An Uncommon Understanding

05 March 2019

Why not “A Common Understanding”?  Well, because when it comes to cost sharing, a common understanding is all too rare.

The contribution of well-established processes considered industry-standard and clearly understood by participants to efficient operations is undeniable.  And there are many good examples in an industry characterised by complex commercial arrangements and relationships.  But equally, many companies think that they can do better and develop their own processes…which a few of them, arguably the minority, may well achieve.

The sharing of costs has been a feature of the oil and gas industry for many years and therefore we expect to see these well-established, clearly understood processes.  So why choose to write about it now?  There are two principal reasons why this is more relevant than ever. Firstly, collaboration, which undoubtedly brings efficiencies in operations but requires the sharing of resources and cost. Secondly, as production from mature assets declines, many commercial arrangements switch from a complex tariff model to a “simple” cost share as the tariff based on production/ throughput no longer covers the cost of the treatment/ processing/ transportation

Now “cost” is a simple principle but when some costs are included in or excluded from a cost pool and there are options for the basis of the allocation to activities driving cost, there is ample room for the simple principle to become a complex practice requiring many subjective decisions.  And of course, this only works when all the costs are in the right place!

Whether you’re working with a new agreement or an older one which was produced on a typewriter, there is often a disconnect between the legal or commercial intention and the practical accounting application of that intention, not just between the parties to the agreement but sometimes between different functions in the same business.  Not so much a common understanding as a complete lack of understanding.  The broad principle of activity driving cost often loses something in translation.

In the world of Upstream Accounting and Finance, there is a set of standard procedures, the appropriately named Standard Oil Accounting Procedures (“SOAPs”).  These were developed by respected industry professionals, originally to narrow the diverse range of accounting practice within the industry.  And whilst they are not mandatory, they are used extensively, particularly in areas where costs are shared by ventures.  So let’s make use of the tools at our disposal.

Of course, the best way to avoid disagreements or disputes is clarity in drafting agreements.  Precise definitions, clear principles supported by examples and calculations of costs eligible or ineligible for inclusion in cost pools are a good start.  Great in theory and both desirable and possible when new agreements are drafted but companies often find themselves working with older agreements where today’s practices perhaps weren’t foreseen.  A little transparency can go a long way in overcoming our natural suspicion.  If the objective is to forge truly collaborative relationships and build trust, why wouldn’t you?  Some costs are by their very nature, confidential or opaque, or even both, for example payroll costs.  Audit rights can bring some assurance but they are not a substitute for constructive engagement at the right time, both by Operators and their Partners.

Which brings us back to the SOAPs.  The SOAPs provide a well-established framework or guidelines for the allocation of shared costs.  Use them.  Be transparent.  Be fair.  Don’t collaborate in name only.  But, importantly, challenge at the right time.  The benefit of the SOAPs is that they are widely recognised and understood, and the principles are clear.  Of course, there are grey areas where there are disagreements. But there will be less of them if using processes applied fairly consistently across the industry for many years.  And if the guidelines don’t cover a situation, ask, discuss and clarify how the procedures adopted meet the general principle or intent.

For more information please contact Ian McPherson (ian.mcpherson@aab.uk) or your usual AAB contact.

To find out more about Ian and the Audit and Assurance team, click here. 

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