FEATURE

ALLOCATION of COSTS between LIQUIDS and GASES

HUMBLE OIL & REFINING CO. E. E. HUNTER HOUSTON, TEX. Downloaded from http://onepetro.org/jpt/article-pdf/6/07/11/2237694/spe-292-g.pdf by guest on 02 October 2021 Introduction increased to a rate of about 7.5 trillion cu ft in 1951 and over 8 trillion in 1952. The increase in demand Petroleum producers have been engaged for many thus indicated has been close to 12 per cent a year years in supplying several different types of materials since 1946, more than twice as great as the rate of from the leases they operate. Some leases produce crude increase in demand for crude oil. oil and casinghead gas, others produce gas-well gas and condensate, and still others produce all four of these This extraordinary growth in the volume and value materials. Therefore, the problem of allocating costs of gas has raised it to a position of importance that com­ between these intermingled products is not a new one. pels recognition, even by companies interested princi­ pally in oil production, of its status as a joint product. While in some fields gas has been the dominant prod­ (For some companies and in some fields gas has for uct, most producers have been interested principally in many years been a primary product.) Good account­ oil. Consequently, little has been done about the cost allo­ ing practice and business prudence dictate that oil cation problem by oil producing companies. For account­ producers now adopt some method of allocating costs ing purposes, these companies have generally con­ to gas, or actually to all four of the joint products sidered gas a by-product, and whatever realization was involved - crude oil, casinghead gas, gas-well gas, and obtained from it was accounted for as a reduction of condensate. However, full industry recognition of this producing costs, which were all considered to be ap­ fact has come so recently that no generally accepted plicable to crude oil. The inadequacy of this procedure method of making the allocating has been found. under present day conditions, and the need for a more realistic approach to the problem of accounting for Difficulties Involved costs, can probably be illustrated best by a brief review The difficulties involved in allocating costs between of the growing importance of gas in the economic the various products supplied by petroleum producers structure of the industry. arise from the fact that the intermingled products are Need for Allocation so often produced at a cost that is common to all. Known reserves in the United States Liquid and gases are lifted through the same well bore, approximately doubled during the 10 years ending with by the same manpower, and under the same supervision. 1952, rising to a total of nearly 200 trillion cu ft at Under these circumstances costs cannot be traced exactly the beginning of 1953. In terms of heat value the 200 to each joint product. trillion cu ft of gas is approximately equal to the com­ This problem of allocating common costs is not bined heat content of the 28 billion bbls of crude oil peculiar to the petroleum producing industry. For and the 5 billion bbls of condensate in reserve at the example, the meat packing, milling, chemical, lumber, beginning of 1953. However, the heat units produced and petroleum refining industries all are faced with in the form of oil in 1952 were almost twice as great the problem of allocating common costs between two as those produced in the form of gas - a good indica­ or more joint products. The difficulty or impossibility, of tion that there is much more room for expansion in allocating such costs "exactly' by no means lessens production of gas than for crude oil. the need for some careful estimates of the cost of The rapid growth in demand for gas since the end each product for the purpose of measuring the relative of World War II has brought about a substantial in­ profitability of various operations and as a general crease in the wellhead price, despite increasing reserves. yardstick for testing the adequacy of sales prices. Each In the Southwest, for instance, the price doubled in industry has developed cost accounting procedures the period from 1943 to 1951, rising to an average of that are logical under the prevailing operating circum­ approximately 5.6 cents a thousand in the latter year. stances. As conditions change, the accounting pro­ Marketed production of gas in the United States had cedures change with them. There is no reason why petroleum producers cannot change their traditional custom of considering that all costs are applicable to Manuscript received in the Petroleum Branch office Oct. 19. 195:l. crude oil, just as other industries have changed their Paper presented at the Petroleum Branch Fall Meeting in Dallas. Oct. 19-21. 1953. customs when necessary. SPE 292-0 JULY, 1954 11 A Method of Allocation line with their heat value, and that costs thus allocated may appear distorted in relation to the realization. This The discussion that follows will be devoted principally is simply arguing that the realization method is a better to the method of allocating producing cost that has method of allocation, but the objection can be overcome been adopted by Humble Oil & Refining Co. In the to a large degree even if the realization method has search for a method that would take into account merit. Gas-well gas at 15 cents/Mcf is delivered to the peculiar characteristics of oil and gas producing industrial users on the Gulf Coast at a realization per operations and would provide reasonably accurate indi­ Btu of only half that of fuel oil, its chief competitor, cations of relative costs, two methods of allocation were which is presently selling for about $1.85 a ; and seriously considered. These can be termed the realiza­ gas at this price is even cheaper in relation to crude oil. tion method and the energy content method. The energy However, since costs directly identifiable with the pro­ content method is the one that was adopted, but the ducing activity are substantially less per Btu for gas­ realization method will be discussed briefly first because well gas than for crude oil, because of the wide spacing it is familiar to so many people. of gas wells and the natural flow of the gas, the profit Disadvantages of Realization Method per heat unit should equal that of crude oil when the selling price of gas per heat unit is less than that of The realization method of allocating costs assumes crude oil. Gas prices have advanced more rapidly in that costs are incurred in proportion to sales value. This recent years than crude oil prices, and are continuing method has a fundamental weakness. If the price of one to move upward. Consequently, an allocation of costs product declines relative to others, its allocation of costs between liquids and gas on the basis of heat content will is reduced correspondingly, although there may be no

