SPE 162932

Reserves Booking in Upstream Fiscal Systems Hampered by Inconsistency

F. Demirmen, SPE, Independent Petroleum Consultant

Copyright 2012, Society of Petroleum Engineers

This paper was prepared for presentation at the 2012 SPE Hydrocarbon, Economics, and Evaluation Symposium held in Calgary, Alberta, Canada, 24–25 September 2012.

This paper was selected for presentation by an SPE program committee following review of information contained in an abstract submitted by the author(s). Contents of the paper have not been
reviewed by the Society of Petroleum Engineers and are subject to correction by the author(s). The material does not necessarily reflect any position of the Society of Petroleum Engineers, its
officers, or members. Electronic reproduction, distribution, or storage of any part of this paper without the written consent of the Society of Petroleum Engineers is prohibited. Permission to
reproduce in print is restricted to an abstract of not more than 300 words; illustrations may not be copied. The abstract must contain conspicuous acknowledgment of SPE copyright.

Abstract
Lack of consistency has long hampered reserves booking in upstream fiscal systems, in particular in foreign jurisdictions.
This is notwithstanding the fact that US oil companies derive a major portion of their earnings from foreign operations. The
root cause is ambiguity in reporting standards that leave much room for interpretation. There are currently no clear guidelines
issued by the US Securities and Exchange Commission (SEC) for recognition of reserves in different fiscal systems. Oil
companies use their own interpretation to book reserves from across the spectrum of fiscal settings. Some of the reserves
reported appear to be overstated.

Separate from inconsistency, reserves that are currently reported from foreign operations may bear little relation to what the
investment community generally perceives as reserves. Investors need better transparency and better comparability.

Criteria currently used for booking reserves in the industry rely on contingencies devised by the US accounting organization
Financial Accounting Standards Board (FASB) in 1977. The SEC has not unified these contingencies into a coherent set of
standards. SEC’s 2008 “Modernization” left this subject untouched.

This paper will address problems in the current reserves recognition practices, in particular in foreign jurisdictions, and
propose revised guidelines aimed to bring transparency and consistency in reserves recognition. We will also provide
relevant formulation. A key criterion for reserves recognition under the proposed scheme is ownership in kind, as allowed by
the host government. We exclude from consideration reserves corresponding to taxes as well as volumes converted from
revenue received from a foreign government. We simplify royalty treatment and discourage the working interest method. The
author hopes that the paper will stimulate further discussion on the subject and prompt the SEC to issue clarifying guidance.
A second aim is to align the reported reserves with the expectation of investors.

Introduction
Oil and gas reserves represent the asset base of oil companies and, despite their shortcomings, are essential for corporate
planning and for assessing the value and future growth potential of these companies. As such, they are of major importance
not only for the oil companies, but also for the investment community. The manner by which reserves are reported by oil
companies registered with the SEC, however, has been plagued by inconsistencies. The problem lies in the ambiguities in
regulatory standards that cater primarily to US operations. Currently there is no consistent industry approach for reserves
recognition, especially from foreign jurisdictions. Further, the reported hydrocarbon volumes are not always in alignment
with what the investors perceive as reserves.

The regulatory disclosure standards date back to 1977. Surprisingly, SEC’s “Modernization” (SEC 2008) did not address the
ambiguities relating to reserves recognition. With the option now available to oil companies to report proved plus unproved
reserves as well as nontraditional resources following the “Modernization,” consistency in reserves reporting has gained
added significance.

The PRMS guidelines issued recently, relying on existing regulatory standards, have failed to bring sufficient clarity.

Until there is transparency in this respect, ambiguities and attendant inconsistencies in reserves disclosures will continue. The
industry needs better consistency, and investors deserve better transparency.
2 SPE 162932

This paper will propose revised criteria and accompanying formulation aimed to bring greater transparency to reserves
accounting. It is hoped that this will stimulate further discussion in the industry and prompt the SEC to issue clarifying
guidance on this subject.

Fiscal Systems

General Aspects. There are three main types of upstream fiscal systems: Royalty/tax (R/T), production sharing (PSC), and
service (Fig. 1). The first category, also known as the concessionary system, is the traditional system. The latter categories,
also known as contractual systems, evolved over the years starting with the implementation of PSC in Indonesia in the 1960s

In all systems, title to the resource originally rests with the

E&P Fiscal Systems resource owner, most typically the state. In the R/T system
the resource owner surrenders ownership of the resource to
the licensee (lic.) or concession holder. Traditionally it was
Royalty/Tax Prod. Sharing Service
System System System
understood that this ownership meant title in the ground;
but with rise of nationalism some foreign governments
Title 100% Lic. Title 100% State Title 100% State adopting the concessionary system have added a nuance to
this understanding, asserting that the ownership passes to
the licensee at the wellhead or the export point.
Pure Service Risk Service

In contractual systems ownership to the resource still

remains with the state, but with a PSC, the production is
Differences Mainly Philosophical shared with the contractor under an agreed scheme. Subject
Fiscal Terms Determine Division of Production & Economic Rent
to strict stipulation, some service systems also allow
transfer of some production (“lifting”) to the contractor.
The majority of fiscal systems in the world follow the PSC
Fig. 1 – Types of upstream fiscal systems.
model. The US and Canada subscribe to the R/T model.

