On July 31st, 2018, ConocoPhillips released its second quarter 2018 10-Q, which was filed with the Securities and Exchange Commission (SEC).
A couple weeks later, the Legislative Research group released a table which showed the production levels and net income that the ConocoPhillips filing reported.
The table also included a statistic in which the total net income was divided by the barrels of oil equivalent from the reported regions. The result was a statistic that showed Alaska as having much higher net income per BOE than other regions around the world.
The picture is hard to read, so I’ll re-print them in a table:
|Net Income Per BOE (2Q 2018)|
|Asia Pacific / Middle East||$13.63|
This table appears to be an update from a requested report that was published May 1, 2018.
Shortly after publishing, some people began citing this statistic as evidence that ConocoPhillips is making excessive profits in Alaska. Let’s take a closer look.
Confirming the Statistic
Before evaluating if the conclusion is supported by the data, let’s make sure the numbers are right. For brevity, I’ll only look at Alaska and the L48 numbers.
Here are my calculations:
|Production Rate per Day||185,000||387,000|
|Days||x 91||x 91|
|Total BOE||= 16,835,000||= 35,217,000|
|$/BOE||= $24.83||= $11.64|
|Source: ConocoPhillips 2Q 2018 10-Q SEC Filing pages 45 and 46|
I am pretty sure the numbers are off because Leg Research used 90 days to calculate the total BOE. There are actually 91 days in the second quarter. An honest mistake, but it doesn’t really change the conclusion.
Alaska does yield the highest net income per barrel of oil equivalent in ConocoPhillips’ portfolio. But that is not the same thing as what people allege.
Understanding the Metric
To ensure this measure is being correctly interpreted, we need to understand what it means. There are two parts to the metric that need clarification. First, we need to know what “net income” means. Second, we need to understand what “barrels of oil equivalent” are.
Different Measures of Making Money
The term “net income” comes from accounting books. It is often confused with the terms “profits” and “positive cash flows.” This might sound like semantics to non-economists, but it has very real implications in business.
Let’s look at a simple example.
Let’s say you do buy a piece of machinery for $1,000 today. You rent this thing out at a rate of $50 per month. To keep this simple, assume you earn exactly $50 per month, on the first of every month. And let’s assume that it can only run for 2 years, then it breaks down beyond repair.
This is what your cash flow looks like:
|Year||Net Cash Flow|
Notice that you lost money in 2018, as you paid for the machine. Next year you will make $600 in positive cash flow. But you probably realize that you haven’t earned enough to cover your initial investment yet.
That’s the difference between cash flows and profits. You won’t make a profit until 2020.
It’s probably easy to see how a disagreement about how “profitable” your business is can arise. Someone observing you would say “you made $600 profit in 2019!” And you would say “I did not! I haven’t made a cent from this business yet!”
Net Income is a little different. It’s an accounting concept used to keep your books balanced and to pay your taxes.
Basically the concept is that the machine has resale value. But, as you use the machine, its resale value decreases. Let’s use a simple straight-line depreciation schedule here, over the 24 months of life.
|Date||Asset Value||Lost Asset Value||Cash Flow||Net Income|
From an accounting perspective, your cash outlay today is offset by the value of the asset you received in exchange.
So, even though you shelled out $1,000 in cash, your net income is zero this year. And every month in the future, your accounting ledger will show a $8.33 net income, even though your bank account will show $50 deposits.
It will never tell you if you’ve actually made a profit.
To understand what net income means in the context of ConocoPhillips, let’s look at how it is calculated. The quarterly SEC reports don’t break down the numbers, but the annual reports do. So let’s look at the 2017 filing.
Here is what I find for Alaska and the L48.
|Direct Costs (Not Including Capitalized Costs)||-$1,113||-$2,378|
|Net Cash Flow Before Taxes||$1,741||$2,179|
|Taxes other than Income Taxes||-$275||-$318|
|Net Income Taxes (Federal and State)||$678||$2,424|
|After Tax Cash Flow||$2,144||$4,285|
|Net Accounting Income||$1,235||-$2,369|
The biggest driver of the accounting loss in the L48 is depreciation and impairments (basically write-offs for projects that are abandoned).
