Advances in technology and efficiency of U.S. oil and natural gas have led to significant increases in production, and with that, additional accounting challenges for well owners.
Because gas wells produce at sometimes unpredictable rates, and are influenced by market fluctuations, imbalances in production can occur. This is further complicated by the ownership of oil and gas production fields and wells, which is often shared by multiple parties.
In order to account for multiparty ownership and production fluctuations, owners will often enter into gas balancing contracts. Gas balancing helps to keep production of an oil well flexible while still accounting for situations in which a site has over- or underproduced in a given time period, such as a month or quarter, or when one owner has sold more of a share of the gas stream than other owners. These situations are referred to as pipeline imbalances and producer imbalances.
“Gas balancing keeps production flexible while still accounting for over- or underproduction.”
Pipeline imbalance
Often, well owners will enter into sales contracts guaranteeing future production that might not match actual production. This may occur because market fluctuations necessitate slowing production below what was initially scheduled or because weather or other site conditions meant the well could not produce at its normal rate. When the wells produce more or less than the amount sold, these production changes are called pipeline imbalances and can be recorded on a daily or hourly basis. However, they may be settled on a monthly or quarterly basis depending on the specifics of the gas balancing agreement.
Producer imbalance
In situations of multiparty ownership, co-owners of properties producing natural gas have a right to their percentage of the gas produced by the well. This may be determined based on gross working interest, royalty interest, proportionate production interest or net working interest. Often, once actual production has been determined, records may indicate owners sold more or less of the product than they were entitled to. This is called producer imbalance and is usually reported by the operator of the production facility to the interest owners.
Accounting for balance
While these two situations are handled differently for accounting purposes, both result in an owner not receiving his or her proportionate share of the gas production of the site, otherwise known as a gas imbalance. In an imbalance, one or more owners may have received an underproduced share or one or more owners will have received an overproduced share. Typically, the gas balancing agreement will then be used to dictate how these imbalances will be reconciled, with the overproducers making payments to the underproducers either in the form of future gas production or the exchange of cash.
Often, owners don’t consider these fluctuations to be income. These numbers often change on a monthly basis and may simply be thought of as numbers on a balance sheet. However, for tax reporting purposes, the IRS considers changes in monthly imbalances from year to year to be taxable income or expense.
“Gas balancing dictates how production imbalances will be reconciled between owners.”
These situations then present additional challenges when it comes to reporting to the IRS. The federal agency requires consistent methods be used for reporting income from gas sales when imbalances occurred, which means gas well owners must use the cumulative gas balancing method for tax purposes except in cases where the IRS has provided advanced permission to use the annual gas balancing method.
With a cumulative gas balancing agreement, each producer must recognize his or her income as the gas that he or she markets. This means an owner who overproduces may only claim a deduction for a balancing payment made to the underproducer. However, an underproducer must claim these payments as income. Additional complications may occur if different owners are tracking their imbalances based on different sale prices. This may present confusion when reporting to the IRS. Additionally, if a co-owner fails to comply with the IRS guidelines for cumulative gas balancing accounting, it could result in owed payments to the IRS as well as penalties.
Working with a certified public accountant trained in oil and natural gas accounting can help to bring gas balancing agreement records into compliance with IRS standards. For more information on this and other oil and natural gas industry topics, contact a member of LaPorte’s Energy Industry Group today.