Full Cost

Full Cost is an accounting method used almost exclusively by companies in the oil and gas industry. Imagine a wildcatter drilling for oil. Sometimes they strike black gold, and other times they just hit dirt. The Full Cost method essentially says, “It's all part of the game.” It allows a company to lump together every single cost related to finding and developing oil and gas reserves within a large geographical area—like an entire country—into a single giant asset account on the balance sheet. This includes the costs of geological surveys, drilling rigs, and even the expensive failures, the infamous “dry holes.” Instead of immediately recognizing the cost of a failed well as a loss, the company capitalizes it, adding it to the asset pool. This pool of costs is then gradually expensed (a process called depletion) over the life of the successful reserves that are eventually found and produced. This approach smooths out earnings, making performance look less volatile than it might actually be.

Think of the Full Cost method as creating a single “cost bucket” for a whole country. Every dollar spent on exploration and development in that region gets tossed into the bucket.

• Successful Wells: The cost to drill a gusher goes into the bucket.
• Unsuccessful Wells (Dry Holes): The cost of drilling a hole that comes up empty also goes into the same bucket.
• Other Costs: Seismic data, land acquisition rights, geological staff salaries—it all goes in.

This giant bucket of accumulated costs is then treated as an asset. As the company pumps oil and gas from its successful wells, it gradually writes off a portion of this asset's value against its revenue. This write-off is typically calculated using the units of production method. For example, if a company has 100 million barrels of proved reserves and its cost bucket is $1 billion, it would expense $10 for every barrel it produces ($1 billion / 100 million barrels). This makes earnings appear stable, as the immediate sting of a failed drilling project is deferred and spread out over many years.

The arch-rival of the Full Cost method is the Successful Efforts Method. Understanding the difference is critical for any investor analyzing oil and gas stocks. The choice between these two methods dramatically changes how a company's financial statements look.

• Full Cost: Capitalizes all exploration and development costs, successful or not. It's an optimistic approach that views failures as a necessary and unavoidable cost of finding successful reserves.
• Successful Efforts: Only capitalizes the costs directly associated with successful wells. The costs of dry holes are expensed immediately on the income statement, hitting that period's profits directly. This is a more conservative and arguably more transparent approach.

As a value investor, your job is to see through accounting quirks to find a company's true economic reality. The Full Cost method can sometimes obscure that reality.

You simply cannot compare two oil companies—one using Full Cost and the other Successful Efforts—by looking at their P/E ratio or price-to-book ratio alone. The Full Cost company will almost always look cheaper on a book value basis and may have a more stable earnings history, but this can be misleading. You're not comparing apples to apples.

Regulators know that the Full Cost method can lead to massively overvalued assets. To counter this, the U.S. SEC mandates a quarterly “ceiling test.” In simple terms, the total capitalized cost in the “bucket” cannot exceed the estimated future net revenue from the company's proved reserves (calculated using a 12-month average oil price). If the costs on the books are higher than the value of the oil in the ground, the company must take a writedown, which can crush earnings in a single quarter. A sharp drop in oil prices can trigger these writedowns across the industry for Full Cost users.

When analyzing a company using the Full Cost method, smart investors dig deeper:

• Focus on Cash Flow: Reported earnings can be easily massaged. Look at Free Cash Flow instead. A company can report a profit under Full Cost accounting while burning through cash on unsuccessful drilling.
• Use Industry-Specific Metrics: Metrics like EBITDAX (Earnings Before Interest, Taxes, Depreciation, Amortization, and Exploration Expense) are popular because they remove some of the major accounting distortions, allowing for a better comparison between companies.
• Read the Footnotes: Always check the footnotes of the annual report to see which accounting method is being used. The company will disclose it there.

The bottom line? The Full Cost method isn't inherently “bad,” but it demands more skepticism from investors. It delays the recognition of failure, and in the world of high-risk oil exploration, failure is a frequent and important piece of information. The Successful Efforts method, while creating more volatile earnings, gives you a much more honest, real-time scorecard of a company's ability to actually find oil.