What determines the division of the economic rent or benefit between the state and the contractor is the set of terms that
underlies a particular system. A metric known as “take” is customarily used to measure the economic rent, i.e., “government
take” and “contractor take,” referring to split of profit after tax. For the contractor, other metrics such as the net present value
or rate of return may be more relevant. While the contractor’s share of production may vary, in theory it is possible to design
the three fiscal arrangements in such a way that the “take” statistics would be identical.

A multitude of fiscal terms, from signature bonus to crypto taxes, go into the design of a fiscal system (Johnston 2003). A
critical element in fiscal design is to ensure equitable share of the economic rent between the government and the contractor
(Demirmen 2008, 2010). An equitable share would promote fiscal stability.

Royalty/tax system. In the R/T system bonus, royalty, corporate income tax and special taxes constitute the main fiscal
elements. Royalty is usually levied on a sliding scale based on production, and is paid in cash or in kind. But fixed-rate
royalties, and those based on oil price or water depth, are also present.

Production sharing system. Under a PSC, the contractor typically receives part of the produced oil known as “cost oil”
(C/O) for recovery of exploration and production costs and shares the remainder of the production (net of royalty if
applicable) known as “profit oil” (P/O). The sum of C/O and the contractor’s share of P/O is usually called “entitlement.”
The sharing percentage may be indexed to production rate or a profitability index such as the R-factor. Bonus and taxes are
frequently levied. Uncommonly, e.g., in the Peruvian case, the production that is shared is gross production. Some PSCs also
include royalty. (Hereafter in abbreviations “oil” will also mean gas, if applicable).

To ensure some revenue for the government early during production, in a fiscal cycle cost recovery is typically subject to a
limit as a percent of gross revenue, or occasionally, as in the Equatorial New Guinean PSC, of gross revenue net of royalty.
The recovery limit ranges from about 20% upward to 100%. Uncommonly, e.g., India, royalty is included in cost recovery.

The entitlement is price-sensitive, i.e., with increasing oil or gas prices the entitlement goes down, and vice versa. That is
because, e.g., when the oil price goes up, the C/O volumetrically declines. The contractor’s share of P/O volumetrically
increases, but not enough to offset the decline in C/O. The net effect is reduction in entitlement. The reduction is identical to
increase in the government’s share of P/O. Thus the government gains reserves. Table 1 shows these relationships. With
price decrease, the effect is opposite. Price sensitivity is a counterintuitive aspect of reserves recognition. 
SPE 162932 3

Table 1 - Oil price effect on entitlement, PSC The standard Indonesian PSC includes “first tranche petroleum”
(FTP) as well as “domestic market obligation” (DMO) (Yuwono
Oil price, USD/bbl 60 90
2006). FTP, first introduced in 1988, is a percentage (usually from
Gross reserves, million bbl 100 100 10 to 20%) of gross production and is shared between the
Gross reserves, million USD 6,000 9,000 government and the contractor before cost recovery. As such, it
Cost recovery limit 40% 40% may be viewed as a quasi-royalty. The sharing percentage is the
Government profit oil share 70% 70% same as that applicable for P/O. FTP ensures a minimum amount
Contractor profit oil share 30% 30% of income for the government and is taxed at a higher rate than
Cost oil, million USD 2,400 2,400 the P/O.
Cost oil, million bbl 40.0 26.7
DMO—a type of crypto tax—represents the contractor’s
Total profit oil, million USD 3,600 6,600
obligation to sell a portion of its entitlement to the government
Total profit oil, million bbl 60.0 73.3
after the start of production from a given field. It equals 25% of
Government profit oil, million bbl 42.0 51.3 the gross production times contractor’s P/O share. During the first
Contractor profit oil, million USD 1,080 1,980 5 years the contractor receives a fee based on the export price; but
Contractor profit oil, million bbl 18.0 22.0 after 5 years it receives only a fraction of the export price.
Contractor entitlement, million bbl 58.0 48.7
Difference in entitlement, million bbl 9.3 The Indonesian contracts also include “investment credit” (I/C)
designed to recover a portion (up to 125% in deep water) of
contractor’s capital investment for production facilities early out of gross production. It is applied after FTP, but before
conventional cost recovery. Improved oil recovery may also qualify for I/C. The benefit is taxable. Although tax
consequences are different, the effect of I/C on contractor’s entitlement is the same as that of conventional cost recovery, and
for booking purposes the I/C should be treated as part of the ordinary cost recovery.

