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Abandonment Liability & Expense

As a well is producing, it is accruing an abandonment liability that has to be paid for later. Initially, this liability is zero. But during production, the abandonment expense is recorded for each month and the liability increases.

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This abandonment expense rate (AER) is determined by dividing the abandonment costs by the estimated life of the well. In most cases, the abandonment costs will be fully realized by the time the well is abandoned.

Abandonment expenses are not cash outflows for the financier. Rather, the cash outflow will occur when the financier decides to abandon the well.

Abandonment expenses, as they are being accrued, are valid expenses for tax calculations as the well is producing, even though no cash is actually being spent. When abandonment has been decided, the total abandonment cost is not applied in the tax calculations because it has been already deducted during the life of the well.

For example, a well in Ghawar has an estimated life of 200 OF Days. Its abandonment expense of $500,000 calculates an AER of $2,500 per OF Day of production. On its first day of production, the well will accrue $2,500 of liability. The $2,500 expense can be used to reduce taxes, even though no cash left the financier's account to pay for that expense. On the second day of production, another $2,500 is expensed out similarly, but the liability has increased to $5,000.

When this well is abandoned, either $500,000 will be removed from the financier's cash account or $500,000 is added to the loan he currently holds. The money will not be used to reduce taxes because it has already been expensed out over previous OF Days.

 
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