Project Management in the Oil and Gas Industry

Time
Barrel oil per day
Figure 2.2 Production performance over project life time.

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Project Economic Analysis 43
for this equipment and the value of this depreciation is related to financial 
rules for the government who will tax you.
Assume you purchase a new car that costs 20,000 dollars now. The 
next year you want to sell it and, according to the market, its price value 
is 15,000 dollars. To be easy in calculation, you assume an equation for 
reducing the money from $20,000 to $15,000. But, what about in 2014? 
So you return to the financial department to ask the book value in that 
year. Assume the book value is $18,000 in 2012, but in the market it will 
cost $15,000. This will be a problem. In a private company this is not a 
problem, as you will be the loser. But for a government or public company, 
this will be a problem, especially in developing countries where the rules 
are very restricted, requiring that you sell the car based on the book value 
or higher.
There is usually a financial argument between the company’s finan-
cial department and the government’s taxes department as the depreciat-
ing value of the equipment will be deducted from the taxes. So the rate of 
depreciation is calculated by different methods, but any of these methods 
are used based on the government’s taxes, rules, and laws. The all common 
depreciation method will be illustrated.
2.2.1 Depreciation 
Methods
Capitalized items to depreciation include casing, tubing, flow lines, tanks, 
platforms, and the like. Tangible investments are basically related to any 
item that has a life in excess of one year.
Campbell, et al. (1987) mention that the depreciation write-offs depend 
on the type of expenditures. The law presently divides investment into two 
categories: five- and seven-year lives. The depreciation schedule for each 
project life is presented. The life year values under the 1987 laws in the 
USA are derived from a 200 percent declining balance over five years, often 
referred to as a 40 percent decline balance in Europe, and in Canada depre-
ciation in the seven-year category converts to a 28.6 percent declining 
balance in this area. The seven-year category covers virtually every petro-
leum investment except for drilling equipment (five years), oil refining 
equipment (ten years), and transmission pipeline and related equipment 
(fifteen years).
Depreciation begins when the project is classified as “ready for service.” 
The definition of ready of service varies among companies. Some define 
ready for service as capable of producing, while others require produc-
tion to actually take place before depreciation. Gas wells, for example, are 
often completed but not hooked up. Process plants take several years to 

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44 Project Management in the Oil and Gas Industry
build, start-up offshore platforms are constructed, and wells are drilled, but 
production cannot commence until the product is disposed of. The same 
situation exists in remote, onshore areas. Each example experiences a delay 
between the completion of the project from a technical perspective and the 
initial flow of revenue.
The question is whether a tangible investment that is capable of 
working, but not active, is ready for service and can be depreciated. 
Opinions and practice vary. Some argue that capable of working is the 
same as ready for service. Others take a more conservative position and 
begin depreciation only when sale begins. Decisions regarding the cor-
rect approach depend on the legal staff ’s opinion about what they can 
justify in court. The capable of working interpretation lowers the after 
tax cost of investment by beginning depreciation writes-off earlier. The 
various depreciation methods will be as follows for different industrial 
projects:
2.2.1.1 Straight-Line 
Method
The rate of depreciation is calculated by the following equation:
 
D
t
= (1/n) (C–SV),
(2.1)
where C equals original cost of capitalized investment, D
t
equals depre-
ciation in year, t, SV equals salvage value of capitalized investment, and N 
equals number of years of depreciation.
This method can be illustrated by the following example, where it is 
assumed that the value of the equipment after five years is equal to $10,000 
and this price is based on the value of the equipment at the sale after five 
years. 
It is worth mentioning that salvage value is usually taken to equal zero.
Depreciation rate per year = (50000–10000)/5 = $8,000.