Decommissioning Cost Allocation Methods &

Alternatives Financial Assurance

Benny Lubiantara

Presented in Decommissioning Forum, Surabaya, 2004

 Presentation Overview
• Decommissioning Cost Allocation Methods
• Alternatives Financial Assurance
• Example of Field Experience
Decommissioning Cost Allocation Methods
Worldwide Fiscal Provision
for Abandonment

• Carry Back
• Amortised over Field Life
• Unit of Production
• Expensed
• Tax Credit
 Carry Back

• For tax purposes, abandonment costs are carried back for

a maximum period and offset against income.

• The taxable income in those years sets a limit on the tax

relief for abandonment which can be obtained, A tax
rebate would be obtained in the year of abandonment.

• Carry back method are incorporated in the fiscal terms of

the UK, Ireland, New Zealand and the Falkland Islands.
 Carry Back Decommissioning
Cost

Source: A.J. Pittard and C.P. Davitt , “Worldwide Fiscal Systems- How are Abandonment Costs Treated”, SPE 39724, 1996
 Amortised over Field Life

• After the Government has approved an estimate

of the cost of Abandonment, the cost are
amortised over the remaining field life with the
contractor depositing the amortised amounts
into an abandonment fund.

• The deposits are then recoverable from revenue

generated from production under cost recovery
provisions.
 Amortised over Field Life

Source: A.J. Pittard and C.P. Davitt , “Worldwide Fiscal Systems- How are Abandonment Costs Treated”, SPE 39724, 1996
 Unit of Production

• Similar to amortised over field life method,

under units of production systems, estimated
abandonment costs are deposited into an
abandonment fund and recovered on a units of
production basis over the final years of the
project.

• Countries which have incorporated such

provisions in their Fiscal terms: Venezuela,
Angola and the Netherlands.
 Unit of Production

Source: A.J. Pittard and C.P. Davitt , “Worldwide Fiscal Systems- How are Abandonment Costs Treated”, SPE 39724, 1996
 Expensed

• The costs of field abandonment are expensed in

the year they are incurred and written off
against income from the field or from other
sources.

• The cost of abandonment effectively creates a

tax credit or tax deduction in the final year of
the project.

• Countries which have incorporated such

provisions in their Fiscal terms: Thailand,
Tanzania, Romania
 Expensed

Source: A.J. Pittard and C.P. Davitt , “Worldwide Fiscal Systems- How are Abandonment Costs Treated”, SPE 39724, 1996
 Tax Credit

• Tax credit is given on excess abandonment cost

for the year in which abandonment occurs.
Abandonment cost can be expensed in the year
it occurs to a maximum of the taxable income
for that year.

• After the abandonment process has occurred,

the abandonment cost is deducted in the last
year with the excess abandonment cost gaining
a tax credit of 40 percent. The maximum
allowable to be deducted in the last year is
equal to the taxable income in this year.
 Tax Credit

In the example only US$5 million can be deducted in the last year. Although
US$ 20 million was spent on abandonment, the net revenue in the last year
is only US$5 million. The remaining US$15 million will be given a tax credit
as shown:
Tax Credit = (Abandonment cost - last year taxable income)*40%

Source: A.J. Pittard and C.P. Davitt , “Worldwide Fiscal Systems- How are Abandonment Costs Treated”, SPE 39724, 1996
 Economic Effect of Fiscal Provision
for Abandonment

In order to compare the economic effect, The Net Present

Value (NPV) is used – The cash flow is discounted at 15%

• Carry Back - NPV @ 15% = 71.10 MM$

• Amortised - NPV @ 15% = 63.58 MM$
• Unit of Production - NPV @ 15% = 64.86 MM$
• Expensed - NPV @ 15% = 64.78 MM$
• Tax Credit - NPV @ 15% = 67.77 MM$
 Economic Effect of Fiscal Provision
for Abandonment

In order to compare the economic effect, The Net Present

Value (NPV) is used – The cash flow is discounted at 15%

• Carry Back - NPV @ 15% = 71.10 MM$

• Amortised - NPV @ 15% = 63.58 MM$
• Unit of Production - NPV @ 15% = 64.86 MM$
• Expensed - NPV @ 15% = 64.78 MM$
• Tax Credit - NPV @ 15% = 67.77 MM$
Alternatives Financial Assurance
Financial Assurance mechanisms
may be placed in two basic categories:

• Funds are actually set aside

(Escrows Account, Trusts Fund, and
deposits with the Regulatory Authority).

