How Do Oil Companies Estimate Their Environmental Debts?

The timing and amount of cash flows to extinguish oil and gas AROs are inherently uncertain. Faced with this uncertainty, how do oil companies go about estimating their environmental debts?  First, they “guestimate” future asset retirement costs on new assets during the project approval phase when incentives are strong to low-ball expected costs in order to enhance projected returns and make project approval and funding more likely.  Cost estimates are then often left unchanged for decades (“set it and forget it”).  Finally, when assets become uneconomic and permanent retirement can be deferred no longer, detailed engineering cost estimates for decommissioning are prepared.  These estimates are usually much higher than the amounts originally recorded years earlier and often much lower than the actual costs incurred when the work is completed a few years later.  The late-life engineering studies trigger cost estimate increases.  Cost overruns incurred during actual decommissioning trigger additional cost estimate revisions.   And this process continues year after year.

The accounting process is flawed, but there may be no realistic alternative.  Mature oil companies have hundreds of thousands of production assets and asset retirement obligations.  Performing detailed cost estimates of future decommissioning projects would entail undue cost and effort.  Moreover, independent third party reports indicate that such estimates would probably still be inaccurate and skewed toward lower costs than those that will ultimately be realized when the decommissioning work is performed.

Accounting standards are “one size fits all” and do not require or even allow companies to report statistical or actuarial estimates based on projections of historical costs and growth rates.  Financial auditors’ hands are tied by generally accepted accounting principles and practical limitations.  As long as a company’s estimation process is reasonable, auditable and consistently applied, independent auditors have little choice but to sign off. Everyone involved may know that the estimates are just management guesses based on outdated and overly optimistic assumptions, but the accounting standards and practices are well established.  They are not going to change any time soon.

Reported liabilities for asset retirement obligations are management estimates.  Yet, in our experience, senior corporate management typically is uninformed about the methodology, assumptions and data used to produce these estimates or the degree to which they fail to reflect economic reality. “If you can’t measure it, you can’t manage it.”  Regrettably, the existence of audited financial estimates creates the false impression that environmental debt is understood and under control.

When reported accounting estimates of environmental debt self-evidently do not reflect economic reality, investors, creditors and regulators must seek alternative measures.  The re-pricing of AROs using discounted cash flow and statistical analysis may be the only practical way to arrive at valuations of carbon-intensive financial assets that accurately reflect the risks, rights, and benefits of investors, creditors and regulators; enable more meaningful peer-to-peer and period-over-period comparisons; and facilitate more robust financial forecasts.