Service system. Depending on whether the capital is at risk, the service contract comes in two forms: pure service and risk
service (RSC). In a pure-service arrangement the state bears the risk and pays the contractor a flat fee for its services. In a
RSC the contractor is responsible to provide capital, but is allowed to recover its costs in cash or in kind, and in addition
receives remuneration for its services. The remuneration may be based on R-factor or a pre-determined rate of return. The
concepts of royalty, FTP and P/O are not relevant. Only few countries in the world have service agreements.

In the Iranian “buyback” version of a RSC, first awarded in 1995, the contractor funds all the investment and in return is
reimbursed for its costs and in addition receives an agreed remuneration fee for its services. The payments come from
produced oil and gas. The remuneration period is usually 5-8 years after the start of production. Strict controls are placed on
cost recovery and operations, with allowed internal rate of return in the range of 15–21%. The international oil company
(IOC) gains lifting rights to a portion of production. Service contracts recently awarded by Iraq’s Central Government have
similar features.

Carried interest. Fiscal systems may also have “carried interest” provisions that give the national oil company (NOC) the
right to participate in development and production after a commercial discovery. The NOC usually reimburses the contractor
for past exploration costs. The financial impact of NOC
participation is similar to that of a working interest (W.I.)
Guidance on Reserves Accounting partner. With a PSC, the P/O is shared three ways between
the contractor, the government and the NOC.
SEC Regulation S-X SPE Res. Guidelines
1978
(Rule 4-10) (2001) Regulatory Framework
Successful Efforts Method* The regulatory framework applicable to publicly traded oil
companies in the US is embodied in SEC Regulations S-X
FAS 19** PRMS Guidelines
1977
(& Amendments) (2011)
(17 CFR, Part 210) and S-K (17 CFR, Part 229), dating
back to 1978 and 1982, respectively. Regulation S-K
includes Industry Guide 2. Rule 4-10 of Regulation S-X,
FAS 69 *Subsequently in particular, is the primary source the industry has relied
1982
(& Industry Guide 2) Also Full Cost Method on for external disclosure of reserves volumes (Fig. 2).

**In particular It is significant that the original Rule 4-10 did not address
2008 SEC Modernization
Para. 11, 47, 50, 51, 53 reserves accounting. Following the passing of the Energy
and Conservation Act of 1975 (EPCA) by the Congress,
2010 Update Topic 932 the SEC relegated the reserves accounting task to FASB, a
private-sector accounting organization (Pielsticker and
Fig. 2 – Framework background for reserves recognition. Steiger 1980). After two years of extensive study, in
December 1977 FASB issued Statement No. 19 (FAS 19).
4 SPE 162932

At that time FAS 19 endorsed only the successful efforts method for accounting of oil and gas activities. For reserves
accounting, Regulation S-X, in Rule 4-10(b), made reference to FAS 19:

Rule 4-10(b): “A reporting entity that follows the successful efforts method shall comply with the accounting and financial
reporting disclosure requirements of Statement of Financial Accounting Standards No. 19, as amended.”

When, following protests from the industry, the SEC subsequently allowed full-cost accounting as an alternative to the
successful efforts method, it left the wording of Rule 4-10(b) unchanged.

Notwithstanding that the full-cost accounting method, through cost recovery, would affect reported reserves volumes in some
fiscal settings. The industry assumed that the requirements as set forth in FAS 19 would also be applicable under the full-cost
accounting, and in fact under the accounting methods mandated in foreign jurisdictions. Amendments made to FAS 19,
including the most significant FAS 69 issued in 1982, did not materially affect the reserves accounting standards of FAS 19.
The industry used FAS 19 for guidance for all reserves reporting.

In 2008 FASB codified FAS 19 and FAS 69 into FASB ASC 932 (Topic 932 – Extractive Industries, Oil and Gas) under the
Generally Accepted Accounting Principles (GAAP), effective on July 1, 2009.

In December 2008 the SEC issued Modernization of Oil and Gas Reporting, Final Rule (SEC 2008) to revise Rule 4-10 and
update oil and gas disclosure requirements and consolidate them to Subpart 1200 of Regulation S-K. Despite major revisions
to the existing standards, the Modernization did not address the wording of Rule 4-10(b), in effect leaving (somewhat
anachronistically!) reference to the successful efforts method unchanged and implicitly reaffirming reserves accounting
provisions of FAS 19. There is no mention of Topic 932 in SEC’s Modernization.

FASB’s Update of Topic 932, issued in January 2010, incorporated the revisions of SEC’s Modernization but left the
reserves accounting standards embodied in FAS 19 unchanged. Likewise, SEC’s recent interpretive “Guidance” (SEC 2011),
representing the views of the staff, addressed this issue only superficially.

In discussing resource recognition rules, SPE’s Guidelines for Application of the Petroleum Resources Management System
(Young 2011) makes extensive use of FAS 19.

At present FAS 19, or its codified version in FASB ASC 932, remains as practically the sole regulatory reference for reserves
recognition in different fiscal systems.

