Considering a Joint Interest Audit? Answer These Questions First

Oil and gas companies and others affected by recent decreases in commodity prices and overall changes in operations due to COVID-19 may be looking for ways to save money. In times like these, a Joint Interest Audit (JIA) may prove beneficial.

If you are considering an audit of the operator of your oil and gas properties, you will need to review all aspects of the project and set realistic expectations for everyone involved. Before undertaking a JIA, you should be aware of the issues that may justify the effort and be prepared to navigate the audit logistics.

Should you even go to the trouble of conducting the audit?

It can be difficult to know which issues with the operating company justify an audit. Keep in mind that the operator has a duty to respond to questions related to it operatorship and you retain the right to perform an audit. Whether there is suspected non-compliance with the Joint Operating Agreement (JOA) or you simply if want to gain more insight into the operations of the properties, it may be a good time to consider an audit. 

Who will perform the audit?

The Council of Petroleum Accountants Societies (COPAS) Accounting Guide 19 (AG-19), which outlines the protocol for JIAs, gives no preference to whether an audit must be performed by in-house personnel, or if an outside audit firm should be used. The required audit steps and all communications and protocols are the same; however, you should consider the following when making this decision:

1. Do we have the internal personnel with expertise to perform the audit?
2. If our internal personnel has the expertise, do they have the time and bandwidth? Audits often require a minimum of 80 hours, and occasionally significantly more. On top of someone’s regular job, it may be difficult to timely work through each step of the audit.
3. Can an outside firm add value through additional perspectives from working with various companies and situations?

How much will the audit cost?

For businesses, the most pressing concern typically is the audit’s projected cost. If operator non-compliance is expected to generate cost recoveries, these are likely to far exceed the audit cost. There are, however, several opportunities to reduce costs related to the audit:

1. Most properties have multiple non-operating owners. Even if you are leading the audit, other non-operating entities can be balloted to find out if others would like to participate and share in the costs.
2. Pre-identifying areas most susceptible to error and exception, defining the parameters of the audit, and having a focused approach on the areas you know have exceptions can help contain costs. Audit firms can approach an audit to catch a wide range of types of exceptions. This can sometimes yield results that the non-operating company wasn’t even aware of.

What about defending the audit?

Many businesses own both operated and non-operated properties and may know firsthand the pain of being audited. Many audits progress amicably and with mutual understanding. Some companies with internal audit departments even perform them routinely. However, there are times when it is difficult to reach an understanding. To defend your position, AG-19 provides steps to navigate the process, but it can be helpful to hire an audit firm to perform additional research. An external audit firm can analyze the reported exceptions and supporting data to compare to COPAS guidelines which can help support your position.

Common Audit Exceptions

Reviewing common audit exceptions can be useful for both operators and non-operators to ensure operators or your own company are acting in accordance with COPAS guidelines. While COPAS provides clear guidelines for operator functions in typical circumstances, the JOA can be modified for any situation to best suit the parties involved. That is why it’s important to refer to the specific details in the JOA.

COPAS Overhead Recovery

Determining what is allowed to be a direct charge to the joint account and what is covered by the overhead rate can be challenging. Field offices are of particular concern, as they often carry administrative functions as well as the cost of engineers and other in-house technical employees.

Escalation can also be tricky. Operators typically use the correct overhead rate, as dictated in the JOA, but it is common to see rates that are not escalated properly. It is important for non-operators to understand their rights in this area. If operators do not escalate rates when allowed to do so, they can recuperate costs up to two years in arrears if the error is subsequently discovered.

Another area to watch is the proper use of drilling overhead rates and producing overhead rates. Although the rules of applicability are clear, the dollar difference in these two rates is often sizeable and can impact the recovery process. Operators should ensure that drilling rates are prorated for the days when active drilling or completion equipment is on site, while keeping in mind that there are several different accounting procedure templates with different rules as to how to calculate drilling and completion dates. Each individual JOA should be reviewed to understand the applicable rules.

Coding Errors

Coding errors are difficult to catch without performing a JIA, especially without knowing details of the current operations. Companies that operate many wells can easily miscode charges to the incorrect well.

Allocations

Allocations should be questioned if any aspect is misunderstood. Some common allocation areas include field offices, gathering systems, tank batteries and frac ponds. For major facilities, it is prudent to have a separately negotiated agreement for the operation of the facilities and equipment. Most JOA’s include these two main methods for these allocations:

1. Charged with rates commensurate with ownership. This is typically done with a calculation that factors operating expenses, insurance, taxes, depreciation and interest on investment. This often comes in a separate agreement. See COPAS AG-4 for an example.
2. Charge average commercial rates prevailing in the area, less 20%.

Make sure the joint account is not charged for anything that should be covered under the overhead rate. Examples include field office expenses, personnel and benefits costs, and other in-house drilling or completion costs.

Automotive equipment continues to be an area of common audit exception. Many operators have adopted a practice of allocating vehicle payments to wells, or just charging a flat fee. But standard JOAs typically recommend using specified rates, although modification to the method is allowable.

Internal Charges

Legal work and permits may relate to more than one property. If not allocated and charged 100% to one property, there is a risk that the charge does actually benefit more than one property and should be allocated.

Materials

When drilling and completing a well, you should expect to see credits for bits, casing and fuel. Typically the joint account is charged at 100% when the materials are purchased, but if not all materials are  used on a particular well, it is moved to the next well by the operator. Perfect forecasting of material needs is not possible, so credits are used to back out the excess materials purchased.

Pricing of materials is another aspect to review. COPAS guides how much can be charged for materials that are owned by the operator. An audit can help identify if any materials have been marked-up in ways that are not allowable.

Working Interest Percentages

Always review Joint Interest Billing Statements to ensure that the correct working interest is being used. Sometimes there are complex arrangements based on changing interests dealing with consents, before/after casing point, etc. It may be beneficial to perform a JIA under complex circumstances.

For questions about the join interest audit process, contact us. We are here to help.

Authored by Matt Federle, CPA, James Jones, CPA, and Tyler Martin, CPA.

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