in time appear more realistic relative to prices. In addi­ Downloaded from http://onepetro.org/jpt/article-pdf/6/07/11/2237694/spe-292-g.pdf by guest on 02 October 2021 change in the costs incident to the total operation or in tion, it avoids the limitations and the constant changes the costs involved in handling the individual products. involved in the use of the realization method. This is not so much a method of allocating costs as of allocating profit or loss according to sales values. Modification of Energy Content Method The realization method has the additional disadvan­ The energy content method of allocation may be tage of providing no indication as to what may be a applied, if necessary, with modification designed to realistic cost basis and, therefore, a minimum level of fit the peculiar circumstances of individual operators or price for the various joint products, since it is keyed particular situations. One of the major problems in con­ to what the product is selling for and makes no attempt nection with allocation of costs relates to casinghead to determine what it should be selling for to return gas. Such gas frequently brings a lower price than a reasonable share of total costs. This method also gas-well gas because its supply is regulated by the pro­ differs in principle from the long established practice ductivity of oil rather than by the needs of the cus­ of determining certain unit costs of producing oil on tomers, and because of other problems incident to the basis of barrels produced without regard to realiza­ the handling of casinghead gas. In such circumstances, tion, even though the price may vary between grades the allocation of costs on a strict heat value basis of crude oil produced by the same operator from $2 may indicate a higher total cost for casinghead gas to $3/bbl and sometimes even more in case of special than can be realized from its sale. Nevertheless, if high or low grades of crude. the oil is to be produced and casinghead gas must also be produced, an economic advantage will be gained Advantages of Energy Content Method from selling the casinghead gas if a price is received The energy cont~.,t method, or principle, of allocat­ which more than covers the direct cost of handling ing costs is based on the fact that the the gas after it has come to the wellhead, even if is engaged in supplying energy in the form of heat. it does not cover its full share of total cost. The heat content of the liquid and gaseous fuels sup­ It is generally recognized that casinghead gas may plied is, to a large degree, the measure of the real value facilitate the production of oil by helping to bring it of the material. The energy content is, therefore, a good to the well bore and even to lift it to the wellhead. measure of the intrinsic value of the In view of this, any formula devised for allocation of being produced. It is reasonable to assume that the producing costs may well allow casinghead gas some effort put forth to find and produce crude oil and gas, credit for the assistance it provides in lifting oil. Sev­ and the co-products of each, is in relation to the intrinsic eral means of determining the amount of such credit value of each and should thus be divisible in relation might be developed. In some cases operators may have to the energy content of each. Since the expenditure gas repressuring projects in which they know the cost of money is usually very closely related to the effort incurred in using gas to increase recovery of oil. Such put forth, it is reasonable to conclude that costs can be costs might be considered as the credit to be given other divided in the same manner as the effort when there casinghead gas produced with oil for its assistance in is no more exact means of making the division. The unit the oil production. Other operators may have both oil of measure common to all forms of heat energy that can and gas operations of sufficient magnitude to determine be used for the purpose of this allocation is the British the direct costs of handling gas from gas wells, and Thermal Unit. A barrel of crude oil, like a barrel of may then use such direct costs as representing those fuel oil, has a heat value of approximately 6 million for the casinghead gas as well. This procedure also Btu's, while an Mcf of gas usually contains approxi­ results in a credit to casinghead gas for its assistance in mately 1 million Btu's. lifting oil, since it costs less to produce the same The energy content method has the advantages of amount of energy from gas wells than from oil wells. simplicity and stability, since the constant ratio of heat content can be used as the measure of energy produced. Application of Energy Content Method One argument that may be presented against the allocation of costs on the basis of heat value is that Having decided on the basic principle of allocation realization for the various products may not be in to be used, the next problem is to apply the principle

