COPAS Accounting Procedure A new direction By E.M. “Terraine” Wilson AAPL COPAS Liaison A new accounting procedure form was approved by COPAS last fall and is now available from Kraftbilt for use with operating agreements for joint ventures. COPAS-1995 is structured quite differently from prior forms and will require some adjustments in both the negotiation and administration of agreements which use it. The most obvious change in this form is the inclusion of a “FIXED RATE” option for the operator to charge the joint account to operate the property. If chosen, this fee will be negotiated by the parties and then applied based on the number of active completions on the joint property each month. Active completions for this purpose are defined as those that would qualify for application of producing overhead if the “cost” method were chosen. The fixed rate is in lieu of charges that would generally fall in the category of “routine operating costs.” The intent is to cover the vast majority of the ongoing operations that are fairly stable over the months and years. The “non-routine” operations excluded from the rate are defined by the agreement as: • • • • Royalty Payments and Production/Severance Taxes – Since these costs are based on production rates, they can vary significantly; therefore, setting a fixed rate to include these costs would be unrealistic. Ad Valorem Taxes – investment and tax rate changes as well as the requirement to bill individual parties based on the tax value generated by their interests in some instances cause these costs to be a legitimate exclusion from a fix rate. Controllable Materials - This exclusion is driven by the need to maintain records of the assets and to properly identify ownership when their disposition is at hand. Downhole Well Work – Although some would argue that certain downhole work is “routine” and predictable, determining an appropriate and describable separation between such activity and the “non-routine” proves to be a formidable challenge. To avoid such debates and any temptation for the operator to neglect wells under this agreement to the favor of those where such costs are chargeable, all downhole work was excluded from the fixed rate. Drill Wells and Projects I- Drill wells and projects that qualify for major construction or catastrophe overhead application are clearly “non-routine” and are therefore excluded from the fixed rate. • If these costs are excluded from the rate, the question of the moment then becomes: “How are these costs recouped by the operator?” To solve that, the agreement requires the use of the provisions of the second option titled “COSTS.” At first glance, these provisions appear to be the same provisions as included in prior COPAS accounting procedure forms. A closer look, however, proves that impression to be in error. The most significant difference between the COSTS methodology of COPAS-1995 and the provisions of the prior COPAS forms is the means of determining how costs are recouped, i.e., via direct charges, allocations or an overhead charge. In prior forms, the determining factor is the function that gives rise to the cost. Accounting functions, for example, are overhead, and compressor maintenance functions are directly chargeable. In contrast, COPAS-1995 uses location as the primary determining factor. If the cost is incurred on the joint property, it is directly chargeable; if incurred off the joint property, it may be allocated or covered by the overhead rates, depending on part on how the parties negotiate the agreement. Key to the administration of this concept are the definitions of “joint property” and “joint operations.” A discussion of these definitions and some of the major provisions should help further your understanding of COPAS-1995. • Joint Operations – means activities required to handle specific operating conditions and problems for the exploration, development, production, protection, maintenance, abandonment and restoration of the joint property. This is intended to encompass all the activities that are necessary to operate a property from inception to abandonment but to exclude superfluous activities such as media visits to a showcase operation or general information gathering at the location by management or other visitors. With a clear understanding of this definition, the requirement that costs be incurred in the conduct of joint operations takes on a new meaning when compared to the prior COPAS forms. The next step is to determine where such costs were incurred. • Joint Property – means the real and personal property subject to the agreement to which the accounting procedure is attached. This includes not only the real estate and minerals owned or leased by the parties but materials and equipment governed by the agreement as well. Therefore, a facility or piece of treating equipment to be installed under the agreement is “joint property” just as the well and minerals governed by the agreement are. Costs incurred on the joint property, then, would not only be such things as the testing of a well repair of a separator, construction of a flowline which we normally consider a direct charge, but also onshore fabrication of a platform for use offshore and equipment repair or tubular inspection at the vendor’s location. • Labor – With the two preceding definitions in mind, consider the options available to the operator for organizing to meet operational needs. If the real property is large with many wells and complicated additional recovery operations, it may be desirable to have engineers and geologist located on the joint property with responsibilities focused exclusively on that joint property. Under COPAS-1995, that organizational structure can be accommodated with the engineers and geologists charged directly to the joint account. The operator is then assured of the recovery of the cost instead of relying on a negotiated overhead rate for reimbursement. If, on the other hand, the property is small and uncomplicated, a shared group of engineers and geologists located in an office away from the joint property may make more sense. In that case, the parties have an option of covering those costs via the overhead rate (similar to prior forms) or naming the office as an offsite facility chargeable to the joint account on a negotiated basis. Of course engineers and geologists are not the only employees that may be located either on or off the joint property. If the employees are engaged in activities