• Financial guarantees
(surety bonds, Bank Guarantte, letters
of credit, and insurance).
 Funds “set-aside”

Trust Fund -
is an arrangement in which a separate legal
entity, the trustee, is created by the oil
company to hold assets or funds for the
purpose of decommissioning works.
 Funds “set-aside”

Deposit with the Regulatory Authority

A deposit of cash , certificate of deposit with the

Regulatory Authority for decommissioning
works.
 Funds “set-aside”
Escrow account -
Cash is placed in a bank account by the Oil
Company under an escrow agreement between
the oil company, the bank, and the Regulatory
Authority, An escrow agreement specify that the
Regulatory Authority has full control over the
account until it is released when the
decommissioning work has commenced.
 Financial Guarantee
Surety Bond
Surety company writes a surety bond, it guarantees that the oil
company will perform all operations related to the
decommissioning works. Otherwise, the Surety Company will pay
the bond sum to the regulatory authority, which will pay a private
contractor to perform the decommissioning.

Surety bonds are similar to insurance policies in that oil companies

pay annual premiums to keep the surety bonds in place.
 Financial Guarantee
Insurance - An applicant takes out a closure insurance policy
from an insurance company. The policy must be issued in an
amount adequate to cover the decommissioning costs. The
Regulatory Authority is the beneficiary of the policy.

Letter of Credit - This is similar to a bond with a bank or financial

institution taking the place of a surety. A irrevocable letter of
credit is established solely for the purpose of guaranteeing
performance of obligations under a reclamation permit. The bank
or financial institution bank agrees to pay in event of default.
Why Financial Guarantee needed ?

Because there is no guarantee that enough

funding are available at the end of the project.
 Field Experience :
Cook Inlet Alaska Oil & Gas Facilities

Source : Van Dyke & Daniel Zobrist,

“Funding For Abandonment of Cook Inlet Alaska Oil and Gas Facilities: A Landowner's Perspective”, SPE 68853, 2001
 Abandonment Funding Agreement

• The abandonment funding agreement is intended to balance the

Regulatory Authority’s need for risk mitigation while keeping
the oil company incentive for incremental investment.

• It recognizes the collateral value of oil and gas in the ground but
includes supplemental bonding, and stand-alone escrow funding
when the collateral slips below a specified cushion.
 Bonding
Until abandonment obligations are complete, an
annually renewed surety bond is provided to the
Regulatory Authority. This is intended to remove the
risk to the Regulatory Authority of immediately
raising cash to maintain and operate the offshore
platforms in case of bankruptcy by the oil company.
 Proved Reserves
• The existence of proved reserves serve as collateral to the
Regulatory Authority. By recognizing this asset, the Regulatory
Authority avoids unnecessarily burdening the oil company with
costly guarantees that mitigate risks that may not exist at the
time.

• The oil company prepares an annual Proved Reserves Report to

record changes in reserve value, as oil and gas forecasts change
and production occurs. The Proved Reserves Report is subject
to audit and the selection of price, cost and discount rate is
stipulated in the Agreement.
 Escrow Account
• An Escrow Account is established to pay for the
actual costs to abandon the facilities.

• Payments into the Account begin only when the

value of the oil and gas reserves have dropped to
a level insufficient (in the view of the Regulatory
Authority) to act as collateral for the cost of
abandonment of the platforms.

• The uncertainty of the actual cost of

abandonment make the Regulatory Authority to
require a 150% cushion of collateral.
 Escrow Account
• The oil company begins making payments into the Fund when
the NPV of the net proved reserves is less than 150% of the
NPV of the estimated abandonment costs.
• The amount of the payment into the fund each year is the
difference between 150 percent of the NPV of the estimated
abandonment costs and the sum of the Fund and NPV value of
the reserves.

• No payment is necessary when the balance of the fund equals

or exceeds the amount of the estimated abandonment costs.

• The monies in the Escrow Account are released to reimburse

the oil company for abandonment expenditures when
abandonment operations have commenced.
 Case Illustration:
Assumptions:
• Discount rate = 15% (for NPV calculation)
• Abandonment cost $31MM in 2009
• The principle of the fund is assumed to grow at an
annual rate of 5%
• Initial payment begins when the sum of the NPV of
the Fund and Proved Reserves < 150% of the PV of
the abandonment cost.
 Spreadsheet calculations

Source : Van Dyke & Daniel Zobrist,

“Funding For Abandonment of Cook Inlet Alaska Oil and Gas Facilities: A Landowner's Perspective”, SPE 68853, 2001