12 JOURN AL OF PETROLEUM TECHNOLOGY to the costs that are related to production. Three gen­ can be illustrated by the following hypothetical example, eral types of costs are involved. They are: direct pro­ which compares the traditional method of allocating all ducing cost, indirect producing cost, and exploration cost to crude oil with the energy content method of cost. Each of these presents its own peculiar problems. allocation: Direct Costs Crude Casing- Gas-well Con- Direct costs include all costs that can be directly Oil head Gas densate traced to the smallest unit used for accounting purposes, Vol. of production - OOO'L 1,000 Bbl 1,000 M:f 1,000 Mcf 1 Bbl which is usually a lease. Examples of these costs are: Heat equivalent - ~OD's. 1,000 Bbl 167 Bbl 167 Bbl 1 Bbl depreciation, taxes, maintenance, fuel, pumping, recon­ ditioning, etc. It can be seen that this category of pro­ COST PER UNIT Traditional Allocated by Energy Content Method ducing cost requires allocation only to a limited extent. Method (approximate figures) The cost of working over an , for instance, could Crude Crude Casing- Gas- Con- be attributed to the production of crude oil- if it Total Oil Oil head Well densate Cost Per Per Per Per Per were not for the fact that casinghead gas is also being $ 000 Bbl 8bl Mcf Mcf Bbl produced from the well. Thus, the problem here is to Direct Cost- find a way to allocate the cost between crude oil and Gas Leases .... $ $ .06 $ .36 casinghead gas; or the problem might be one of alloca­ 60 $).00 Direct Cost- ! tion between gas-well gas and condensate. Oil leases ...... 940 $ .88 $ .06 The method adopted for this purpose is basically the I ndi reet Cost ...... 330 .33 .29 .02 .02 .12 Exploration Cost 500 .50 .37 .06+ .06+ .37 cnergy content method, with a modification that has -- $1.54 $ .14 $ .14 $ .85 already been described. Direct costs applicable to gas Total ...... $1,830 $1.83 Downloaded from http://onepetro.org/jpt/article-pdf/6/07/11/2237694/spe-292-g.pdf by guest on 02 October 2021 leases are first compiled and allocated between gas-well It must be remembered that direct costs are accumu­ gas and condensate in proportion to the aggregate heat lated for gas leases and for oil leases and that the content of each. The unit cost thus obtained for gas­ allocation is made separately - hence the difference well gas is then applied to the volume of casinghead in cost per Btu and per barrel between crude oil gas produced on oil leases, and the balance of direct and condensate. It must also be remembered that these costs compiled for oil leases is allocated to crude oil figures are purely hypothetical. production. This assumes that it costs exactly as much per unit to produce casinghead gas as it does to pro­ Definition of Gas Production duce gas-well gas. One of the troublesome problems involved in the Indirect Costs entire procedure of producing cost allocation is the Indirect costs, usually including division and home definition of gas production for the purpose of comput­ office supervision and staff expenses, present a some­ ing the allocation factors. The fact that gas is often what different problem because they are not directly handled more than once before it is sold or used as related to either oil wells or gas wells. Since these fuel is the root of this problem. Spent gas lift gas, costs are closely related to direct costs they are allocated for instance, should not be included as production in proportion to the amount of direct costs allocated for the purpose of this allocation because to include to each product. There is considerable precedent in it would have the effect of allocating more cost to accounting practice for this type of allocation. gas, while it actually helps reduce the cost of lifting oil. The same thing is true of cycled gas and gas returned Exploration Costs to the same reservoir for pressure maintenance. Flared Exploration costs usually include such items as dry gas would appear