SEPA
68-01-6425
OPERATOR'S REFERENCE MANUAL
FINANCIAL RESPONSIBILITY FOR WELL
PLUGGING AND ABANDONMENT
SUBMITTED TO
DR. JENTAI YANG
OFFICE OF DRINKING WATER
U.S. ENVIRONMENTAL PROTECTION AGENCY
MARCH 1983
BOOZ-ALLEN & HAMILTON, INC.
UNDER THE DIRECTION OF
GERAGHTY & MILLER, INC.
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vvEPA
68-01-6425
OPERATOR'S REFERENCE MANUAL
FINANCIAL RESPONSIBILITY FOR WELL
PLUGGING AND ABANDONMENT
SUBMITTED TO
DR. JENTAI YANG
OFFICE OF DRINKING WATER
U.S. ENVIRONMENTAL PROTECTION AGENCY
MARCH 1983
BOOZ ALLEN & HAMILTON, INC.
UNDER THE DIRECTION OF
GERAGHTY & MILLER, INC.
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ACKNOWLEDGEMENT
This manual was prepared for EPA's Office of Drinking
Water by Booz, Allen & Hamilton, Inc. under the direction
of Goraghty & Miller, Inc. The Booz, Allen project manager
was Dr. Joanne Wyman. Dr. Wyman received assistance from
Mr. John Durkin and Mr. Walter Mardis of Booz, Allen &
Hamilton. The Geraghty & Miller project manager was Mr.
William Thompson, and Mr. Roger Anzzolin v;as the EPA task
manager.
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TABLE
0 F
CONTENTS
I. INTRODUCTION TO THE MANUAL
1. Regulatory Requirements
2. Program Administration
3. Organization of the Manual
Page
Number
1-1
1-2
1-3
1-4
II. MECHANISMS FOR DEMONSTRATING FINANCIAL
RESPONSIBILITY
1. Surety Bonds
2. Letters of Credit
3. Trust Funds
4. Escrow Accounts
5. Corporate Financial Test
II-l
II-l
II-4
II-6
II-8
II-8
III. SELECTION OF FINANCIAL RESPONSIBILITY
MECHANISM
1. Overview of the Selection Process
2. Availability of Mechanisms
3. Cost of Mechanism
4. Acceptability of Mechanism
III-l
III-l
III-2
III-2
III-4
APPENDIX A -
APPENDIX B -
Cost Elements of Alternative Financial
Responsibility Assurance Mechanisms
Total Cost of Well Abandonment
Using Alternative Financial
Responsibility Assurance Mechanisms
APPENDIX C - Glossary of Financial Terms
11
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LIST OF EXHIBITS
Page
Number
II-l Surety Bond Form II-3
II-2 Example of Letter of Credit II-5
II-3 Simplified Financial Statement 11-10
II-4 Approaches to Financial Data Analysis 11-12
111
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I. INTRODUCTION TO THE MANUAL
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I. INTRODUCTION TO THE MANUAL
The Underground Injection Control (UIC) Program, estab-
lished under the Safe Drinking Water Act places a variety of
regulatory requirements on owners and operators of injection
wells. One of these requirements is that a well be properly
plugged and abandoned at the end of its useful life. To ensure
that well owners and operators will be financially capable of
meeting this obligation, the regulations direct the Program
Director* to require permittees to provide evidence of avail-
able assets ("financial responsibility").
Several options are open to injection well owners and
operators to demonstrate that they have adequate financial
resources to comply with the plugging conditions of their
permits. Some of the most widely used mechanisms for meeting
environmental or other regulatory obligations include:
Surety (performance) bonds
Letters of credit
Trust funds
Escrow accounts
Financial statements.
Since some states have required demonstration of financial
responsibility in the past, many operators already may be
familiar with one or more of these mechanisms.
The purpose of this manual is to assist each well owner and
operator in determining which of these financial responsibility
mechanisms best meets his needs. Technical guidelines are pro-
vided in EPA's Technical Well Abandonment Manual.
This manual provides a general introduction to financial
responsibility assurance mechansims in order to aid well owners
and operators with varying amounts of experience on the sub-
ject. It includes:
Background on the regulations
Description of financial responsibility mechanisms
(Chapter II)
Guidelines for selecting a mechanism (Chapter III).
Depending on which agency administers the program in a
given state, the Director may be the EPA Regional
Administrator or a state official.
1-1
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In addition, the manual contains a glossary of financial terms
as well as guidelines for calculating the comparative costs of
alternative financial responsibility mechanisms.
