Cash Calls in Oil and Gas Joint Ventures

Sometimes, you finish eating at your favorite restaurant when suddenly, your bank app crashes, leaving you unable to pay. Panic sets in as you realize your friends, who promised to have your back in times of need, are nowhere to be found - you call them, they refuse to pick up.

With no other option, you face the daunting prospect of either washing plates or making a solemn promise to settle your bill once your app is up and running again.

To avoid finding yourself in this precarious situation again, you have a meeting with your two closest friends. "Our payment apps are too unreliable," you declare. "Let's pool our resources and contribute to a single card each month. This card will be our lifeline whenever we dine together. We eat together, and I'll foot the bill using our collective funds." Unanimously, your friends agree to this ingenious plan, and contributions are promptly made.

However, should one friend fail to contribute their share for a particular month, they're promptly reminded to honor their commitment. With this system in place, you can dine out with confidence, knowing that you and your friends have each other's backs no matter what.

In the real world of joint ventures, sometimes even your friends might face money hiccups. In this piece, we discuss the nature and types of cash calls, the cash call funding process, when cost is expensed and capitalized, and what happens when a party to a petroleum joint venture is low on cash.

Cash calls are an essential feature of petroleum contracts, especially joint ventures (JV) governed by joint operating agreements (JOA).

Here is a Joint Venture:

• Two or more companies participate in the business of petroleum exploration and production within a license area.
• One party is identified as the operator responsible for managing the operations of the JV.
• Then other parties are referred to as the non-operators or working interest owners, on whose behalf the operator manages the joint venture. Each party has a percentage of ownership.
• Decision making is undertaken by an Operating Committee comprising representatives of each party. This is to ensure the interests of non-operating parties are well represented.

The responsibility of funding the JV (an unincorporated JV) is not borne by the operator alone. The non -operators have a responsibility to finance the operation too. This process of funding is referred to as cash calls.

A cash call is a request sent to non-operators/working interest owners participating in an unincorporated JV for the payment of their share of cost related to the JV. Since this is an obligation, it is reasonable that provisions be made for what happens when there is default.

The failure of a party to comply with the terms of a cash call by an operator will become a default. A default clause will provide for the consequences of a non-operator neglecting to respond to its share of a cash call.

There is also a provision for cure periods and remedies available to non-defaulting parties. When a party defaults in cash calls, his rights may be limited or suspended; but he remains a party to the JV.

A cure period is that period of grace before a party’s participation is terminated. When a defaulting party fails to make amends before the expiry of the cure period either by making the necessary payments or by diluting his interest in the JV as substitute for payment, then some payment restructuring, ?which will be explained later, are made.

Types of Cash Calls

Cash calls can be categorized based on their timing (when) or based on their purpose (why).

Based on timing

Advance cash call: a request for funds by an operator before the actual expenditure is incurred. The operator does this by estimating the costs for the upcoming period and asks the JV participants to provide their share of funds in advance.

Monthly cash call: refers to regular requests made to JV participants to contribute their share of anticipated monthly expenditures and are based on the operator’s monthly budget.

Supplementary cash call: this cash call request is made when additional funds are required beyond the budgeted amount. It could arise due to unforeseen expenses or changes in the scope of the project.

Contingency cash call: these are made to create a reserve fund for the unexpected expenses or potential cost overruns. This creates a sort of financial buffer to address unseen events.

Based on purpose

This classification of cash costs is intended to address funding needs in various stages of petroleum exploration and production. For instance, drill participation cost cash call would cover expenses for drilling exploratory wells to assess potential reserves. Development cost cash calls fund the development of a confirmed oil field. And operating costs cash calls support ongoing operational expenses like production, maintenance, and staff.

Process of Cash Call Funding, Account Reconciliation and Reporting

The financial management of a petroleum joint venture starts from the point cash call is initiated to the stage where reporting is made to the JV participants and other stakeholders.

Here is cash call funding:

• Budget preparation and approval: A budget (called WP&B – Work Program and Budget) is prepared by the operator at the beginning of each year or month as the JOA may specify. This outlines the planned activities and associated cost for the year. Then the budget is reviewed and approved by the JV participants.
• Cash calls: the operator sends a cash call notice to the non-operating participants, detailing the amount required, the due date, the specific activities to be funded, and the amount each participant needs to contribute, usually proportional to their ownership stake in the JV.
• Funding: Participants contribute their respective shares as stated in the cash call notice to a designated JV bank account. The operator confirms receipt of funds and utilizes the funds to carry out activities outlined in the work program and budget.

Account reconciliation and reporting are embarked on to ensure accuracy and compliance with regulations. At regular intervals, the operator prepares a bank reconciliation statement to compare the bank’s records with the JV’s internal financial records and resolve discrepancies. Then, the operator prepares reports on production volumes, sales, expenditure cash call status and any other issues. These reports are sent to all JV participants. The operator may also conduct internal audits and procure external audits to ensure compliance and accuracy.

Can there be an option to bypass cash calls?

Instead of the typical cash call procedure, the JOA can require a participant to send all its required commitment that would cover a period of time, into an escrow account controlled by the JV. When the JV needs the money, they just pull from that account instead. This is bypassing cash calls.

