Finding and Development Costs (F&D)

Finding and Development Costs (F&D) are the total expenses an oil and gas company incurs to add new energy reserves to its portfolio. Think of it as the all-in price tag for discovering a new underground stash of oil or natural gas and getting it ready for extraction. This isn't just the cost of drilling a successful well; it includes every penny spent on the hunt. This means paying for geological surveys, leasing mineral rights, drilling both successful and unsuccessful exploratory wells (dry holes), and building the initial infrastructure needed to access the reserves. For a value investor analyzing an energy company, F&D cost isn't just an accounting line item; it's a direct measure of the company's skill. A company that can consistently find and develop energy for a low cost has a powerful and sustainable competitive advantage, much like a retailer who can acquire prime store locations for less than its rivals.

For an oil and gas company, its reserves are its lifeblood. Just like a factory depreciates, an oil well depletes over time. To survive and thrive, the company must constantly replace the oil and gas it pumps out of the ground. F&D costs tell you how efficiently it's doing this. The key metric here is the F&D cost per barrel of oil equivalent (BOE). This single number tells you how much capital the company had to spend to add one barrel of new reserves. A low and stable F&D cost per BOE is a hallmark of a well-run operation. It suggests the management team has superior geological expertise, better technology, or a shrewder land-acquisition strategy than its competitors. Conversely, a rapidly rising F&D cost is a major red flag. It can indicate that the company is running out of easy-to-find resources and is now spending more and more money just to stand still, a sure-fire way to destroy shareholder value over the long term.

Looking at F&D costs isn't just an academic exercise. It's a practical tool for sizing up an energy investment. Here’s how to use it.

The basic formula is straightforward, though it requires a bit of digging in a company's annual report. F&D Cost per BOE = Total Exploration and Development Costs / Total New Proved Reserves Added (in BOE)

• Exploration and Development Costs: This is the total money spent on finding and developing new reserves, often referred to as Capital Expenditures (CapEx) in the “Investing Activities” section of the cash flow statement. You are looking for the costs associated with exploration and development, sometimes called “E&D.”
• New Proved Reserves Added: This figure is found in the supplementary information of the annual report, usually in a table detailing changes in the company's proved reserves over the year.

Important: Because large discoveries are lumpy and don't happen on a neat annual schedule, it's crucial to use a multi-year average (typically 3 to 5 years) for both the costs and the added reserves. This smooths out the volatility and gives you a much more reliable picture of the company's true replacement efficiency.

A “good” F&D number is always relative. An F&D cost of $15 per barrel might be excellent for a deep-water project in the Gulf of Mexico but terrible for an onshore shale gas well in Texas. The key is to compare a company's F&D cost against its direct peers operating in the same geographical and geological areas. To take your analysis to the next level, you can calculate the Recycle Ratio. This powerful metric shows how many times the company can earn back its F&D cost from the profit generated by a barrel of oil. Recycle Ratio = Netback per BOE / F&D Cost per BOE The Netback is the operating profit margin per barrel after subtracting all the costs of lifting the oil out of the ground (production costs, taxes, and royalties). A Recycle Ratio of 2.0x means that for every $1 the company spends finding a barrel of oil, it expects to generate $2 of pre-tax profit from that barrel over its lifetime. The higher the Recycle Ratio, the more profitable the company's growth engine is. A ratio consistently above 2.0x is generally considered healthy.

When analyzing the F&D costs of an oil and gas company, keep these points in mind:

• Look for a low and stable trend. Is the 3-year average F&D cost per BOE consistently low compared to peers and stable or declining over time?
• Compare against the competition. A company's F&D cost is only meaningful when benchmarked against its direct competitors.
• Calculate the Recycle Ratio. This is the true test of profitability. A company might have low F&D costs, but if its production costs are high (resulting in a low Netback), the investment may still be unattractive.
• Beware of rising costs. A company whose F&D costs are relentlessly climbing is likely facing operational challenges or depleting its best assets. This is a warning sign that future returns may be under pressure.