Our Solution Part IV

Allowing the producers to have their balance sheets bloated with assets that are never written down. And as a result, their income statements realizing only small portions of the real costs of capital incurred in the production process. Leaves the investors twisting in the wind waiting for a return of their capital from the industry. Although the bureaucrats may report profits. They really are just the gross margins of the producer firm. The actual overhead and the capital costs of the property are never moved to the income statement. The overhead of the producer is capitalized to the balance sheet and sits there for eternity to pass. The net result of this process is the producers look spectacularly effective in their operations. Their assets continue to grow as long as they spend. Their profits are high no matter what they do. However in terms of really producing anything of value, forget it. As the investors are now learning, oil and gas is a lost cause.

The focus of People, Ideas & Objects derision of this process has been squarely on the SEC and the public accounting firms. They want to relate to the world that they are cool and understand the sciences of geology and engineering. So they've come up with this contrived process of capitalizing everything that the producer does and recognizing almost nothing in terms of the annual depletion of its capital costs. But who is it to say that what they do is wrong? And what’s to say the manner in which People, Ideas & Objects calculates profits at the property is the more appropriate method of dealing with the costs of capital?

If you look at the average oil and gas producer. And yes I am making generalizations here. The producer is expending approximately one third of their asset base in current year capital expenditures. These capital costs are what are required to sustain and grow the deliverability of the firm. These are all being added to the asset classes on the balance sheet. In addition the accountants capitalize most, if not all, of the overhead that is incurred in the head office. You will then notice, that most producers, take approximately 6 - 10% of their asset base as their depletion for the year. These capital costs are moved to the income statement of the producer. Leaving the asset life approximately equivalent to the reserve life index of the reserves. In most cases the reserve life index is ten years and the assets on a simple mathematical basis would therefore also be written off in ten years. This is what the public accountants would say they are doing. Matching the capital costs of the business to the life of the business.

To whose benefit does this provide any value. In a capital intensive industry the oil and gas producer needs to deploy their capital effectively. When every producer capitalizes every dollar spent each year. How do you assess the effectiveness of their capital deployment? According to the accountants using their process, you need to look at the firm from the point of view of the capital assets life, or reserve life index, or in this example the ten years. I feel the horse has bolted from the barn and locking the gate is useless. Investors need to have a more timely gage in which to assess the capabilities of the management of the producer firm. I would also suggest that the assets at the ten year mark will probably sit for a while longer yet. I suggest that we look at what the costs that were incurred to maintain and expand the deliverability. That this cost in the current fiscal year is the cost of capital necessary to maintain and grow the deliverability of the firm. And is therefore a cost that is spent. That this cost has been expended and is irretrievable, and therefore should be expensed in the current fiscal year. Or in other words the size of the capital asset depletion should be the same or even much larger than what the amount is expended in the current year to maintain and grow the deliverability of the producer.

Only then, when the capital costs of the producer firm flow from the balance sheet to the income statement, can the investor assess the performance of the producer. It will become apparent quickly who is wasting money and who is building a sustainable firm. All of the producers will be passing large costs to their income statements each year. If they are unprofitable then they are not going to be in business for long. Something that we can not assess of the current crop of producers. If they are profitable then they are operating the firm in a manner that is consistent with good business practices. If this is done in the short term as suggested by People, Ideas & Objects method of accounting for all of the costs at the property level. Then the investor has the ability to make the assessment of the producers performance. And they will conclude, as I have, that the investor will need to stop subsidizing the oil and gas industry in terms of the prices that are received for the oil and gas commodities.

Measurement of a firms assets and the timing of their movement to the income statement is a key principle in accounting. I think the public accountants and the SEC have messed it up badly in oil and gas. Leading to the investment community essentially subsidizing the oil and gas consumer by funding the capital expenditure programs of producers with no expectation of any return on investment, ever. This has to change if the industry is going to approach the needs of society in the next 25 years. Undertaking the $40 trillion in investment that is alleged to be necessary with nothing but disgruntled investors is not going to do it. Sure investors sit on producers that are well capitalized in terms of their assets on the balance sheet. But they never make any real money. And at the end of the day, all that happens is that a new day begins with the bureaucrats who run this business. We need a change.

The Preliminary Specification and user community provides the oil and gas producer with the most dynamic, innovative, profitable and successful means of oil and gas operations. People, Ideas & Objects Revenue Model specifies the means in which investors can participate in these user defined software developments. Users are welcome to join me here. Together we can begin to meet the future demands for energy. And don't forget to join our network on Twitter @piobiz anyone can contact me at 403-200-2302 or email here. 

