With today’s low crude oil and natural gas prices, the survival of exploration and production companies depends on razor-thin margins. Lease operating expenses––the costs incurred by an operator to keep production flowing after the initial cost of drilling and completing a well have been incurred––are a go-to variable in assessing the financial health of E&Ps. But it’s not enough for investors and analysts to pull LOE line items from Securities and Exchange Commission filings to find the lowest cost producers, plays, or basins. More than ever we need to understand—really, truly, deeply—what LOEs are, why they matter, how they change with commodity prices, production volumes, and other factors, and how we should use them when comparing players and plays. Today we begin a series on a little-explored but important factor in assessing oil and gas production costs.
The slump in crude oil prices that started nearly two and a half years ago––and natural gas prices that, by and large, have remained lower than many had hoped––have put additional financial strain on many types of companies within the energy sector, E&Ps chief among them. Still, there’s been remarkable resilience; despite oil prices below $50/bbl and natural gas prices well south of $3/MMBtu, many E&Ps have significantly improved their drilling, completion and operating efficiencies; slashed their costs; divested properties with higher costs and focused on those with lower costs, all with the aim of surviving––even thriving––in tough times. In our ongoing analysis of upstream capital spending production trends (Been Down So Long; You Go Your Way, I’ll Go Mine; and Different Strokes by Different Folks) we’ve noted that while capital spending at most E&Ps is down sharply from where it was a couple of years ago, there’s been a new sense of optimism that by improving efficiencies, cutting costs and zeroing in on the very best production areas that an E&P can make a go of it even in an era of low oil and gas prices.
A key metric in assessing how well (or how poorly) E&Ps are doing on the cost side of the ledger is LOEs, which as we said are the costs incurred by an operator to keep production flowing after the initial cost of drilling and completing a well have been incurred. What’s included in the LOE “basket”? For one thing, the costs associated with employees known as “pumpers,” “well tenders,” or “lease operators,” who regularly monitor and maintain onshore wells. Their wages, vehicle expenses, gasoline costs, and any other expenses they have for items they use while tending to the wells (such as methanol for de-icing) are all LOEs. Other LOE elements come from operating and maintaining the on-site production equipment used to keep wells flowing and to process the hydrocarbons they produce so that they will be in a form suitable for transportation away from the lease. However, not all well costs are included in the LOE basket. For example, the initial cost to purchase and install the equipment is capitalized as part of the “producing property,” but the expenses for fuel used to power and maintain equipment at the lease site are included among LOEs.
LOEs typically are studied to help determine the degree to which it makes sense for a company’s wells to continue operating. In the case of existing wells, if expected revenues fall materially below LOEs the operator will usually shut-in the well and may even plug and abandon it. For undeveloped well sites, if the cost of drilling and completing the well is not offset by a surplus of revenues over LOEs (i.e. expected future cash flows) enough to provide an attractive rate of return, the operator is likely to stop drilling and completing new wells altogether (barring other considerations).
E&Ps generally cite their LOEs in their quarterly earnings and report LOEs to the SEC, suggesting that you could do apples-to-apples LOE comparisons among various companies and get a good sense of where they stand. The catch is that, in many cases, the LOEs that E&Ps present are a mix of apples, oranges, bananas and … well, you get the idea. There are no hard and fast rules that say exactly what LOEs must mean when presented in the unaudited sections of an SEC filing or in an investor presentation. And even in the audited sections a company can report certain LOE elements as separate line items––things like “workovers” (regular maintenance procedures performed on underground parts of the well and that therefore require the use of a “workover rig”); and “ad valorem taxes” and “production taxes”––that can either help or hurt in developing an accurate assessment of how an E&P is doing. Figure 1 provides an example from one E&P’s 10-K filing to the SEC with LOEs reported in dollars per barrels of oil equivalent ($/boe; for more on boe see Golden Age).