Industry’s Interpretive Approach to Date

Upstream fiscal systems have evolved in a major way since 1977 when FAS 19 was released; but the reserves recognition
standards have remained largely unchanged over time. These standards have been closely intertwined with financial
accounting principles (e.g., FASB Statements No. 19, 25, 69, 121, 144, Topic 932), and there has been little debate in the
petroleum engineering profession as to the merits of the existing standards. Understandably, the accounting profession has
been somewhat “removed” from the engineering aspects of this subject. Further, the standards have largely catered to US
situations, e.g, royalty playing a dominant role in regulatory pronouncements.

With little direct guidance on reserves recognition in different fiscal systems, the industry took a largely interpretive approach
on this issue (McMichael and Young 1997, 2001; Reiter and Bolling 2000). The recent SPE guidelines for PRMS prescribe
the following criteria for reserves recognition (Young 2011):

a. The right to extract oil or gas

b. The right to take produced volumes in kind
c. The right to share in the proceeds from sale of oil and gas
d. Exposure to market risk and technical risk
e. The opportunity for reward through participation in producing activities

Items (a), (d) and (e) are considered key elements. These guidelines reflect those generally used by the industry.

The SEC has refrained from taking an official position on this issue. Informally, however, the SEC has generally endorsed
the industry’s position. In a SEC/industry forum held in 2003, the SEC engineers noted that the right to take volumes in kind
and exposure to risk and reward are the two most important elements in reserves recognition (Ryder Scott 2003-2004). The
right to extract oil and gas and ownership of a mineral interest were third and fourth most important.
SPE 162932 5

Significantly, the SEC engineers did not mention item (c) above as being a criterion for reserves recognition.

Ambiguities and Inconsistencies

The problem with the industry’s current approach is that it is too broad, lacking specificity and open to different
interpretations. A major uncertainty is that, of the various criteria, such as those listed above, it is not clear whether any
single criterion, or several simultaneously, must be satisfied for reserves recognition. Arguably, the intent is that all the
criteria must be met, but there is no mention of such caveat.

One key yardstick, “risk,” is particularly problematic, as it could lead to reserves recognition in a broad spectrum of
situations. Risk of some kind is present in almost all upstream activities, and it starts the moment an oil company makes a bid
for a lease or contract. Likewise, there is very commonly a “reward” of some kind, monetary or otherwise, in production
activities. Associating “risk” and “reward” with reserves recognition gives an IOC much leeway in interpretive reserves
booking, especially if risk and reward are viewed as stand-alone criteria.

A SEC/industry forum held in 2001 highlighted the problem in this respect. In the meeting the SEC engineers commented
that they would allow booking of reserves in a RSC if the contractor is exposed to “risk and reward.” The PRMS itself (SPE
2007, p. 20) has reflected a similar position: “Reserves can be claimed in an RSC on the basis that the producers are exposed
to capital at risk.” There is no caveat as to the satisfaction of other criteria, and the implication is that reserves are bookable
even when there is no ownership in kind.

There is no mention, implicit or explicit, of “risk” and “reward” as being criteria for reserves recognition in FAS 19 and
FASB’s Topic 932.

Another questionable yardstick is the ability to book reserves when there is right to share in the proceeds from the sale of oil
or gas (item c above). This is based on the concept of “economic interest.” By using this yardstick, an IOC can choose to
book reserves corresponding to value, financial benefit, or revenues received from the sale of oil or gas, irrespective of
whether it owns any portion of production (Reiter and Bolling 2000; McMichael and Young 2001; Young 2011). Likewise,
from Young and McMichael (2002): In a RSC, “… contractor entitlement would be on a monetary basis. For reserves
reporting purposes, monetary entitlements are typically converted to volume equivalent based on prevailing product prices.”

There is also no apparent regulatory support in FAS 19 and Topic 932 for this position.

From the 10-K and 20-F annual filings of the SEC registrants it is impossible to gauge whether and to what extent IOCs
actually book value- or revenue-related reserves in different fiscal systems, e.g., with the DMO fee received in an Indonesian
PSC. But RSCs and even pure-service contracts are prime candidates for such practice.

It is very doubtful foreign authorities would agree to such bookings when the IOC receives no in-kind payment.

Another dubious practice in the industry is booking reserves corresponding to in-lieu tax in foreign jurisdictions, e.g., Libya,
Egypt, Oman (Johnston 1995). In-lieu tax is income tax paid by the NOC for and on behalf of the IOC. In these instances
IOCs are known to claim extra entitlement to oil and gas, with the rationale that tax comes out of P/O, i.e., if the IOC itself
paid the tax in cash, its share of P/O would be greater. Hence tax is equated with reserves. Through a grossing-up calculation,
whereby the contractor’s P/O is divided by a factor equal to 1 minus the tax rate, IOCs add to their entitlement oil and gas
corresponding to in-lieu tax. In a high-tax environment, reserves booked this way could increase substantially.