Our Solution Part III

The only way that producers are going to be able to make any money in this business for the next 25 years is if they institute some form of production allocation. The current business model that has the producer delivering all of their production to the marketplace will only continue to depress commodity markets. There will be no change in this situation until such time as the producers change. And as we have mentioned here many times before, bureaucracies can’t, won’t, will not ever change. There are many industries in which we can look too to prove this fact. Bureaucrats are the fundamental, necessary, precursor to creative destruction. Without bureaucrats nothing would ever die or otherwise fall apart.

Our solution provides, as an alternative, the industry wide capability to make decisions based on facts. To produce a property, or not, based on profitability. Something that no producer is able to provide in terms of the information they produce today. Ask a producer what it costs for a property in terms of its royalties, operations, overheads and a reasonable allocation of the capital cost and they will work for decades trying to find that factual information. None of them can. They can provide estimates of what the overheads were based on, which were allowances. But to know the actual overhead necessary to operate a specific property it is impossible for them to ever know in the current system.

Yet it is the overhead that they incur in developing their fixed administrative and accounting capabilities that cause them to have to produce everything that they can. It is the high throughput production model that needs to be operated at full productive capacity in order to ensure that all of the “high fixed cost machinery and organizations, variations and interruptions that leave significant overheads uncovered” are covered off. This business model has worked somewhat for the oil and gas industry when the oil and gas resources were scarce. Now that the oil and gas resources are in abundance, it is an absolute failure. What is needed is a new business model that takes the high fixed cost organization of the current producer and makes them the variable overhead cost of the Joint Operating Committee.

With the Preliminary Specifications decentralized production model. The industry will have a business model capable of dealing with the abundance brought about by shale. Employing a production allocation methodology based on profits is a fair and equitable means of determining who can produce and where. The decentralized production model ensures that the entire industry is employed in profitable operations. And employed in real profitable operations. Not the gross margins of revenue less royalties and operating costs that are claimed by bureaucrats these days. Profits based on the revenues less royalties, operating costs, actual overheads and the real capital costs of the production. Real profits, not gross margins the bureaucrats try to get away with today.

It is on this basis of accounting for the actual costs of operations that our business model, the decentralized production model, provides $5.7 trillion dollars in additional profits over the next 25 years. A bold claim, and one that can be verified by reading this blog and the Preliminary Specification, and understanding how it is different. A new way for the industry to operate. One in which the future investors, whoever they may be, will actually have with that promise of higher profits, and because we include the cost of capital in determining the cost of production, their investment in the industry returned to them as well. Currently producers are using accounting methods designed by the SEC and public accountants that allow the balance sheets to be bloated and the income statements to never see any of the real costs of capital. Leaving the current oil and gas investors to wonder when it is that they will ever get profits or even their investments back.

The Preliminary Specification and user community provides the oil and gas producer with the most dynamic, innovative, profitable and successful means of oil and gas operations. People, Ideas & Objects Revenue Model specifies the means in which investors can participate in these user defined software developments. Users are welcome to join me here. Together we can begin to meet the future demands for energy. And don't forget to join our network on Twitter @piobiz anyone can contact me at 403-200-2302 or email here. 

Our Solution Part II

Our user community will be the key to the quality of our software and service solution. There is much work to be done to take the Preliminary Specification and define the software that will be used by the industry. It is this work that the user community will undertake. The detailed work of determining what is needed in order to ensure all of the producers processes are covered off and managed in an effective way. This work will require the full understanding of the industry and involve the estimated 3,000 members of the user community. Taking what they know about the industry, designing new software to define and support the work that they will do in the new oil and gas industry.

It will also be the user community that provides the foundation and entrepreneurial spirit behind our service providers. It will be our users who will form these service provider firms on an exclusive basis. Using their understanding of what they’ve developed in terms of the software processes and the need to manage these processes by their people. It will be their opportunity to build a service based organization to provide the services and software to the producer firms. This will be done under license and provide the service provider with the exclusive rights to the domain of the process they manage.

Therefore from a producer point of view the difference between the way in which the industry is operated today and the way it is done in the future will be significant. First they will no longer have any of the administrative or accounting people on staff as direct employees. This allows them to be freed from the fixed costs of the overhead that is currently causing them to lose money. It also relieves them from having to build the administrative and accounting capabilities needed to operate within the industry. Producers can then acquire these capabilities from the service providers on an as needed basis, based on production at each individual Joint Operating Committee. And it will be the service providers focus on specialization, the division of labor, control of the development of the software and automation of the processes that will enable them to provide the producers with better and more cost effective services than what the producers were able to build themselves prior to the industry changing to the Preliminary Specifications decentralized production model.