Federal UIC regulations governing financial responsibility
give the Program Director considerable flexibility. Specific
requirements may vary widely across states and well classes.
The well operator may therefore need to consult regulatory
agency personnel, attorneys, and accountants in order to deter-
mine how the Program Director is implementing the financial
responsibility requirements and what compliance options are
available.
The remainder of this chapter provides background infor-
mation. First, it summarizes the technical and financial
provisions of the regulations. This is followed by an overview
of the administrative arrangements that may be encountered.
The chapter ends with a discussion of the organization of the
rest of the manual.
1. REGULATORY REQUIREMENTS
Congress created the UIC program in response to evidence
that injection activities could have an adverse impact on the
quality of groundwater. In some cases, the contamination has
been traced to improper plugging and abandonment practices.
Accordingly, in carrying out its statutory obligation to
establish minimum technical criteria and standards, EPA has
issued rules governing the plugging and abandonment of injec-
tion wells in Classes I-III. One set of rules (40 CFR 146)
stipulates plugging and abandonment methods while the other set
(40 CFR 122) directs states to require permittees to demon-
strate that they will have adequate financial resources to
carry out their approved plugging plans.
(1) Technical Criteria and Standards
The objective of the plugging and abandonment stan-
dards is to prevent "the movement of fluids either into or
between underground sources of drinking water." In order
to achieve that objective, well owners and operators gen-
erally must plug their wells with cement, although Class
III wells may be plugged with other materials satisfactory
to the Program Director. EPA further directs that prior to
placing the plugs, the well must be in a "state of static
equilibrium with the mud weight equalized top to bottom,
either by circulating the mud in the well at least once or
by a comparable method prescribed by the Director (40 CFR
146.10)." These requirements are discussed in greater
detail in EPA's Technical Well Abandonment Manual.
1-2
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The well owner or operator must prepare a "plugging
and abandonment plan" as part of the permit application (40
CFR 122.42(f)). The Program Director will review this
plan; and, if it is adequate, the plan will become part of
the permit. If the plan is inadequate, the Director can
require that the plan be revised, deny the permit applica-
tion, or prescribe the conditions to be met. In preparing
the plugging and abandonment plan, the well operator should
consult regulatory agency permitting personnel to determine
the specific information required.
(2) Financial Responsibility Requirements
The permitting regulations (40 CFR 122.42) direct that
UIC permits require permittees to maintain financial re-
sources to comply with the plugging and abandonment plan.
Compliance instruments may include surety bonds, financial
statements, or other assurances acceptable to the Director.
In some states, at the Director's discretion, operators may
be able to furnish financial assurances covering their
operations statewide instead of on an individual well
basis. Chapter II of this manual describes several alter-
natives that may be available, and Chapter III provides
guidelines on how to select a mechanism.
2. PROGRAM ADMINISTRATION
The Safe Drinking Water Act (SDWA) provides for either EPA
or state administration of the UIC program. Two types of state
program submission are possible:
Primacy; EPA determines that a state program meets
all the requirements set forth in the Federal rules
Optional Demonstration; According to section 1425 of
SDWA, states with existing regulatory programs for
Class II wells (used in oil/gas production) may demon-
strate that these programs are as effective as the
Federal requirements and fulfill the SDWA requirements.
Where states decide against accepting program enforcement
responsibility, or if EPA disapproves a state's submission, the
law requires EPA to establish a program. Since financial
responsibility requirements may vary from state to state and
different agencies may regulate each well class, operators must
determine which agency regulates their wells. They should con-
tact that agency for details on the requirements.
1-3
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3. ORGANIZATION OF THE MANUAL
The next two chapters of the manual describe five alter-
native methods available to satisfy financial responsibility
requirements. Chapter II describes the terms and conditions of
and how to use each alternative. Chapter III provides a step-
by-step outline of how each operator can select the approach
most suitable to his circumstances.
1-4
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II. MECHANISMS FOR DEMONSTRATING
FINANCIAL RESPONSIBILITY
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II. MECHANISMS FOR DEMONSTRATING
FINANCIAL RESPONSIBILITY
The purpose of the financial responsibility requirement is
to ensure the regulatory agency's access to funds in case well
operators fail to comply with the plugging and abandonment con-
ditions of their permits. In order to assist operators in
determining how to meet the requirements, this chapter de-
scribes and evaluates the financial responsibility alternatives
available.