In the absence of a specific clause in the agreement toward reserves recognition, it is highly questionable whether foreign
governments would put their stamp of approval on such “reserves enhancements.” Even if the NOC does not pay the tax in
lieu, a foreign government could easily tailor its fiscal system in such a way that the IOC would keep a small share of the P/O
but pay tax at a low rate, yielding the same “take” statistics.

Royalty is another element that could lead to questionable booking. Royalty is paid out of gross production, and has no direct
relationship to income tax. Under the ownership in-kind principle, if royalty is paid in kind, it does not qualify to be
recognized as reserves. But the practice in the industry is somewhat fuzzy. Some oil companies do not book royalty volumes
from US operations, but make an exception in foreign operations. The rationale is not clear, but presumably it relates to
viewing and treating the royalty obligation as a form tax, e.g., severance tax. Under this interpretation, recognition of royalty
volumes as reserves is permissible. The PRMS guidelines (Young 2011, p. 176) support this position.

Some IOCs also view the NOC participation as a form of tax and may choose to book the participating interest of the NOC.

Treatment of royalty and the NOC participation in this manner is difficult to justify. There is no support in FAS 19 or Topic
6 SPE 162932

932 for such positions. It is also highly doubtful foreign governments would agree to such bookings.

In connection with disclosure of royalty volumes, the following statement in Industry Guide 2, also embraced in SEC’s 2008
Modernization, is ambiguous and needs clarification: “However, in special situations (e.g., foreign production) net
production before royalties may be provided, if more appropriate. If ‘net before royalty’ production figures are furnished, the
change from the usage of “net production” should be noted.”

What is meant here by “special situations”?

But perhaps the most questionable practice in the industry is booking W.I. barrels in a PSC (net of royalty) or RSC, the
rationale being that such booking would eliminate the drawback of oil-price sensitivity. Such practice would clearly violate
the “net quantities” provision of FAS 19 (see below). With no apparent justification, some oil companies evidently also
adjust the reserves they book in a RSC according to the difference in market oil price and the remuneration per barrel they
receive (Ross 1998).

As a final comment on the industry practice, it is also noteworthy that booked reserves corresponding to revenue and tax
generally run counter the concept of reserves as perceived by the investment community. Investors associate reserves with
physical quantities of oil and gas (“in kind”). In contrast, revenue- and tax-related reserves are imputed, and may be called
“phantom reserves.” Hence the likelihood to mislead investors.

Arguably, price-related reserves fluctuations are also imputed or “phantom” reserves. But the reality with the world fiscal
systems is that such volatility is unavoidable.

Before offering suggestions for consistency on reserves booking, a re-visit of regulatory standards is in order.

Overview of Regulatory Standards

Sections particularly relevant to reserves recognition in FAS 19 are Paragraphs 11, 47, 50, 51 and 53. We will not repeat
these paragraphs here. From a careful reading, the following provisions stand out as being useful for reserves recognition and
nonrecognition:

1. Mineral interests and net quantities

2. Legal right to extract oil and gas
3. Being an operator or producer
4. Ownership of oil and gas production or volumes
5. Receipt of oil and gas
6. Non-operating interests including royalty qualifying
7. Oil and gas subject to long-term supply or purchase agreements nonqualifying unless acting as an operator or
producer
8. Purchase and sale of minerals-in-place to be reported
9. Right to purchase oil and gas without right to extract nonqualifying
10. Net quantities belonging to others not to be reported

Further, consistent with the premise of legal right to produce, and waiver of disclosure requirements if a government
prohibits such disclosure, as embodied in SEC’s 2008 Modernization,

11. In foreign jurisdictions reserves recognition should have the approval of the government.

Also, in compliance with SEC’s Modernization,

12. Booked reserves should possess the attributes of “reserves,” e.g., economic producibility, reliable technology, and
categorized as proved, unproved, developed, etc., as appropriate.

Finally, it is self-evident, and imperative, that as a check,

13. Reserves owned by various owners including the government from a field or project should add up to 100%.

Provisions (1) through (5) and provision (11) refer to situations when an oil company acts as a producer or operator—
situations in which most subjectivity enters reserves recognition, and in which inconsistencies in the industry have been most
prevalent.
SPE 162932 7

In particular, provisions (1) and (2) are the key standards for all types of reserves in all fiscal settings, and provisions (3), (4),
(5) and (11) key standards for reserves recognition in R/T and PSC systems. Provisions (5) and (7) are useful for reserves
recognition in RSCs.

For reserves booking in an operator setting, not only one, but all provisions (1) through (5) plus provision (11) should be
satisfied.

Provisions (6) through (10) identify other contingencies, including non-operator situations and elements that do not support
the recognition of reserves.

Provisions (12) and (13) are self-explanatory.

For reasons noted earlier, “risk,” including capital at risk, and the associated “reward” are not included among the provisions
above. The totality of criteria (1) through (5) in an operating environment renders risk and reward a moot question.

