Company Valuation Under IFRS : Interpreting and Forecasting ...

Company valuation under IFRS
of it will be recoverable, using current technology and predicted oil prices.
Higher prices permit the application of enhanced oil recovery techniques that
increase recovery factors. So reserve estimates are not merely technical
calculations. They are also commercial.
In fact, the current convention is to divide reserves into three categories. The first
is commercial reserves. The second is technical reserves: those that could be
recovered, but not commercially. And the third comprises the upside from
exploration or appraisal drilling.
The probability distribution for commercial reserves is conventionally cut at
three points: that which is 90 per cent likely to be exceeded (proven), that which
is 50 per cent likely to be exceeded (proven and probable); and that which is only
10 per cent likely to be exceeded (proven, probable and possible).
When companies make investment decisions or buy reserves they will put a value
on all three categories, and would typically value commercial reserves using
proven and probable volumes. When companies account, they use proven
reserves only in the calculation of fixed assets per barrel, and in the calculation
of depletion charges.
The rumpus that surrounded Shell’s downgrading of its reserves by some 25 per
cent in early 2004 highlighted another feature of reserve accounting. The industry
standard had for many years been the requirements set by the US Securities and
Exchange Commission (SEC) but these permitted only the use of information
drawn from exploration wells, not from interpretation of seismic data. But since
the 1980s, seismic data had been much more reliable, and would generally be
regarded as an acceptable basis for reserve estimation by companies when
making investment decisions. So at time of writing a large discrepancy has
emerged between industry practice and the relevant accounting standards, which
is in urgent need of resolution.
However it is resolved, certain issues will not change. It will still be necessary to
have reserve estimates if depletion charges are to be calculated. And there will
remain at least two ways to arrange the calculations. The first is ‘successful
efforts’ accounting. Under successful efforts, each oilfield is treated as a separate
asset, and is capitalised and depleted accordingly. The second is ‘full cost’
accounting. Under this method, costs are capitalised in geographical pools and
depleted against production from the pool.
The former method involves the writing off of unsuccessful exploration
expenditure as the company incurs it. The latter will involve the capitalisation of all
expenditure so long as the overall cost pool is not impaired. The difference, in
practical terms, is akin to a company capitalising or expensing most of its
marketing costs, or its R&D costs. As we have seen, in our valuations we would do
better to calculate returns on capital and invested capital using the full cost method.
Most large companies use successful efforts, so there is some adjusting to do, in the
same way that we capitalised Danone’s historical marketing costs in Chapter five.
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