Finding and Development (F&D) Costs

Finding and Development (F&D) Costs are a crucial performance metric used primarily in the `Oil and Gas Industry`. Think of an oil company like a tub of water with the drain constantly open; the oil it sells is flowing out, and it must find and add new water (oil reserves) just to keep the level from dropping. F&D cost is the price tag on refilling the tub. It measures the total cost an `Upstream` (exploration and production) company spends to add one new `barrel of oil equivalent (BOE)` to its inventory of `proved reserves`. This isn't just the cost of a single drill bit; it encompasses all `capital expenditures (CapEx)` on exploration activities—like seismic surveys and exploratory drilling—and development activities, which involve drilling production wells and building the infrastructure to get the oil or gas out of the ground. In essence, it's the all-in cost of replacing the reserves the company produces each year. A low and stable F&D cost is the hallmark of an efficient, well-run oil and gas operator.

For a `value investing` enthusiast, F&D cost is more than just industry jargon; it’s a window into a company's operational excellence and long-term viability. Since oil and gas are finite resources, a company's ability to replace them cheaply is fundamental to its survival and profitability.

A low F&D cost is a powerful indicator of a company's competitive advantage, or `moat`. A company that can replenish its reserves for $10 per barrel while its competitors are spending $20 has a massive structural advantage. This efficiency translates directly into higher potential profit margins, stronger `free cash flow`, and a superior `Return on Capital Employed (ROCE)`. It tells you whether management is skilled at finding valuable assets (`geological expertise`) and developing them cost-effectively (`project management skill`). A company that consistently posts industry-leading F&D costs is demonstrating a durable skill that is difficult for rivals to replicate.

It's crucial not to judge a company based on a single year's F&D cost. The figure can be notoriously “lumpy.” A company might spend heavily on exploration for several years with little to show for it, and then make one giant, low-cost discovery that makes the F&D cost for that year look spectacularly low. Conversely, a year with high spending but no major discoveries can make an excellent operator look inefficient. The smart investor smooths out this volatility by looking at a 3-year or 5-year rolling average. This approach provides a much clearer picture of the company's true, underlying efficiency and helps you spot a genuine trend rather than reacting to a one-off event.

While the concept is straightforward, the calculation can have its nuances. The basic formula is: F&D Cost = Total Exploration & Development Costs / Total New Reserves Added Let's break down the two parts.

This is the total capital spent on finding and developing new reserves within a period. It primarily includes:

• Exploration Costs: Money spent on activities like geological surveys and drilling exploratory wells in unproven areas.
• Development Costs: Money spent to drill production wells and build facilities on fields that are already known to contain oil and gas.

Some companies also include the cost of buying reserves from other companies (`acquisition costs`) in their calculation. This creates a different metric, often called “Finding, Development, and Acquisition (FD&A) Cost.” It's vital to read the company's annual report to understand exactly what is included in their reported figure.

This is the total volume of new proved reserves added during the year, measured in BOE. These additions come from three sources:

• Discoveries: Brand new fields found through exploration.
• Extensions and Revisions: Upward adjustments to the size of existing fields as more is learned about them.
• Improved Recovery: Additions from using new technology to extract more oil or gas from existing reservoirs.

This number is closely related to another key metric, the `Reserve Replacement Ratio (RRR)`, which measures if a company is adding more reserves than it produces.

When analyzing a company's F&D costs, keep these practical points in mind:

• Check for Consistency: Does the company calculate F&D costs the same way every year? Be wary of management teams that change the formula to make the numbers look better.
• Compare with Peers: How does the company's 3-year average F&D cost stack up against its direct competitors operating in the same geographic regions? A driller in the cheap-to-access Permian Basin will naturally have different costs than one in a deepwater offshore project.
• Look at the Trend: Is the multi-year average F&D cost rising or falling? A consistently rising cost, especially if it's rising faster than its peers, is a major red flag about the quality of its assets or the skill of its management.
• Connect to Profitability: A low F&D cost is meaningless if the price of oil is even lower. Always compare the F&D cost per barrel to the average price the company receives per barrel to understand the potential profit margin on new reserves.
• Read the Fine Print: Don't just look at the number. Scour the management discussion and analysis (MD&A) section of the annual report for context. Management should explain the reasons behind their F&D performance, detailing exploration successes and failures.