It should further be evident that none of the provisions listed above lends support to the recognition of reserves corresponding
to financial benefits or revenues received from a foreign entity. Likewise, we exclude reserves corresponding to in-lieu taxes
and “taxes” corresponding to NOC participation in foreign jurisdictions. The ownership-in-kind concept, which derives its
strength from reference made to “mineral interest,” “production payments payable in oil and gas” in FAS 19 and Topic 932,
and “production that is owned” in Industry Guide 2, are strong arguments for such exclusion. Revenue- and tax-related
reserves as well as W.I. barrels in PSCs and RSCs are not reportable.

The ownership-in-kind concept is also a simple, pragmatic criterion to recognize royalty as bookable reserves when it is paid
in cash (see below).

Proposed Guidelines
The aforementioned 13 provisions, considered to honor closely the intent of FAS 19, should significantly limit subjectivity
and bring comparability and consistency to reserves booking under different fiscal systems. Booking reserves when there is
no operatorship is usually straightforward. When operatorship is involved, the proposed guidelines are summarized below
and illustrated in Figs. 3-6.

9 In R/T systems: Whether in US or foreign jurisdiction, recognize royalty as reserves if royalty is paid in cash;
otherwise exclude royalty from bookable reserves. The difference in treatment should be reflected in company
financial balance sheet. Tax-related royalty reserves not permitted. Keep the “in-kind” concept in focus.
9 In PSCs: Recognize reserves (entitlement) as the sum of C/O and contractor’s share of P/O. In complex PSCs such
as the Indonesian model, treat the I/C or the like as a form of C/O. Royalty in kind and the government’s share of
FTP, or the like, and DMO, if applicable, to be excluded. Revenue-related “reserves” such as the DMO fee received
from the government and quantities corresponding to in-lieu tax or the “NOC tax” not bookable. Bookable reserves
sensitive to oil or gas prices. Keep the “in-kind” concept in focus.
9 In service contracts: Pure-service contracts not eligible for reserves recognition. Any oil and gas production received
in a RSC toward cost recovery plus in-kind remuneration to be treated as bookable reserves. Cost recovery in cash
and remuneration received in monetary terms do not qualify as reserves. As with a PSC, the bookable reserves are
price-sensitive. Keep the “in-kind” concept in focus.

In foreign jurisdictions recognition of reserves is subject to consent of the government. Unless the likelihood of contract
extension is reasonably certain, and commitment to continued development exists, bookable reserves should be confined to
recoverable volumes during the contract period. While reserves are disclosed annually, they should be estimated and reported
on a full life-cycle project basis.

Operated and Non-Operated Reserves

To assist reserves accounting, we also propose that the reporting entities make a distinction between “operated reserves” and
“non-operated reserves.” The former category comprises reportable quantities of oil and gas which an oil company produces
or otherwise acts as the operator of the underlying reserves. Quantities received as a producer under long-term supply or
purchase agreements qualify. Quantities attributable to taxes and oil and gas volumes converted from revenue do not.

Non-operated reserves are quantities of oil and gas which a reporting entity receives, or is entitled to receive, as a non-
operator in accordance with an underlying agreement. Receivable royalty in kind, W.I. share in kind (in a joint venture),
purchase of reserves in place, and production payment received in return for funding an E&P venture are common types of
non-operated reserves. Supply agreements or contracts that represent merely the right to purchase oil and gas do not qualify.
8 SPE 162932

Booking Numbers
For calculating bookable reserves, the industry has used two approaches: the W.I. method and economic interest method. The
former is generally considered to be applicable in a R/T system. Under this method the W.I. percentage is applied to gross, or
net-of-royalty gross reserves. If there is royalty in-kind obligation, however, results from the gross-reserves alternative would
be in error because the resource owner’s royalty would be included in the booked reserves.

The W.I. method in a PSC becomes fuzzier. An example given in Reiter and Bolling (2000) shows greatly inflated reserves
in a PSC figured with the W.I. method. In the past, some IOCs seem to have booked W.I. reserves in a PSC, as much as
100% of the gross production if they are the sole participant in the project—resulting in a dramatic overstatement of bookable
reserves (Michael and Young 2001). Similar liberty is evidently taken with RSCs.

SEC (2011) cautions against the use of the W.I. method, but does not disallow it.

Royalty/Tax System Standard PSC with Royalty

A. Royalty paid  in kind B. Royalty paid  in cash Gross Production
Gross Production Gross Production
Royalty
Royalty Royalty
Cost Oil

Net of Royalty Net of Royalty
65 % 35 %
Total Profit Oil

Royalty Bookable Bookable

Resource Contractor Contractor Royalty
First Tranche Petrol.
Cost Oil Bookable
Owner
Gov’t Profit Oil
Gov’t P/O
Contr. Profit Oil
Contractor P/O Bookable
Fig. 3 – Booking reserves in a royalty/tax system.
Government Contractor

Fig. 4 – Reserves recognition in a PSC with royalty.

Percentages hypothetical.