Cost Management in Joint Ventures

Cash calls are largely determined by anticipated or already incurred costs. Hence, it is apposite we examine various costs concepts, costs allocation, costing by product and activity-based costing in petroleum joint ventures.

The key cost concepts are familiar: Direct costs, indirect costs, fixed costs and variable costs

Direct costs are directly attributable to a specific product (oil, gas) or activity(drilling a well). This could include wellhead production costs, transportation costs for shipment of a specific product

Indirect costs are not directly linked to a specific product or activity but necessary for overall operations. These include administrative salaries, insurance, and electricity bills for the entire operation

Fixed costs remain constant notwithstanding the level of production or intensity of activity. They do not vary with the volume of oil or gas produced. These include lease payments for equipment and salaries of permanent staff.

Variable Costs on the other hand, fluctuate in direct proportion to the level of production or activity. As production increases, variable costs rise, and as production decreases, they fall. Examples include costs for raw materials and fuel for drilling rigs.

Cost Allocation in Petroleum Joint Venture Operations

Cost allocation refers to the method of sharing costs among participants in a JV. Various methods abound but we will just mention a few common ones. The chosen allocation method depends on the specific cost category and the terms of the JOA.

Allocation by Ownership interests: here, costs are allocated based on each participant’s working interest in the JV. This is also known as equitable cost sharing. If three JV parties have ownership stakes of 50%, 30% and 20% respectively, costs are then divided in these proportions.

Well operating costs: Costs associated with a specific well are shared based on partners’ ownership interest in that well.

Allocation on a functional basis: costs for shared services, transportation for instance, are allocated based on the level of usage by each participant.

Overhead costs may also be allocated to different activities based on predetermined rates such as labor hours, machine hours etc. for instance, administrative expenses may be allocated based on the proportion of labor hours each project consumes.

Costing by Product in Petroleum Joint Venture Operations

Costing by product involves determining the total costs associated with producing each product, such as crude oil or natural gas, within the JV operations, This could be by assessing full costs or assessing only ‘successful costs’.

In the full cost method, all exploration, development and production costs are capitalized and matched with revenue over the productive life of the reserves. While in the successful cost method, only the costs of successful exploration and development efforts are capitalized and costs associated with unsuccessful efforts are expensed immediately.

To capitalize a cost means to record it as an asset on the balance sheet rather than as an expense on the income statement. This asset is then gradually expensed over its useful life through depreciation or depletion. In the successful cost method, these costs are recorded as assets because they are expected to generate future economic benefits in the form of oil and gas production. An example is the cost of drilling exploratory wells that result in the discovery of proven reserves.

To expense a cost means to record it as an expense on the income statement and thereby reducing the net income for that period. In the successful costs method, the costs associated with exploration and development activities that do not result in the discovery of economically viable reserves are expensed in the income statement. They are not capitalized because they do not provide future economic benefits.

By capitalizing successful costs, the JV spreads the expense over the productive life of the asset through depreciation or depletion. By doing so, the initial cost does not impact net income immediately but is matched against the revenue generated from the reserves over time.

While the full cost method provides a comprehensive view of costs and long-term revenue and expenses, the successful cost method provides a clearer picture of short-term financial performance and profitability.

Activity based costing in petroleum joint venture operations.

Activity Based Costing is used to identify activities that drive costs within the JV. It focuses, not on allocating costs, but on understanding cost drivers. Cost drivers are factors that cause costs to be incurred. This could range from the number of drilling hours to the number of maintenance requests.

Through activity-based costing, the costs are allocated to each activity based on the resources consumed by that activity. The cost of drilling equipment is assigned to the drilling activity while the cost of transportation is assigned to the logistics activity.

When a Party refuses to pay, what happens?

One of the troubling issues in a joint venture is a party refusing to meet up with payment obligations. This results in outstanding cash calls ( also called defaults or deficits). Outstanding cash call is a situation where the non-operating parties fail to meet their financial obligation as outlined in the cash call issued by the operator.

In contemplation of this, a JOA would usually put in place repayment options and implications to ensure that the joint venture can continue its operations smoothly.

Here are the common repayment options:

• Negotiated payment plan: the parties may agree on a payment schedule allowing the defaulting party to pay the outstanding amount in instalments over a period
• Revenue set off: Ordinarily, a party is entitled to revenues from the sale of petroleum by the JV. But when a party defaults, the future revenues the defaulting party is entitled is used to cover the outstanding cash call.
• Increase of future cash calls: Subsequent cash calls issued to the defaulting party are increased to recover the outstanding amount.
• Equity dilution: The interest of the defaulting party in the JV is reduced to reflect their unpaid contribution. The unpaid amount is then converted unto additional equity share for non-defaulting parties.
• External financing: The JV can secure loans to cover the outstanding amount but the defaulting partner will be responsible for repayment of the loan
• Legal remedies: the JOA may provide for legal actions to enforce the repayment such as arbitration and litigation.

No one can accurately predict the possible outcomes and contingencies of an investment. However, the aftermath of unforeseen contingencies can be managed through specific clauses in the JOA. Default in payment of cash calls could impede the smooth operation of a joint venture if it is not managed by adequate repayment options. By understanding the types of cash call, the process of cash call funding, reporting, and repayment options, you gain insights into how joint ventures in the oil and gas industry manage their finances and share the burden of expenses.

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Peter Okediya