GEOLOGICAL

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GEOLOGICAL GEOPHYSICAL COSTS

• EXPLORATION
• FOR OIL AND GAS
• BY
• PATRICK HENNESSEE

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4.5 billion years ago
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PLATE TECHTONICS
construction
San Andreas fault
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400 million years ago
100 million years ago
250 million years ago
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EROSION
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Marine Creatures and Plants Inhabited the Great
Inland Seas Covering the Continents
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FORMATION OF OIL
Silt
Organic matter converted into oil by heat,
bacteria, radiation, etc.
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Earth Cross Section Oil in Reservoirs
Oil squeezed out of shale beds into more porous
sandstone or limestone
Then, crust of the earth warped and oil migrated
along the bed until it became trapped
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Close Up of Oil Between Grains of Rock
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Physical Forms of Petroleum
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EXPLORATION ACTIVITIES

• MAGNETIC SURVEYS
• GRAVIMETRIC SURVEYS
• SEISMOGRAPH STUDIES
• CORE DRILLING
• PALEONTOLOGICAL STUDIES
• CHEMICAL ANALYSIS OF ROCK

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Blast
Repeat blast
Recorders
Recorders
Reflected Waves
Vibration
Reflected Waves
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PETROLEUM RESERVOIR

• A POROUS AND PERMEABLE UNDERGROUND FORMATION
  CONTAINING A NATURAL ACCUMULATION OF PRODUCIBLE
  OIL OR GAS THAT IS CONFINED BY IMPERMEABLE ROCK
  OR WATER BARRIERS AND IS INDIVIDUAL FROM OTHER
  RESERVOIRS
• FASB STATEMENT 19

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POROUS PERMEABLE

• POROUS SPACE IN ROCKS
• PERMEABLE
• MEASURE OF HOW EASILY FLUIDS CAN MOVE THROUGH
  THIS PORE SPACE

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In a commercial reservoir porosity ranges from
about 10 to 30 of the volume
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Saturation
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Pembina Core from Canada
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Ghawar Core from Saudi Arabia
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FORMATIONS
Three Types of Rocks

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SEDIMENTARY BEDS

• SANDSTONE
• LIMESTONE
• DOLOMITES
• SHALE

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HYDROCARBONS

• SOURCE BEDS
• MIGRATION TO RESERVOIR ROCK
• OIL AND GAS TRAPS
• CAPROCK

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PETROLEUM RESERVOIRS

• STRUCTURAL TRAPS (UPHEAVALS)
• ANTICLINES DOMES
• FAULTS
• STRATIGRAPHIC TRAPS
• ANCIENT BEACHES OR RIVERS
• PINCH OUTS
• CONTROLLED BY THE DEPOSITIONAL ENVIRONMENT

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ANTICLINE

.
Gas
OIL
Underground hill, dome, or ridgeline - created by
fold in rock beds. Oil and gas migrates to a
cap rock trap.
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ANTICLINE
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Sheep Mountain
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FAULT

OIL
Rock beds broken and moved out of position -
different kinds of rock face each other at the
break - where oil is trapped.
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FAULT
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Stratigraphic Trap

OIL
Buried shore line (one type) of an old
ocean. Permeable bed of rock pinches out or
disappears where the shore line ends. East Texas
field is an example.
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STRATIGRAPHIC TRAP
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DRIVE MECHANISMS

• RATE OF DECLINE OF THE BOTTOM HOLE PRESSURE (BHP)
• FACTOR CONTROLLING THE RATE OF DECLINE DRIVE
  MECHANISM
• FRONTAL WATER DRIVE
• GAS CAP DRIVE
• SOLUTION GAS
• COMBINATION OF ABOVE 3

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Production Wells
Water
Water
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Production Wells
Gas
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THE TAX ISSUE

• EXPLORATION COSTS
• ORDINARY AND NECESSARY BUSINESS EXPENSE
• OR
• CAPITAL EXPENDITURE
• OBJECTIVE
• ACQUIRING AND COLLECTING INFORMATION
• BASIS TO ACQUIRE OR RETAIN PROPERTIES

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PROJECT AREA

• EXPLORED ADVANTAGEOUSLY IN A SINGLE INTEGRATED
  OPERATION
• RECONNAISSANCE - TYPE SURVEY
• TO IDENTIFY SPECIFIC GEOLOGICAL FEATURES THAT
  MERIT FURTHER EXPLORATION
• REV. RUL. 77-188