Several financial responsibility mechanisms are available,
although all may not be acceptable in all states or for all
operators. Five key mechanisms are:
Surety bonds
Letters of credit
Trust funds
Escrow accounts
Financial statements
Historically, these mechanisms have been used to ensure
performance of a wide variety of Federal, State, or local
regulatory obligations. In order to assist operators in
selecting the most suitable mechanism, this section describes
their terms, conditions, and operation.
1. SURETY BONDS
Surety, or performance, bonding is the most widely used
approach for demonstrating financial responsibility, particu-
larly in the oil and gas industry. Bonding is a mechanism
whereby a licensed surety company*, in return for an annual fee
paid by the operator, assumes liability for the well operator's
plugging and abandonment obligation. The surety company is not
released from this liability until it receives notification
from the regulatory agency that the operator has performed his
obligation adequately. Bonds written for individual wells
cannot be cancelled even if the operator fails to pay the
annual fee; and while cancellation of a blanket bond does not
relieve the surety company from any liability for wells
previously covered by the bond, it does absolve the company
from incurring additional liability for any new wells.
Over 300 surety companies are certified by the U.S.
Treasury for bonding under Federal programs (See U.S.
Treasury Department Circular 570), and others are licensed
by the states.
II-l
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If the operator fails to perform, the surety company is
responsible for promoting proper plugging and abandonment.
Depending upon state law and regulation/ a bond is written
either to provide a beneficiary (e.g., the regulatory agency)
with funds to carry out plugging or to specify that the surety
company itself will arrange for plugging. Surety companies
often prefer to have a choice, since the actual cost of plug-
ging may be less than the estimated cost upon which the bond
value was established. Both approaches relieve the regulatory
agency of either having to provide plugging funds or take
enforcement action to recover plugging costs from the
operator.
(1) Types of Bonds
Surety companies currently offer two types of plugging
bonds. The most widely used is the blanket bond, which
covers all of an operator's wells within a single state.
Bonds may also be written for individual wells. In the
past, the regulations of each state have dictated the type
and value of the bond required. Exhibit ll-l shows the
surety bond form which has been used in.Oklahoma. It is
similar to forms used in other states. Under the UIC
program, state regulations will prevail in primacy states;
otherwise, operators must meet rules established by EPA.
(2) Bonding Procedures
Procedures for obtaining a bond are well established,
and both operators and regulators find bonding a simple
mechanism to use. The operator typically will contact the
agent from whom he obtains workmen's compensation and other
insurance. The agent will prescribe what financial data is
required. Usually, the agent will request a company's
financial statement for the past one or two years. If the
applicant's operation is very small, the agent probably
will request a credit report.
The agent will transmit the bond application and sup-
porting data to a branch office of the underwriter. If the
operator's financial statement has not been prepared by a
certified public accountant, the underwriter will take
steps to verify the statement. The underwriter then will
determine whether the operator appears to be financially
capable of carrying out the plugging and abandonment
obligations for which he is requesting a bond. If the
operator's financial status is clear, the underwriter will
either write or decline the bond; he may require collateral
in borderline cases. Once the bond is written, the agent
sends evidence of the bond to the appropriate authorities.
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EXHIBIT II-l
Surety Bond Form
SuHni Bond No
'""'"*" OKLAHOMA CORPORATION COMMISSION
CONSERVATION DIVISION
MO Jim Thorp* Building
Oklatunu Olf. Oklihoou 73105
SURETY BOND FOR PLUGGING OIL, GAS AND
SERVICE WELLS WITHIN THE STATE OF OKLAHOMA
KNOW ALL MEN BY THESE PRESENTS:
Thai as Principal,
Mailing
. Zip Code.
And TVM as Surely.
Mailing Address ,
. Zip Code.
authorized to do business within the State of Oklahoma are held and firmly bound unto said State in the penal sum
of Ten Thousand Dollars (SIO.OOO). lawful money of the United States, for which payment well and truly to be made,
we bind ourselves, and each of us, and each of our heirs, executors, administrators or successors, and assigns jointly
and severally, firmly by these presents.
The condition of this obligation a thai whereas the above bounden principal proposes to drill and/or operate an
oil. gas, injection, disposal or service well or wells within the State of Oklahoma, and has furnished his agreement in
writing to the Corporation Commission of the Slate of Oklahoma to plug each such well at the time anj in the manner
prescribed by the laws of the State of Oklahoma and the General Rules and Regulations and Special Orders of the
Commission.