Why are these categories so much higher in the L48? Because that is where the company has been spending its money. Depreciation in Alaska is lower because most of the assets are over 30 years old and fully depreciated.
If you don’t include the depreciation and impairments, the L48 starts looking a whole lot better.
Breakdown by BOE
Let’s convert these figures to BOE, just for fun. Then I’ll explain what that even means.
|Direct Costs (Not Including Capitalized Costs)||-$16.75||-$16.33|
|Net Cash Flow Before Taxes||$26.21||$14.96|
|Taxes other than Income Taxes||-$4.14||-$2.18|
|Net Income Taxes (Federal and State)||$10.21||$16.64|
|After Tax Cash Flow||$32.27||$29.42|
|Net Accounting Income||$18.59||-$16.27|
Note that the price per barrel is much higher in Alaska than in the L48. This is because ConocoPhillips doesn’t really have natural gas production in Alaska. Since the L48 production count includes a lower value product, it dilutes the value of the BOE.
You might also notice that taxes per BOE are higher in Alaska than in the L48. But mostly you should note that it’s those past costs that are being written down that gives the impression Alaska is more “profitable.”
Barrels of Oil Equivalent
Crude oil is a liquid. We talk about volumes of crude oil in 42 gallon increments, which we call a barrel.
Natural gas is, well, a gas. Because a gas can compress, we need to standardize what we are talking about. So we measure natural gas as the space it consumes at 60 degrees Fahrenheit and standard atmospheric pressure. We talk about volumes of natural gas in increments of thousand cubic feet.
As an energy company, it’s common to talk about all your production as a single number. That’s where the barrel of oil equivalent comes in.
In order to convert natural gas production into something we can combine with oil production numbers, we translate natural gas volumes by the equivalent amount of energy each contains.
When you do the math, it takes about six-thousand cubic feet of natural gas to equal the energy that exists in 42 gallons of crude oil.
Energy Equivalence vs Price Equivalence
ConocoPhillips reported earning $53.33 for a barrel of Alaska Crude, but they had to pay $10.63 to get it to market. This netted them $42.70 in oil revenue for each barrel of production.
In the L48, they reported earning $43.36 per barrel. And the production was already at the market.
In contrast, they report earning $2.73 per thousand cubic feet of natural gas. Since there are 6 thousand cubic feet in a barrel of oil equivalent, one BOE of natural gas is worth $16.38. In other words, oil production is nearly 3 times as valuable.
About 38% of ConocoPhillips’ production in the L48 was natural gas. Less than 1% of its Alaska production was. By combining the much lower value of the natural gas with the higher value crude oil, we end up with a number that doesn’t mean a whole lot.
BOE is a measure of energy equivalence. So, when we talk about things related to money in terms of BOE, it’s not a very useful statistic.
It is often tempting to compare things. But sometimes comparing apples and oranges isn’t really fair.
Think about the way Dollars/BOE is being used here. It would be a little like converting apples to orange equivalents based on juice content. Then comparing the price per orange equivalent. What would that even tell you? The price per juice content of fruit? Ok, thanks. If I want orange juice, I’m still buying oranges.
Or maybe you decide that a motorcycle is superior to a car based on miles per gallon of fuel consumption. Sure, it is superior – but only on that basis. That comparison tells you nothing about safety, or the ability to transport children.
That’s the problem we have here. Yes, Alaska provides the best net income per barrel of oil equivalent. But what does that even mean?
Should ConocoPhillips abandon their low margin gas production in order to bump up its average net income per BOE? No. That would be foolish.
Should it stop investing in the L48 so that its depreciation stops dragging down the average value per BOE? Of course not.
It is true that Alaska generated the highest net income per barrel of oil equivalent during 2Q 2018. But that says nothing about how profitable Alaska is. And it says even less about whether or not the tax system needs to be changed.
But it does raise an interesting question. Are the companies making too much money in Alaska?
That’s something I can take an objective look at. My first analysis on the topic said, “probably not.” But I’ll take another look.