Depletion

Depletion is the accounting cousin of depreciation and amortization. While depreciation spreads the cost of a factory or machine over its useful life, and amortization does the same for intangible assets like patents, depletion is all about natural resources. Think of it as the way companies in the mining, oil and gas, or timber industries account for using up their valuable, finite assets. When an oil company pumps a barrel of crude or a mining firm digs up an ounce of gold, it's not just gaining revenue; it's also “depleting” its primary asset—the oil reserve or the gold mine. Depletion is the process of allocating the original cost of that resource over the period it's consumed. This cost is recorded as an expense on the income statement, which reduces the company's taxable income and, theoretically, reflects the “using up” of the company's wealth. For an investor, understanding depletion is key to seeing the true economic picture of a natural resource company, separating the accounting from the reality of a dwindling asset.

The goal of depletion is to match the cost of acquiring a natural resource with the revenue it generates. This is typically done using one of two methods.

This is the most common and intuitive method, required for financial reporting. The logic is simple: you spread the asset's cost over the total number of units you expect to get from it. The formula is: (Asset's Cost - Salvage Value) / Estimated Total Units x Units Extracted This Period An example makes it easy: Imagine you buy a giant cookie jar (a gold mine) for $1,000. You estimate it holds exactly 1,000 cookies (ounces of gold), and its salvage value (what the empty jar is worth) is $0. This year, you eat—uh, extract—100 cookies.

• Your depletion expense for the year would be: ($1,000 / 1,000 cookies) x 100 cookies = $100.

This $100 is recorded as an expense on your income statement. The value of your cookie jar asset on the balance sheet is now down to $900.

This method is generally only allowed for tax purposes in certain jurisdictions (like the United States) and for specific types of resources. Instead of being based on cost, it's calculated as a fixed percentage of the gross income generated from the resource. Another cookie jar example: Let's say you sell those 100 cookies for a total of $250 in gross income. If the tax law allows a 15% depletion rate for “cookie-ite” minerals, your depletion deduction for tax purposes would be:

• 15% x $250 = $37.50

The strange—and powerful—feature of percentage depletion is that the total deductions claimed over the life of the asset can actually exceed the original $1,000 cost. It's a tax incentive designed to encourage risky exploration for new resources.

For a value investor, depletion isn't just an accounting entry; it's a vital clue about the long-term health and reality of a natural resource business.

Depletion tells you how quickly a company is using up its core assets. A high depletion expense relative to the company's proven reserves can be a major red flag. It suggests the business isn't finding or acquiring new resources fast enough to replace what it's selling. A company that isn't replacing its reserves is, in effect, slowly liquidating itself. The crucial question is always: are they finding new, profitable cookie jars faster than they are emptying the current one?

Depletion is a non-cash charge, just like depreciation. This means that to calculate a company's cash flow, analysts add the depletion expense back to the net income. However, a savvy investor, like Warren Buffett, knows this isn't just free money. While the company didn't write a check for “depletion,” it must spend real cash on capital expenditures (CapEx) to find and develop new reserves. This concept is central to calculating a company's true owner earnings or Free Cash Flow (FCF). If a company's CapEx to replace reserves consistently exceeds its depletion expense, its reported earnings may be overstating its true economic profitability.

You simply cannot value a natural resource company without understanding its reserves and depletion rate.

• Reserves: The total estimated units of a resource (the denominator in the cost depletion formula) is a measure of the company's wealth.
• Depletion Rate: The rate of extraction determines future revenue and cash flow but also how quickly that wealth is consumed.

A company with vast, low-cost reserves that it can exploit for decades is fundamentally different from a company with a few years of high-cost reserves left. By analyzing depletion, you can better forecast a company's future production and its ability to generate cash long into the future, which is the cornerstone of any sound investment.