at first to be the type of production hole costs, lease rentals, surrendered leases, test-well that should bear its fair share of the cost, but with contributions, and all types of geologic, geophysics, conservation practices constantly tightening down on and leasing costs. The allocation of exploration cost flaring of gas to the point where about the only gas that present a more difficult problem than the other two will be flared in the future is that which is not salable types of producing cost. or usable under any circumstances, this first appearance In one sense, exploration cost is related to the might be misleading. If it is not a commercial product volume of hydrocarbons discovered rather than to the it should be considered as a waste product and no volume produced. However, the accounting concept costs allocated to it, as such. Consequently, flared gas of exploration cost is much the same as that of research must be kept out of the production volume for the and development costs. Many industries must, by their purpose of cost allocation. Stored gas, on the other very nature, expend considerable sums in research hand, probably should be considered as production activities in order to remain in a competitive position since the storage process is usually intended to be merely in relation to the other members within that industry. a postponement of sale. The stored gas will also have In this light, such cost must be viewed as a normal to bear its proper share of the cost when it is produced and recurring charge to current operations. from the reservoir in which it is stored. Obviously, the exploration effort of the petroleum industry must be conducted to provide the reserves Limitations of Method that are necessary for a producing company to stay in The method of allocation that has been described was business. For this reason, most companies have elected designed to indicate average costs rather than costs for to expense exploration cost currently. Consistent with individual fields or leases. When applied on an over-all the energy content principle, this expense is allocated company basis, it appears to give results that are reason­ to the four joint products in proportion to the aggre­ able. When applied to smaller areas the results are gate heat content of each. more erratic, and the method may not always be satis­ factory for the alloction of costs in a particular field or Illustration of Allocation on a particular lease. The results of the allocation procedure just described (Continued on Pa.ge !ir)

JULY, 1954 13 Allocation of Costs (Continued from Page 13) Because it depends on the use of gas-well gas costs from a representative number of gas wells to determine casinghead gas unit costs, the application of the energy content method discussed here is not adaptable to companies that have little or no gas··well gas pro­ duction. It is felt, however, that other modifications of the basic principle involved in the energy content method can b'e devised to overcome this limitation.

Conclusion It is recognized that the method outlined herein for allocating the common costs incurred by petroleum pro­ ducers in supplying liquids and gases is not a complete answer to the problem. The need for allocating these costs has come only recently and methods of making the allocation are in the early stages of development. As gas continues to grow in importance, proper C::lst allocation will become increasingly important. As more Downloaded from http://onepetro.org/jpt/article-pdf/6/07/11/2237694/spe-292-g.pdf by guest on 02 October 2021 and more operators in the industry find it necessary to make allocations, improvements in methods will come. The important thing is that we recognize the fact that an appreciable portion of the industry's costs are attributable to gas and begin to make an effort to determine what that portion is. The method used at Humble is, we hope, at least a start in the right direction. ***

JULY,1954 57