Indonesian PSC Model Service Systems

Gross Production Pure‐Service  Contract Risk‐Service Contract
75 % 25 %
First Tranche Petrol.
if if
Flat Cost
Investment Credit
Fee if if
Remun.*
Cost Oil
Paid Paid
in Cash in Kind
75 % 25 %
HC Volumes HC Volumes HC Volumes
Total Profit Oil First Tranche Petrol. Not Bookable Not Bookable Bookable
Investment Credit
*Remuneration
First Tranche Petrol.
First Tranche Petrol.
Cost Oil Bookable
Fig. 6 – Booking reserves in service systems.
Gov’t P/O
Gov’t Profit Oil
Contractor P/O
Contr. Profit Oil
In the economic interest method oil and gas volumes
DMO 9
Dom.  Market Obl. net of all obligations such as royalty in kind, the
Dom. Market Obl.

Government Contractor government’s shares of the FTP and P/O, and the
DMO are calculated first before applying the W.I.
Fig. 5 – Booking reserves in an Indonesian PSC. percentages, if applicable. For reserves recognition
Percentages hypothetical. purposes the term “economic interest” is basically an
interpretive spinoff from the term “mineral interest”
as defined in FAS 19. Because “economic interest” is too broad in implication (oil companies always have “economic
interest” of some kind in their business), and to emphasize the in-kind concept in reserves recognition, the preferred approach
for figuring bookable reserves is here called the “volumetric interest method.”
SPE 162932 9

Below, we provide a formulation for the volumetric interest method. (See “Nomenclature” for explanation of terms). The
formulation should be applicable to most fiscal systems currently in existence. Unusual fiscal systems deviating from these
models can be evaluated using the approach followed here. With a PSC, we assume that the cost recovery, as customary, is
based on gross reserves.

Contr. RES = GR – Roy(i) – Gov’t P/O – Gov’t FTP – DMO, ……………………………………......………… (1)
Gov’t RES = Roy(i) + Gov’t P/O + Gov’t FTP + DMO. …………………………………………..……………. (2)

Combining Eqs. 1 and 2,

Contr. RES + Gov’t RES = GR, .………………………………………….……..…………………….................. (3)

which provides a check.

We also have:

Total P/O = GR – Roy(i) – C/O – FTP. ………………………………….….…….......................………………. (4)

(When FTP exists, there is usually no royalty). Substituting Eq. 4 in Eq. 1,

Contr. RES = C/O + Contr. P/O + Contr. FTP – DMO. …………………………................................................ (5)

In these expressions,

Gov’t P/O = (1-Pc) × Total P/O, ………………………………………………………………………………….. (6)

Contr. P/O = Pc × Total P/O, ……………………………………………………………………………….. …… (7)
C/O = Lc × GR, …………………………………………………………………………………………................ (8)
Gov’t FTP = (1-Pc) × FTP, ………………………………………………………………………………………. (9)
Contr. FTP = Pc × FTP, ……………………………………………………………………….………………… (10)
DMO = GR x 0.25 × Pc (0.25 applicable for Indonesian PSC). …………………………………………………. (11)

Eqs. 1 and 4 are the alternate expressions for figuring bookable reserves, and Eqs. 2 and 3 can be used as a check on the
calculations. In a R/T system, Eq. 1 is reduced to:

Contr. RES = GR – Roy(i), ………………………………………..………………...……..……………………… (12)

assuming the royalty is payable in kind. Otherwise Roy(i) is zero, and the contractor can book the gross reserves.

Eq. 5 is particularly useful in PSCs with FTP and DMO components. Other, relatively complex PSCs can be handled in a
similar manner. If there is also the I/C component, it is lumped with the ordinary C/O. Without the FTP and DMO
components, Eq. 5 is reduced to:

Contr. RES = C/O + Contr. P/O, .……………………………………..……..………........................................... (13)

which is the familiar expression for a standard PSC. Note that, although the term Roy(i) is not present in Eq. 13, Contr. RES
is affected by royalty in kind, if applicable.

In a RSC, if booking reserves is justified, the bookable reserves will be:

Contr. RES = C/R(i) + REM(i). ………………………………………….…...…................................................... (14)

When, as in a joint venture, the contractor or the operator represents two or more partners, bookable reserves for each partner
(including the contractor) will be in proportion to their W.I. shares.

Tables 2-4 show the W.I. method (improper application) and the volumetric interest method in a R/T system and several
versions of a PSC. In these tables companies A and B are joint-venture partners, with company A representing the contractor
and acting as the operator. Cost recovery is based on gross reserves. In Table 4 the I/C is lumped into cost recovery. The
contractor’s entitlement includes C/O, its shares of FTP and P/O, less DMO. The companies receive proportionate amounts
according to their W.I. shares.
10 SPE 162932

In these tables, if there is NOC back-in, the NOC would act as a stand-alone partner to the contractor, increasing the
government reserves.

