Full Cost Method

The Full Cost Method is an accounting practice used almost exclusively by oil and gas exploration companies. Think of it like this: a wildcatter drills ten wells in a country. Nine are expensive “dry holes,” but the tenth is a gusher. Using the Full Cost method, the company bundles the costs of all ten wells—the successes and the failures—into a single large Asset on its Balance Sheet. This entire capitalized cost is then gradually charged against profits over the productive life of the successful well through a process called Depreciation, Depletion, and Amortization (DD&A). This approach presents a stark contrast to its more conservative rival, the Successful Efforts Method, which requires companies to Expense the cost of failed wells immediately. For investors, understanding this difference is crucial, as it fundamentally changes how a company's profitability and assets appear on paper.

Under the Full Cost method, a company defines a very large geographical “cost center,” which is typically an entire country. All costs incurred in exploring for and developing oil and gas reserves within that area are treated as part of the cost of finding any and all reserves there. These costs include everything from geological surveys and drilling expenses to the salaries of the exploration team. The central idea is that finding oil is a package deal; the failures are an unavoidable part of the process of achieving success. Therefore, all these costs are pooled together and “capitalized”—that is, they are recorded as an asset on the balance sheet rather than an expense on the Income Statement. This creates a large asset pool representing the company's investment in its oil and gas properties. This asset is then slowly depleted (amortized) over the period the company extracts and sells the oil and gas, matching the cost against the revenue it generates.

The choice between the Full Cost and Successful Efforts methods reflects a fundamental difference in accounting philosophy. It's a critical distinction for investors because you cannot directly compare the financial statements of two companies using different methods without making significant mental adjustments.

Proponents of the Full Cost method argue that it provides a more stable and representative picture of an oil and gas company's operations over the long term.

• The Logic: All Exploration Costs are necessary to find reserves, so the cost of the failures is just as much a part of the investment as the cost of the successes.
• The Effect: This method results in smoother and often higher reported Net Income in the early years, especially for smaller companies or those engaged in high-risk exploration with a low success rate. By capitalizing failures, the company avoids the large, immediate hit to earnings that a dry hole would otherwise cause.

The Successful Efforts method is the more conservative of the two and is used by most of the large, integrated oil majors.

• The Logic: Only exploration activities that directly result in the discovery of reserves create a future economic benefit. Therefore, only the costs associated with successful wells should be capitalized as an asset. The cost of a dry hole is a failed endeavor and should be recognized as an expense in the period it was drilled.
• The Effect: Reported earnings are more volatile, as a single expensive dry hole can wipe out a significant portion of a quarter's profits. However, many analysts believe this method provides a more accurate, year-by-year reflection of a company's operational performance and drilling discipline.

As a value investor, you must look past the accounting and understand the underlying economic reality. The choice of accounting method doesn't change the amount of cash a company spends or the amount of oil it finds, but it dramatically changes the story the financial statements tell.

• Higher Reported Earnings: A company using Full Cost will generally report higher Net Income and Earnings per Share (EPS) than an identical company using Successful Efforts, assuming both have some unsuccessful wells.
• Larger Asset Base: The Full Cost company's balance sheet will show a larger asset value, as it includes the costs of all wells drilled, not just the successful ones.
• No Change to Cash Flow: This is the key. The accounting method has no impact on the company's actual Cash Flow. The cash spent on drilling a dry hole is gone regardless of whether it's called an “asset” or an “expense.” This is why savvy investors often focus on the cash flow statement to get a clearer picture of a company's health.

When analyzing an oil and gas company, especially one using the Full Cost method, keep these points in mind:

• Don't Compare Apples to Oranges: Never directly compare the Price-to-Earnings (P/E) ratio or book value of a Full Cost company to a Successful Efforts company. The comparison is meaningless without significant adjustments.
• Focus on Cash, Not Just Earnings: Prioritize analyzing the statement of cash flows. How much cash is the business really generating from its operations? Is it enough to fund its exploration program, or is it constantly relying on debt or issuing new shares?
• Beware the “Ceiling Test”: Full Cost companies are required to perform a quarterly Ceiling Test. This test ensures that the capitalized costs on their balance sheet do not exceed the estimated after-tax future net revenue from their Proved Reserves (calculated using an average of recent oil prices). If oil prices plummet, the value of their reserves can fall below the capitalized cost, forcing the company to take a massive non-cash write-down, which devastates reported earnings.
• Consider Management's Motives: The choice of an aggressive accounting method like Full Cost can sometimes be a red flag. It may be used by management to present a rosier picture than reality warrants, especially if executive compensation is tied to reported earnings.