Oil & Gas E&P Accounting Methods: Full Cost vs. Successful Efforts: Effects on Earnings, Asset Value, Depreciation, and Depletion: RBN Energy Analysis

     This post is a summary of a post on the RBN Energy Blog by Nicholas Cacchione. I don’t have much familiarity with or knowledge of this subject. He first notes that when comparing different oil & gas exploration and production (E&P) companies, one might compare their annual reports. However, this is complicated by the fact that there are two differing accounting methods generally used to value the companies. He compares the two methods: Full Cost (FC) and Successful Efforts (SE), to different tax accounting methods approved by the IRS. The goal for those comparing companies is to get an accurate idea of the real value of the company. Such valuations can inform possible merger and acquisition decisions.

     He notes that while both methods are permitted under U.S. Generally Accepted Accounting Principles (GAAP), they offer different opinions, particularly of exploration successes and failures. He also explains how methods used changed after the shale revolution, where shale is a “resource play” tapping a continuously present, repeatable resource, while mainly vertical pre-shale wells had significant dry hole risks not encountered in shale drilling.

“These differences influence reported earnings, asset values, depreciation and depletion rates, impairment behavior and, ultimately, how companies are perceived by the market. For decades, FC and SE accounting methodologies were viewed largely through the lens of conventional exploration. In that Pre-Shale Era, dry holes were common, exploration risk was high, and accounting methodology played a major role in determining financial results. FC tended to smooth results by spreading failures across large cost pools, while SE forced companies to recognize losses immediately.”

“Today, the most important differences between FC and SE appear in impairment timing, depreciation profiles, reserve revisions, and the way capital costs are embedded in balance sheets over time. However, it is important to recognize that despite whichever accounting methodology a company subscribes to, cash flow and cash flow-related metrics will still tell the economic truth about a company’s financial fortunes.”    

     Pre-shale oil & gas was high risk and high cost. Shale drilling is low risk and high cost. The Successful Efforts (SE) method ensures “project-level accountability and rapid recognition of failure.” This method is transparent and conservative. The Full Cost (FC) method does not operate at the project level, but pools capitalized exploration and development costs into larger portfolios, typically by country.

“Proponents of FC argue that this approach better reflects the long-term economics of resource development. Individual failures are expected to be offset by future discoveries, and capitalizing costs smooths earnings over time. In their view, expensing dry holes immediately creates excessive volatility that does not reflect underlying business value.”

     He gives some history of these methods. In the 1960s and 70s they were hotly debated. Large integrated oil companies, the “majors,” generally favored SE, while smaller independent producers often preferred FC. FC serves to reduce short-term earnings volatility and enable better access to financing.

     As noted, shale drilling brought repeatability and is largely seen as developmental drilling rather than exploratory drilling. The geologic risks are much lower with shale. Shale also benefits, he notes by the density of drilling, which provides much more geological data and information, which further lowers risks.

     The graph below depicts different companies and the accounting method used alongside capitalized costs. Those in red use FC and those in black use SE.

     He notes that in the Shale Era, what has changed mainly is how impairments, or cost write-downs, are accounted. He explains that the Securities and Exchange Commission (SEC) requires the “full cost ceiling test” to limit excessive asset capitalization under FC accounting.

“A ceiling test write-down occurs when a FC company’s net capitalized oil and gas costs exceed the present value of its proved reserves (PV-10), requiring the excess to be written off immediately. These write-downs are often triggered by lower commodity prices or reserve revisions rather than changes in underlying operations.”

     He suggests that SE accounting is more accurate in the sense that it flushes out failures more quickly with the resultant asset valuations being more accurate. The implication is that delaying impairments can be deceiving. He explains that SE accounting is especially more accurate in that asset valuations will better match inventory quality. This is especially important for maturing shale plays.

“In mature shale plays — where core inventory is gradually depleted and development moves outward — this distinction becomes increasingly important. Companies with significant net capitalized costs may appear well-capitalized while facing deteriorating drilling economics.”

     On the other hand, companies involved in exploratory drilling projects, such as those in the Gulf and in offshore plays around the world, must invest large amounts of money in projects that take years to develop. For those companies, FC accounting is most apt.  

     Below, he reiterates that accounting method differences mainly affect the timing of expense recognition and that cash flow is the best indicator of financial performance.

“Because accounting policy primarily affects the timing of expense recognition rather than underlying economics, cash flow remains the most reliable indicator of performance. Investors and analysts evaluating upstream companies should emphasize operating and free cash flow, reinvestment rates, finding-and-development (F&D) costs, reserve replacement efficiency, payout ratios and capital returns. These measures are less distorted by accounting treatment and more closely reflect economic reality.”

     The table below compares the differences between FC and SE accounting in a hypothetical scenario. The result is mainly a difference in profit declared due to the difference in impairment timings. Note that cash flow is the same in both scenarios.

“Shale development narrowed the most visible historical differences between FC and SE by reducing traditional dry-hole risk, but it did not eliminate the importance of accounting methodology. Instead, it shifted the battleground toward impairment timing, DD&A profiles, reserve revisions, and the accumulation of embedded capital on balance sheets.”

“Accounting determines when results are recognized, but cash flow determines whether value is created. In the end, cash flow — not accounting methodology — is the only true measure of success or failure in the upstream oil and gas business.”

     Thus, cash flow is king. I am glad to have learned a little about this topic. The author notes plans for RBN Energy to augment its reporting of year-end reserve reconciliations in future blogs based on accounting methods.

   

 

References:

 

You Go Your Way, I’ll Go Mine – Why Accounting Methods Matter. (No, Seriously, You Gotta Read This). Nicholas Cacchione. RBN Energy. Blog. February 26, 2026.  You Go Your Way, I’ll Go Mine – Why Accounting Methods Matter. (No, Seriously, You Gotta Read This) | RBN Energy