Table 2 - Bookable reserves in R/T system Table 3 - Booking reserves in a PSC

Companies A and B partners W.I. Vol. Int. Companies A and B partners Without With
Oil volumes in million bbl Method* Method** Oil volumes in million bbl Royalty Royalty
Gross reserves 100 100 Gross reserves 100 100
Royalty, payable in kind 15% 15% Royalty, payable in kind 0% 20%
Royalty volume 15 15 Government profit oil share 0.75 0.75
Working interest, Company A 60% 60% Contractor profit oil share 0.25 0.25
Working interest, Company B 40% 40% Cost recovery limit 55% 55%
W.I. volume, Company A 60 51 Working interest, Company A 60% 60%
W.I. volume, Company B 40 34 Working interest, Company B 40% 40%
Reserves, contractor 100 85 Royalty volume 0 20
Back-calculated total reserves 115 100 Cost oil 55.0 55.0
* Improper application. Total profit oil 45.0 25.0
** Volumetric interest method. Contractor profit oil 11.3 6.3
Contractor entitlement 66.3 61.3
Entitlement, Company A 39.8 36.8
Entitlement, Company B 26.5 24.5
Government reserves 33.8 38.8
Back-calculated total reserves 100 100
Conclusions
Inconsistencies in reserves booking in upstream fiscal systems have long been a problem. The root cause is ambiguities in
regulatory standards that leave much room for interpretation. Over the past three decades the existing reserves recognition
standards have not been revised to keep up with changes in fiscal systems. Surprisingly, the petroleum industry has paid only
cursory attention to this problem, with meager debate as to the merits of the existing standards. It is the underlying thesis in
this paper that some of the interpretive liberty taken in the industry toward reserves recognition has been excessive, with
positions falling outside the realm intended in FAS 19.

Table 4 - Booking reserves in a PSC with FTP Reserves estimates, by their nature, already entail varying
degrees of uncertainty, and highly interpretive and subjective
Companies A and B partners Without With
Oil volumes in million bbl DMO DMO
approaches to reserves recognition add another—and
needless— level of uncertainty for the investment community.
Gross reserves 100 100
First tranche petroleum (FTP) 20% 20% Associating reserves recognition with “risk” and “reward,” and
DMO percentage 0% 25% equating the “mineral interest” provision of FAS 19 with
Government profit oil share 0.7116 0.7116 “economic interest” in current practice appear to have
Contractor profit oil share 0.2885 0.2885 unjustifiably broadened the scope of reserves recognition and
Cost recovery limit 50% 50% contributed to inconsistencies. It is deemed more appropriate in
Working interest, Company A 60% 60% this paper to equate the “mineral interest” provision of FAS 19
Working interest, Company B 40% 40% with ownership in kind.
FTP volume 20 20
Cost oil 50.0 50.0 The inconsistencies in the industry relate mainly to (a)
Contractor FTP volume 5.8 5.8
treatment of royalty, (b) reserves recognition associated with
benefit or revenues received from foreign governments, (c) in-
Total profit oil 30.0 30.0
lieu taxes, and (d) treatment of NOC participation as tax. Even
Contractor profit oil 8.7 8.7
more serious, and presumably less frequent, is the application
DMO obligation in oil 0.0 7.2 of the W.I. method in calculating reserves. There is little room
Contractor entitlement before DMO 64.4 64.4 for such positions in the existing official guidance.
Contractor entitlement after DMO 64.4 57.2
Entitlement, Company A 38.7 34.3 Because of aggressive booking, some of the reserves disclosed
Entitlement, Company B 25.8 22.9 in 10-K and 20-F filings are likely overstated. And
Government reserves 35.6 42.8 comparability of reserves bookings from different fiscal
Back-calculated total reserves 100 100 systems appears seriously flawed.

The 13 criteria or provisions proposed in this paper and the formulation provided are aimed to bring transparency and
promote consistency in reserves booking in fiscal systems. The guidelines limit subjective positions and are believed to
SPE 162932 11

closely honor the intent of FAS 19. Ownership in kind is a key provision in the guidelines. It is hoped that this paper will
stimulate debate in the industry and alert the SEC to the need for clearer official guidance on this subject.

Nomenclature
ASC = Accounting Standards Codification
CFR = Code of Federal Regulations
C/O = Cost oil
Contr. P/O = Contractor P/O
Contr. RES = Contractor reserves
C/R(i) = Cost recovery in kind in a RSC (similar to C/O in a PSC)
DMO = Domestic market obligation
Eq. = Equation
FTP = First tranche petroleum
GR = Gross reserves
Gov’t P/O = Government P/O
Gov’t RES = Government (or resource owner) reserves
Lc = Percentage for C/O limit in a PSC
Pc = Percentage for total P/O for contractor in a PSC
PRMS = Petroleum Resources Management System
Roy(i) = Royalty in kind (= 0 if royalty payable in cash)
REM(i) = Remuneration in kind in a RSC
Total P/O = Total P/O

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