that are necessary to the operation of the property, they would be considered “in the conduct of joint operations,” and the method for charging, therefore, would be dependent on their physical location when the costs were incurred. As a final note on labor, we should be aware that labor-related costs (i.e., benefits, governmentally assessed charges, travel expenses, training, etc.) follow the labor charges. While this concept is not new, there are a couple of changes worth mentioning. Training is limited to that mandated by government to minimize disputes on its benefit to the joint account, and employee benefits will be charged at the COPAS recommended percentage of labor charges rather than using that recommendation as a cap on actual charges. Both of these changes are directed toward simplifying administration and reducing audit exceptions. • Materials and Services – Similar to the labor charges, materials and services used “on the joint property in the conduct of joint operations” are directly chargeable to the joint account, while those used elsewhere may be recouped through overhead or charged under one of the “off the joint property” provisions depending on where they were actually used and the elections negotiated by the parties. “Off the Joint Property” – Costs incurred at locations that do not fit the definition of joint property may be charged to the joint account if they are incurred “in the conduct of joint operations” and fall into the category of “facilities,” “ecological and environmental,” “legal expense,” “training” or “engineering, design and drafting.” Further explanation of these categories will be helpful. Facilities – The form subdivides this section into two types of facilities. Provisions for production handling facilities allow more latitude for the operator to determine how these will be charged to the joint account while procedures for other facilities are much more stringently prescribed. Since use of production handling facilities and bases for sharing their costs are less likely to be disputed by the parties and seldom give rise to audit exceptions that cause significant difficulties, the operator is free to allocate their costs on an “equitable and consistent basis” or charge average commercial rates unless the parties list the types of facilities and negotiate fixed rates for those services. Other facilities are another matter altogether. These can be anything from a communications system or shorebase to a home office. Therefore, the form requires that they be identified and a basis for charges agreed upon, if not when the agreement is negotiated, then by amendment or separate agreement. There are three options defining methodologies that may be used for these other facilities; the parties must agree on a methodology for each type of facility. For some types of facilities, the parties may allow the operator to allocate the actual costs, but the basis of the allocation is specified. In other cases, the parties may agree on a fixed rate or the use of average commercial rates. In any case, the key here is to list the type of facility and choose a methodology; otherwise no charges will be allowed for that type of facility until agreement is reached. Any “facilities” identified after negotiation of the JOA would require an amendment to the COPAS exhibit or a separate facility agreement. Ecological and Environmental – Any such costs (e.g., surveys and spill cleanup) that occur on the joint property obviously would be chargeable as labor, materials, services, etc. incurred “on the joint property” under the provisions of this form. Those that are incurred “off the joint property,” however, may be allocated directly to the joint account or covered by the overhead rates depending on the election negotiated by the parties in this provision. • • • • • Legal Expenses – Since virtually all such expenses are incurred off the joint property, this provision remains very much the same as in prior COPAS forms. One change should be noted, however. Title examinations and curative work have been specifically added as chargeable items under the 1995 form. Training – Since it is not always possible or practical to hold all required training at the joint property location, this provision allows the operator to charge the same types of costs for government mandated training whether incurred on or off the joint property. Engineering, Design and Drafting – The major construction overhead provisions of this form are almost identical to those of the COPAS 1986 Offshore form which includes an option for charging these costs, associated with a project, directly to the joint account. To accommodate that option, therefore, provisions were included in this section to allow such chargers only when that construction overhead option is selected. Overhead - Although very few changes have been made to the working of this section, it is important to recognize that the relationship of the overhead provisions to the other sections has changed somewhat. Options have been added (e.g., ecological and environmental) and the criteria for determining what is in overhead have changed from a functional to a location basis. Percentage basis overhead is still included for those who prefer that methodology, and it remains virtually unchanged. In the fixed rate provisions, shut-in gas wells have been removed from the list of wells qualifying for overhead application, and specific reference has been added to qualify source water wells for overhead charges. While overhead for source water wells is not a conceptual change for most of us, it does clarify an issue which has occasionally given rise to debate among parties. The major construction and catastrophe overhead provisions have been combined, and the sliding scale application of the percentages has been removed. This should simplify administration and audit of these charges. • Material Pricing – A number of changes have been made to this section that deal with some of the more difficult issues associated with the pricing of transferred materials and equipment. The first change is the addition of definitions for direct purchases and transfers. These additions are directed toward reducing abuses caused by some operators moving all materials through a stocking point and repricing all movements as transfers. Specific language dealing with vendor stocking programs clearly states that this method of procurement is to be considered a direct purchase, not a