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AREA OF INTEREST

• EACH SEPARABLE, NONCONTIGUOUS PORTION OF THE
  PROJECT AREA
• POSSESSES SUFFICIENT MINERAL PRODUCING POTENTIAL
  TO MERIT FURTHER EXPLORATION

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PROJECT AREA

ANTICLINE
AREAS OF INTEREST
FAULT
DOME
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ALLOCATION METHODS

• RECONNAISSANCE COST
• EQUALLY TO EACH AREA OF INTEREST
• NO AREAS OF INTEREST DEDUCT
• DETAILED SURVEY COSTS
• DIRECTLY TO THE AREA OF INTEREST
• PROPERTY ACQUIRED IN AOI?
• ALLOCATE ALL ACCUMULATED COST
• ON ACREAGE BASIS
• REV. RUL. 77-188

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REV. RUL. 83-105

• NO LEASES ACQUIRED W/I OR ADJACENT TO AN AREA OF
  INTEREST
• DEDUCT ALL ALLOCATED COST AS A LOSS UNDER SEC.
  165(a)
• BUT MUST HAVE AN IDENTIFIABLE EVENT TO JUSTIFY
  LOSS

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IDENTIFIABLE EVENT

• OFFSHORE GOVERNMENT LANDS
• 10 YEARS W/O A LEASE OFFERING
• ANY OTHER AREA
• 5 YEARS W/O A LEASE OFFERING
• OR FACTS CIRCUMSTANCES

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EXPLORATION RIGHTS(SHOOTING RIGHTS)

• TAX TREATMENT G G
• LANDOWNER - INCOME
• OIL CO. - CAPITALIZE
• OPTION TO LEASE WITH THE SHOOTING RIGHTS
• 1. RIGHT TO CONDUCT EXPLORATION
• 2. RIGHT TO ACQUIRE A LEASE
• PAYOR - CAPITALIZE TO LEASEHOLD
• PAYEE - RECOGNIZE ORDINARY INCOME

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Problem 1
The SP-KO Oil Company, an oil and gas producer,
conducted a reconnaissance survey, costing
30,000, on a large project covering 30,000 acres
in an area that may be included in a lease sale.
The survey disclosed the existence of three areas
of interest. The three areas of interest (the
Rocky Ridge Fault Line, the Willow Creek Basin,
and the Sheephead Dome) contained geological
features that indicated sufficient oil and gas
producing potential to merit further
exploration.
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Problem 1 - Continued
A lease sale was announced that included the
Rocky Ridge area and the Willow Creek Basin.
Detailed surveys established the existence of oil
and gas producing potential on both of these
areas. The detailed survey in the Rocky Ridge
area cost 80,000 and the detailed survey in the
Willow Creek Basin cost 100,000. A detailed
survey was not conducted on the Sheephead Dome
area since tracts in that area of interest were
not offered for lease.
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PROJECT AREA
RRFL
Detail 100,000 Recon 10,000 Total 110,000
Recon 10,000 Detail 80,000 Total
90,000
Recon 10,000
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The SP-KO Oil Company was successful in acquiring
three leases in the Rocky Ridge area. The
details of these acquisitions are as
follows The Lease Cost Per Acre
Acres Finley Lease 100
500 Sean Lease 200
800 O'Tracy Lease 300
1,000 Because SP-KO was unsuccessful, however,
in acquiring leases on tracts located in the
Willow Creek Basin, this area of interest was
abandoned as a potential source of oil and gas
production. How should SP-KO handle these
expenditures for tax purposes?
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G G Problem 2
The SP-KO Oil Company acquired an oil lease on a
large track of land and conducted a preliminary
geological and geophysical reconnaissance
survey on the tract. Two large areas of
interest were identified (Willow Creek Basin and
Sheephead Dome). The entire lease consisted of
10,000 acres and was leased for 40 per acre.
The reconnaissance survey cost 30,000. Later in
the taxable year, SP-KO conducted a separate
detailed geological and geophysical survey on
each of the two areas of interest. Each survey
cost 50,000 each. The data obtained from
conducting the detailed survey on Willow Creek
Basin area of interest indicated no oil or gas
producing potential and was was the basis for
SP-KOs decision to abandon further activity in
that area of interest. However, the data
obtained from conducting the detailed survey on
the Sheephead area indicated the presence of oil
and gas producing potential and was the basis for
the recommendation that an exploratory well be
drilled in that area. SP-KO retained the entire
lease based on the data obtained from the
geological surveys of the Sheephead area. How
should SP-KO treat these costs for tax purposes?
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10,000 ACRE LEASE _at_ 40 PER ACRE
Recon. 15,000 Detail 50,000 Total
65,000
Recon. 15,000 Detail 50,000 Total
65,000
LEASEHOLD
400,000 65,000
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G G G - Problem 3 G COSTS - PROBLEM 3 The
SP-KO Oil Company acquired oil and gas leases on
six large contiguous tracts consisting of 1000
acres each, paying 50 per acre. These tracts
are designated as tracts A through F. The lease
on each tract was acquired from a different fee
owner, by a separate conveyance, and at a
different time. SP-KO conducted a geological
and geophysical reconnaissance survey covering
all six tracts at a cost of 20,000 per tract.
The data obtained from the reconnaissance
indicated five areas of interest. One separate
area of interest was located within each of the
five tracts identified as A through E. No area
of interest was located in tract F.
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G G - Problem 3-- continued Later in the same
year, SP-KO conducted a separate detailed
geological and geophysical survey over each of
the five areas of interest costing 40,000 each.
Based on the additional data obtained from the
detailed surveys, SP-KO determined that it could
retain leases on tracts A, B, and C because of
the indication of potential mineral production
within the boundaries of each of these tracts.
Even though SP-KO maintained that the detailed
survey of the area of interest in D did not
indicate potential for oil or gas production,
SP-KO inexplicably retained the lease for tract
D. SP-KO disposed of leases on tract E and
F. How should SP-KO treat these costs for tax
purposes?
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Recon Survey 120,000/5 24,000
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A B C D
E F
24,000
24,000
24,000
24,000
BONUS 50,000
BONUS 50,000
BONUS 50,000
BONUS 50,000
BONUS 50,000
BONUS 50,000
24,000
Detailed 40,000
Detailed 40,000
Detailed 40,000
Detailed 40,000
Detailed 40,000
Total Basis 114,000
Total Basis 114,000
Total Basis 114,000
Total Basis 114,000
Loss 114,000
Loss 50,000
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DAMAGE PAYMENTS