Severance and ad valorem taxes (often called “production taxes”) are indirect costs that get lumped into LOEs. The reason these taxes get included in LOEs is because, unlike corporate income taxes, they are assessed at the lease level and calculated based on the revenues (for severance taxes) and property values (for ad valorem taxes) of the underlying properties. Consequently, a company’s unique tax situation—whether having an unprofitable year or net loss carry-forwards—has no effect on the taxes owed at the lease level. These taxes are “attached to” or “run with” the properties themselves. Consequently, they need to be paid every year, no matter what, to ensure that state and local governments will allow the operator to keep title to the wells and the oil and gas volumes they produce.
Notice that in Figure 1 workovers and production taxes are reported as though they are separate and distinct from LOEs, even though on the company’s own internal accounts these would have all been included within the broader LOE category. The “Actual Total LOEs” figure is then $24.38/boe, which also corresponds to what this E&P and its third-party reserves auditors would have used to estimate their reported reserves and the present value of those reserves. Also notice how the term “Total Production Expenses” is used to indicate a broader category (“LOEs” + workovers) than the term “LOEs” on its own. Contrast this with another E&P’s 10-K, where the term “Lease Operating Expenses” is used as the broader category and includes “Production Costs” (see Figure 2).
Even here, the full amount of LOEs that would be used for internal accounting, reserves, and present-value-of-reserves estimates would need to include “Production Taxes,” which brings the company’s “Actual Total LOEs” to $12.39/Boe. We also suspect that the “Production Costs” figure ($9.02/Boe) already includes some amount of workover expenses. Again, there’s no getting around the fact that we will encounter these ambiguities, and that—to deal with them—we have no choice but to look at the details and see what these terms really mean each time we come across them.
Every fruit (apple, orange, pear or whatever) provides nutritional value, though, and the LOE information that companies provide––varied and inconsistent as it may be––has value too. The important thing is to have a clear understanding of what is being included in a presented LOE figure and what should be included to capture the full economic meaning of LOEs. If we know these two things, we can make the appropriate adjustments for our own analyses. If we don’t, we risk being blindsided either positively by new sources of production that we thought couldn’t get off the ground or negatively by falling production in areas that we thought were more robust than they really are.
As we shall see, figuring out what is and what should be in LOEs can get quite complicated; but leaving aside the more complex cases, we can use a carefully crafted definition to get us very close to the right answer most of the time. Since we couldn’t find a ready-made definition with this guiding purpose in mind, we decided to craft our own:
Lease operating expenses are the direct and indirect costs incurred to maintain the production of a well on the path (trajectory along decline curve) consistent with the capital investment history of the well.
To clarify the italicized part of our definition, we need to look at a case where production equipment is installed not merely to keep production on its original decline curve but to bump it up to another, higher decline curve. Consider a gas well that’s been producing for 10 years and has followed the path of its original decline curve just as predicted. Now suppose that the owner wants to give this well a boost by purchasing and installing a wellhead compressor to effectively suck more gas out of the well bore at a faster rate. (Figure 3 shows the production effect of this hypothetical investment.)
Again, the costs to purchase and install the wellhead compressor would be capitalized and would become a part of the “producing property.” The fuel and maintenance costs, though, would be incurred as ongoing expenses, and included in the LOE.
In Part 2 of this blog series we will take a more comprehensive look at the full breadth of what items can be included in LOEs and we’ll also look at some situations where the logic behind LOEs breaks down a bit. In the latter case, we will use the fundamental reasons for why we care about LOEs in the first place as our guiding compass.
Special thanks to Eric Sellers of Caelus Energy, Professor Linda Nichols of the University of Tulsa, and Professor John Lee of Texas A&M for helping us gain better clarity on the twists and turns of LOEs.
“Lowdown” was the first major hit for singer/songwriter Boz Scaggs, rising to #3 on the Billboard Pop Singles chart in the summer of 1976. The song was one of several well-received tunes on Scaggs’ Silk Degrees albums; others were “Lido Shuffle” and “(Why Can’t You Just Get It Through Your Head) It’s Over.” Scaggs, who was lead singer for The Marksmen (a precursor of The Steve Miller Band in the 1960s), was first called “Boz” while he was a student at St. Mark’s School in Dallas (where he met Steve Miller, by the way); another student started calling him Bosley, and the nickname was soon shortened.