It is this change from the reliance on the producers administrative and accounting capabilities to a reliance on the industry based administrative and accounting capabilities that provides the production flexibility needed in the shale era. When a property falls below the marginal cost to produce. Then it can be shut-in without penalty to the producer firm. It will actually be of financial and long term benefit to the producer to shut-in their unprofitable production. Their firm will perform financially better, with only profitable operations being produced and none of these being diluted by unprofitable operations. The reserves will also be held for a time in which they can be produced profitably. And of course the commodity markets will have less of the commodity in the marketplace, leading to overall higher commodity prices. A win-win situation that occurs due to the fact that when the production is shut-in no operating costs, no royalties and no overhead will be incurred by the property. Only the costs of capital are uncovered during times when properties are shut-in.

It is the service providers competitive advantage to provide a quality service to the producer. This will be in the minds of the users when they are in development of the software that will be derived from the Preliminary Specification. How can they make this environment, where they are building the industry based administrative and accounting based capabilities, far better for the producer firm? By using specialization and the division of labor, control of the software development and automation of the processes they manage. The user community participant and service providers will be able to develop far more significant value than what each individual producer is able to generate within the constraints of providing the administrative and accounting capabilities themselves.

The Preliminary Specification and user community provides the oil and gas producer with the most dynamic, innovative, profitable and successful means of oil and gas operations. People, Ideas & Objects Revenue Model specifies the means in which investors can participate in these user defined software developments. Users are welcome to join me here. Together we can begin to meet the future demands for energy. And don't forget to join our network on Twitter @piobiz anyone can contact me at 403-200-2302 or email here. 

Our Solution

Members of the user community will provide the oil and gas industry with a solution to the issues that I so frustratingly discussed yesterday. We will have changed the manner in which the producers are able to manage their operations so that each property can be engaged based on its optimal strategy. And only if it is profitable. The producers will be able to do what is in the best interests of the property and their shareholders, whoever they may be. A change from the focus on increasing production at all costs. To a focus on increasing profitable operations. Specifically we are moving away from the high throughput production model to the decentralized production model of the Preliminary Specification. In Professor Richard Langlois writings he has described the decentralized production model as follows.

In a world of decentralized production, most costs are variable costs; so, when variations or interruptions in product flow interfere with output, costs decline more or less in line with revenues. But when high-throughput production is accomplished by means of high-fixed-cost machinery and organization, variations and interruptions leave significant overheads uncovered. p.58

We have applied the decentralized production model to the oil and gas industry in the following manner. In order to make the overhead costs of the property variable. We have to turn the fixed overhead of the producer into the variable overhead cost of the Joint Operating Committee. It will be in this way that when the property is shut-in, due to its inability to earn a profit in a low commodity priced environment, the property will be able to incur no overhead in the Joint Operating Committee or the producer firm. And when we talk about the overhead we are talking about all the administrative and accounting costs incurred to own and operate the property. We do this by stripping the prototypical producer down to the C class executives, the earth science and engineering resources, some land and legal, and support staff. The administrative and accounting resources are then reorganized into service providers who focus on a process or subprocess and use the entire industry as their client base. Therefore when the property is shut-in no activity in the property is incurred and no administrative or accounting resources of the service providers are used during the month when production is shut-in, and therefore each of the service providers generate no billing or charges for that property.

The property then incurs a null operation. No profit and no loss from operations. And the producers other profitable properties will not be eroded by losses on the poorly performing properties. The commodity markets have less of the commodity on hand, raising prices to the marginal price. And the producer doesn't have to make up for the properties current losses from future operations. Making the Preliminary Specifications decentralized production model the most profitable means of oil and gas operations. Any producer that continues to produce unprofitable properties will be dealt with by the investment community. As there will be no justifiable reason to continue to do so.

This structural change in the way that the industry operates will provide the flexibility in terms of the industries production profile in both oil and gas. With high cost shale being as prolific as it is today it is necessary to ensure that this flexibility is afforded the dynamic, innovative and profitable oil and gas producer. The ability to overwhelm the markets with flush production from the shale formations has shown the capability to collapse both the oil and natural gas commodity market spaces. This is unfortunate and a reflection of the elasticity of supply and demand of the commodities. With little excess demand or supply of the commodity in the market, the price of the commodity reacts significantly. Therefore any overproduction must be mitigated before the price declines precipitously. Creating a means to allocate production amongst independent producers will only lead to difficulties if it is not seen as being fair and reasonable. And the only reasonable and fair method of allocating production in an environment such as the oil or gas industry is on the basis of profitability of the property itself. And the only way that we are going to be able to implement that method is through the adoption of the Preliminary Specifications decentralized production model.

The Preliminary Specification and user community provides the oil and gas producer with the most dynamic, innovative, profitable and successful means of oil and gas operations. People, Ideas & Objects Revenue Model specifies the means in which investors can participate in these user defined software developments. Users are welcome to join me here. Together we can begin to meet the future demands for energy. And don't forget to join our network on Twitter @piobiz anyone can contact me at 403-200-2302 or email here.