavos.eu/glossary/upstream-midstream-downstream-oil-industry/ Department of Energy [DOE]. (2021). Bureaus and services functions. Retrieved from Department of Energy : https://www.doe.gov.ph/transparency/bureaus-and-services-functions Department of Energy [DOE]. (2021). Laws & issuances (oil and gas). Retrieved from Department of Energy: https://www.doe.gov.ph/laws-issuances-oil-gas?ckattempt=1 Pilipinas Shell Petroleum Corporation. (2020). Annual report for 2020. Pilipinas Shell Petroleum Corporation. PricewaterhouseCoopers [PWC]. (2017). Financial reporting in the oil and gas industry. PricewaterhouseCoopers. Thomson Reuters. (2014). Challenges facing oil and gas auditors. Thomson Reuters. 05 Handout 1 *Property of STI  [email protected] Page 6 of 6