transfer; therefore, pricing must be the actual cost of that material. Another change is the listing of several methodologies that may be followed to price material transferred to the joint property by the operator. All are designed to better reflect the true market value of the material at the time of transfer. Included in the list is the COPAS Computerized Equipment Pricing System (CEPS) which is maintained by a dedicated committee of materials experts to comply as closely as possible with the requirements of the COPAS Accounting Procedure forms. Another method is to use published prices adjusted by the COPAS HPM. • • (Historical Price Multiplier – factors developed and published periodically by COPAS to modify posted prices to reflect realistic acquisition cost of materials.) Also allowed are price quotations from vendors or historical purchase prices, provided they reflect a realistic current acquisition cost. The final possibility is for the parties to agree on the pricing basis. In all of the COPAS forms since the very first in 1962, the percentages specified to adjust re-priced materials for the condition of those materials has been fixed at 75 percent for good used materials and 50 percent for those requiring repair. COPAS has been working on a methodology to change those percentages based on the current market conditions. Although that effort is not yet completed, the drafting committee recognized that those percentages may change at any time it becomes evident that the markets have sufficiently changed and COPAS approves new adjustment factors. COPAS-1995, therefore, has included reference to the most recent COPAS recommended percentages instead of providing fixed adjustments as in the past. In another effort to streamline the administration of the joint account without significant loss of control by the non-operators, the new form allows the operator to dispose of surplus equipment without approval if the sales value does not exceed the expenditure limit in the body of the agreement to which the COPAS form is attached. • Inventories – Responsibilities of the parties in relation to the taking of, as well as paying for, inventories have been clarified. A majority of non-operators may now direct the operator to take a physical inventory, but no more often than every 5 years. In addition, inventories may be taken whenever there is a change of operator or other working interest. These are chargeable to the joint account; however, those conducted at the operator’s discretion or by a non-operator must be absorbed by the party conducting the inventory. While there are other changes in the provisions governing whether and how costs are to be charged to the joint account, the preceding paragraphs cover the more significant ones and should provide the reader an overview of the new form’s provisions in that regard. A number of changes have also been included to streamline the administration of the billing, audit and adjustment provisions. Billing – Two changes worth mentioning here concern the ability to advance bill and the interest rate for delinquencies. Advance billing is only allowed if the succeeding month’s expenditures are expected to total more than a specified amount. That amount is negotiated by the parties and inserted in the provision. This is intended to eliminate the small advances which generally cause more paperwork than they are worth. The delinquency interest rate has been designated as the three-month Treasury Bill’s rate plus 3 percent instead of a bank’s prime rate plus 1 percent. T-Bill rates are well-known and easily determined, and their use eliminates the need to agree on a bank. Audits – The audit provisions have been expanded considerably to include specific language concerning the resolution process and penalties for noncompliance with the provisions. An auditor must provide the formal audit report • • within 180 days after completion of the field work, and the operator must furnish a response to that report within 180 days after its receipt. If those timelines are not met by either party, penalties are specified for each: the auditor loses the right to take exception to any charge billed within the period audited; the operator must pay interest form the date of the audit report on any exceptions that are ultimately granted. Rebuttals and responses to rebuttals must be provided within 90 days; failure, by either the auditor or operator, to meet these timelines will result in resolution of the exception in resolution of the exception in the other’s favor. Any exceptions remaining open for at lease 18 months may be taken to an audit resolution conference which may be called by the lead audit company or the operator. To give weight to this provision, any parties failing to attend will be bound by any decisions reached at the conference. COPAS-1995 also addresses the issue of charges for the operator’s affiliates by placing some boundaries on the charges and providing an option for non-operator audit rights. • Rate Adjustments – As probably evident by now, it is possible to have several more rates in this agreement than we may be accustomed to negotiating. To provide a means to keep these rates in line with costs, the form utilizes an automatic annual adjustment based on a COPAS recommended factor and the possibility of recalculating costs periodically. The provision for automatic adjustment uses a mechanism similar to the automatic overhead rate adjustment familiar to the users of other COPAS forms. However, since there are rates to cover field operations (FIXED RATE method, or facilities) as well as those to cover overhead, one specified rate is not appropriate. Therefore, reference is simply made to the percentage increase or decrease recommended by COPAS for the rate. This will allow COPAS to locate one or several measures to use as best corresponds to the rates to be adjusted. Since the operator is free to structure operations as best suits the needs of its entire organization, determining chargeable costs by physical location makes it more important than ever to provide a means to adjust rates to acknowledge changes in organizational structure. This is accomplished in COPAS-1995 by providing the operator the unilateral authority to recalculate the cost for any of the rates as often as every two years. The calculation is to be done in accordance with COPAS recommendations (or such other procedures as approved by the parties) and the new rate is subject to approval by