• PAYOR
• TAX TREATMENT DEPENDS ON WHEN WHY
• PAYEE
• DAMAGE TO SURFACE
• RETURN OF CAPITAL OR INCOME (DEPENDING ON THE
  FACTS)
• PAYMENT SPECIFICALLY FOR AN ACTUAL AMOUNT OF
  SURFACE DAMAGE
• TREAT AS A RETURN OF CAPITAL

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DRILLING CONTRIBUTIONS

• BOTTOM HOLE CONTRIBUTIONS
• DRY HOLE CONTRIBUTIONS
• TAX TREATMENT
• CONTRIBUTOR MUST CAPITALIZE
• RECIPIENT MUST INCLUDE IN INCOME

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G G COST - PROBLEM 4 Big Oke Oil Co. paid the
Rocking R Ranch 1 per acre for shooting rights
on 60,000 acres of land in Beaver County. Big
Oke conducted reconnaissance work over the
entire 60,000 acres. This preliminary survey,
which cost 20,000, disclosed five separate
areas of interest. Big Oke spent the following
in detailed seismograph surveys on each area of
interest Area 1 (1,500 acres) . . . . . . . .
. . . . . 8,000 Area 2 (5,000 acres) . . . .
. . . . . . . . . 5,000 Area 3 (2,000 acres)
. . . . . . . . . . . . . 12,000 Area 4
(1,000 acres) . . . . . . . . . . . . .
15,000 Area 5 (6,000 acres) . . . . . . . . . .
. . . 4,000
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G G COST - PROBLEM 4 - CONTINUED
After conducting the detailed survey, Big Oke
acquired 3 leases in Area 1 only. These leases
were all geographically separate. Big Oke paid
Rocking R the following for the
leases Lease Acres Bonus Paid A
300 100 per acre B 200 200
per acre C 500 400 per acre How
will these payments be treated for federal income
tax purposes?
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G G Problem 5
Two years have gone by since Big Oke acquired
Lease C and no drilling has taken place. In the
mean time, B D Oil Company acquired a lease
which is contiguous to Big Okes Lease C. One
day Mr. Brown (of B D) approached Big Oke and
offered to pay Big Oke 10,000 as a dry hole
contribution if Big Oke would drill a test well
on lease C. The well was drilled and was
dry. How should Big Oke and B D treat the dry
hole contribution?