April 2018

What’s new in exploration

Things certain in life: Death, taxes and risk in exploration.
William (Bill) Head / Contributing Editor

We are being told, once again, that exploration discoveries, worldwide, are declining drastically.1 The threat is very real to shareholders, and to end-users. Remember the King Hubbert curve—we know the first value was 0, back around 8000 BC, and it will be 0 in the future. The rest is just guessing—not fatal right now, unless you intend to keep your company intact.

When we don’t spend much on looking at new areas or new rock, what should we expect? According to Rystad Energy, the entire global industry was expected to discover just 7 Bboe of oil and gas last year. That’s consistent with a monthly rate of about 580 MMboe. Fellow World Oil columnist Bill Pike and I agree with the trend that this amount “is the lowest volume of discovered resources since the 1940s.

Graham Hollis, senior partner for Deloitte in Aberdeen, says the future of UK oil and gas faces the same threat. While investment in improving production is up for 2018, due mainly to increasing efficiency at the wellhead, the fundamental challenge remains for new exploration, along with the focus on existing fields. “It is in these areas that all parts of the industry need to embrace transformative change—collaboration, innovation and new technology will all be critical to assuring the long-term future of the UKCS.”2

What tax structures encourage exploration? Not many. In the U.S., royalty funds are spent on ethanol or electric cars. In the UK, exploration is taxed until it hurts, then taxed some more. In China, you pay to allow government entities to take technology from you and be your competition. In Brazil, people use PSAs to run for president. You get the gist.

I believe the U.S. Founding Fathers messed up by keeping the fee-simple rule of land ownership, where we “rent” all land in the kingdom for a fee. The French did no better in Louisiana. The Spanish fathers tried somewhat, giving American women the right to pay the rent when their husbands died in the service of the king. So today, pay the fee [tax] or face the power of your elected neighbors to take it from you.

However, a king can be beneficial. “The tax overhaul should raise the value of profitable oil assets by 19%, or $190.4 billion, [in the U.S.] according to Wood Mackenzie. “While we may not see much increase in more marginal assets, the increased profitability of valuable proven onshore and deepwater plays will likely drive more international capital towards the U.S.,” Wood Mackenzie said.3

Companies like Chevron plan to  spend the tax reduction benefit on stock buy-back and infrastructure repair. ExxonMobil plans to bring large cap projects forward. That means hydrocarbons already found will move into the pipeline, but there is no real boost to exploration. “While a lower statutory rate will likely impact the after-tax cash flow of all investments, when it comes to oil and natural gas, there is not an exact “trade-off” between a lower corporate tax rate and the lengthening of cost recovery periods.”4 This means no benefit to exploration costing.

Oil accounts tend to only “see” the past, and not the future, despite being taught constantly that an effective business “forgets” sunk costs. To them, cap structure exists, and it can be manipulated in the tax codes. I remember a USX accountant asking me if Marathon could avoid the dry-hole costs in our annual exploration budget. It took a while to explain why I was willing to throw away the cost of several smelters for the right to find oil. Marathon eventually lost its premier exploration position and was confined to spending no more than 1% to 2% of retail sales.

The big “however” is that 87% of all oil and gas on the planet is owned, not by private companies, but by governments that are reluctant to tax themselves. Table 1 on this page shows some of the larger countries, where NOCs control the reserves completely.

Most country-owners offer some form of risk contract, where after expenses are deducted from revenue, a percentage of working interest is allowed. That percentage is commonly 12% to 15%, and will never exceed 25%. That 15%, of course, is distributed to in-country content, in-country tax, and Seychelles bank accounts.

The U.S. still “allows” exploration expenses, such as Intangible Drilling Costs and Tangible Drilling Costs:

Intangible Drilling Costs include labor, chemicals, mud, grease and other items necessary for drilling. Thus, they are considered intangible. Since it doesn’t matter whether the well actually produces or even strikes oil, but it must start to operate by March 31 of the following year, the deductions will be allowed.

Tangible Drilling Costs are the actual direct costs of drilling equipment. These expenses are 100% deductible, but must be depreciated over seven years. Only the U.S. IRS would categorize a dry hole as “allowed” if it produces, then state that total costs must be amortized past the life of common production. No wonder the USX accountant was confused! wo-box_blue.gif


1. Rystad Energy study, http://www.worldoil.com/magazine/2018/february-2018/columns/energy-issues]

2. Personal communication.

3. Bloomberg, 1/31.

4. www.api.org/~/media/Files/Policy/Taxes/Energy-and-Taxes/Energy-and-Taxes-Primer-highres.pdf

About the Authors
William (Bill) Head
Contributing Editor
William (Bill) Head is a technologist with over 40 years of experience in U.S. and international exploration.
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