vote of the parties. In addition, if a majority of the non-operators have factual data to support a challenge to the operator’s rate(s), the operator must recalculate the challenged rate(s). To avoid abuse of this provision, however, no rate may be challenged more often than once every four years. The calculation methodology and approval process is the same as in the operator-initiated revision. Voting Procedure – Approval of these rates as well as other items in the accounting procedure which require agreement of the parties must be secured in accordance with a revised approval provision. This provision is similar to those found in the body of many joint operating agreements as it requires a certain number of parties with a certain combined percentage interest to approve. Blanks are provided for the parties to negotiate the number and percentage requirements. • Consideration should be given to whether these should be completed in conformity with the body of the agreement or to allow different voting for accounting issues. In addition, the wording in the body of the agreement should be reviewed to ensure that this provision is operable. Summary Definitions The definitions of joint property and joint operations are even more important in this form than in previous COPAS forms because of the significance of the location in determining whether an item of cost is chargeable to the joint account. To avoid charges for personnel located physically on the joint property but not serving any real purpose for the joint account, a good understanding of these terms is needed. It is important for the negotiating parties to recognize the significance of these terms and the application of those provisions that depend on their definitions. Affiliates The new provisions specifically addressing the use of operator’s affiliates will also require some special attention by the parties during negotiation, as well as by the operator once the agreement is executed. If audits are agreed to be allowed, agreement by the affiliate will be required. This probably a change from an operator’s normal procedures and may require special attention to accomplish. In addition, it should be noted that an affiliate’s services or materials may not exceed an average commercial rate. Again, this is not always a test in today’s industry and may require some adjustments in procedures to comply with these terms. Amendment of Rates Here is one of the most important provisions to work through during the negotiation. Without a sound basis of understanding of the operator’s rates and what they cover, it may be difficult to secure any adjustments during the life of the agreement other than application of the annual COPAS adjustment factor. The rate amendment provisions require a calculation of the rates to justify any changes proposed (either by the operator or non-operator) if one is needed beyond the usual COPAS adjustment factor. Without an understanding of the initial determination of the rate, therefore, it would be difficult to ascertain whether the proposed change is justified. Serious consideration should also be given to the voting procedure to make the best effort possible to avoid deadlocks when new rates come for vote and to resolve any conflict that may exist between the accounting procedure and the body of the agreement. Application of Sections Covering “On” and “Off” the Joint Property When the FIXED RATE is not selected (and when items of cost outside the FIXED RATE are to be accounted for), it is important to understand the application of the two sections of direct costs. “On the joint property” means physically located there. Note, however the definition of “joint property” includes more than just the real estate subject to the JOA. For example, a compressor skid or an offshore platform are also joint property within this definition; therefore, personnel working at the site of the construction of either of these items would be “on the joint property.” “Off the joint property” means physically located at a site where no joint property (in the context of that defined term) is located. The most common such cost may be production facilities, but it is important not to forget the “other facilities.” They can be whatever the operator identifies as a cost center that should be shared by the joint account, but the other parties must agree to the methodology for their charges. Negotiating the terms For this agreement more than any other COPAS form, it is very important that the parties develop an understanding of the operator’s accounting procedures, particularly pertaining to costs incurred “off the joint property,” and of the elements included in any fixed rates negotiated (FIXED RATE, overhead, or facility rates). This is critical because of the rate amendment provisions. There are also a number of subtle changes in the way accounting will need to be accomplished because of the basic concept of location driving the determination of chargeable costs incurred by the operator. With this form, we not longer need to worry about categories of labor or functions being performed; it now matters where the cost is incurred. As a result, the non-operators must understand the operator’s organization and how that impacts the charges that will be made directly to the joint account as “on the joint property,” those allocated or charged via fees to the joint account as “off the joint property,” and those that will be covered by the overhead rates. The operator also may have some adjustments to make in accounting systems and personnel orientation to handle the new charging schemes provided in this form. COPAS is recommending the COPAS-1995 for consideration by the industry as an alternative to the COPAS-1984 Onshore and COPAS-1986 Offshore forms. Although it may cause some adjustments in the operator’s procedures and in the negotiation effort required of all parties, it includes a number of improvements designed to streamline the accounting and auditing associated with the joint account and provide a better means of cost recovery for the operator without the non-operator losing reasonable control over those costs. Copies of the COPAS-1995 Accounting Procedure may be secured by writing Kraftbilt, P.O. Box 800, Tulsa, OK 74101-0800 or by calling toll-free 1-800-331-7290 or by fax at 918627-7138 and requesting order #601-95. The interpretive bulletin for the form is nearing completion and is expected to be available through Kraftbilt by year end.