NOW, THEREFORE, if the above bounden principal shall plug each well drilled and/or operated by him within
the State of Oklahoma at the time and in the manner prescribed by the laws of the State of Oklahoma and the Gen-
eral Rules and Regulations and Special Orders of the Corporation Cumnmsion of the State of Oklahoma, then this
obligation shall be null and void: otherwise, the same shall be and remain in full force and effect. This obligation
"may be terminated by the Surety upon six (6) months notice in writing to the Conservation Division. (OCC Rule
1-201; 52 OS Supp 1971 §319.)
PROVIDED. HOWEVER, the aggregate liability of the surety hereunder shall in no event exceed the sum of
this bond.
Witness our hands and seals, this day of .
Principal
Witness our hands and seals, this _____^^^_ Jay of ___^____^_^
COUNTERSIGNED BY:
UklaMuma KriuttHt Sfrmts Aytnt .Surely
(If the principal is a corporation, the bond should be executed by its duly authorized officers, with the seal of the
corporation affixed. When principal or surety executes this bond by agent or attorney in fact, the evidence of author-
ity must accompany the bond.)
Approved ' Date:.
(\injrrTi» 1'onausnnn
II-3
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(3) Costs of Bonds
All operators must pay an annual premium, which
typically ranges from 1.0 to 1.5 percent of the face value
of the bond. The cost of a blanket bond may range up to
5 percent or there may be an added charge for each new
well. Exact rates generally are filed with and approved by
state insurance commissions. While surety companies cannot
impose surcharges on financially weak companies, they often
provide healthier companies with discounts.
The cost may be considerably higher if the surety
company requires the operator to post collateral. Surety
companies are very cautious and, unlike liability insurers,
theoretically assume no risk. If the surety company con-
siders a company's financial position to be at all uncer-
tain, they will ask for collateral equal to all or part of
the bond's face value. Collateral generally consists of
treasury bills, cash, certificates of deposit, government
secured general obligation or revenue bonds, or an irrevoc-
able letter of credit. By posting collateral the operator
incurs an additional cost because capital is tied up in low
yield investments and is not available for higher yield
investments.
2. LETTERS OF CREDIT
An irrevocable letter of credit (LOG) is a less widely used
approach but one which is attractive to some large companies.
As applied to plugging obligations, it is an irrevocable assur-
ance, usually provided by a bank, to pay the beneficiary (i.e.,
the regulatory agency) up to a certain sum in the event of
operator nonperformance. In other words, if the operator fails
to perform, the regulatory agency can draw funds from the bank
upon the presentation of documents consistent with the terms of
the letter of credit. Exhibit II-2 is the form currently used
in Oklahoma for letters of credit.
The availability and cost of the letter of credit may vary
according to the operator's financial status, relationship with
the issuing institution, value of the LOG, and the issuing
institution's outstanding loans. Letters of credit typically
are available only to large companies with a substantial,
verifiable net worth. Banking industry representatives suggest
that large oil companies will find LOC's easy to obtain; firms
with less identifiable assets or with only limited operating
histories may face greater difficulties. Blue chip firms (with
a AAA rating) having an established relationship with the
issuing bank may pay an annual fee of no more than .25 percent
of the full value of the LOG, although the cost can be as high
as one percent. An additional cost to the operator is that the
LOG counts against his credit line and reduces his access to
II-4
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EXHIBIT II-2
Letter of Credit
FOHM NO. I006C (19751 RULE 3-291.4 j|0-
OXLAJKKA CORPORATION OOMOSSION
COJlSEHVATiai DIVISION
IRHEVOCADLE CGS-MEICI/IL LETTER OP CHEDF1
DATE:
TO: Corporation Carmission of the State of Oklahora,
Third Floor, Jim Thorpe Building,
aclanora City, Oklahcma 73105
-Gentlcraen:
He hereby authorize you to draw on
None oj fiont
Mdim Ctxy
by order of _ _
Stutl t.ddwu Cct/; State Tip !
and for account of __ _ __
OpVULto*
up to an amunt not eiceedlnj; Ten Thousand Dollars 010,000) available by your drafts
on ourselves at slgit for 1001 Invoice cost accompanied by a forcal order of the
Corporation Ccnrnlsslon of the State of dclahcnia entered pursuant to and In aid of
the enforcerent of Caimlsslon Rule 3-201 and 52 O.S. 1971 $316.1 and as the rule or
statute coy be aiaended.
This Letter of Credit will expire nidnlght on the _ day of _ , 19 _
or uhen the next succeeding Letter of Credit Is furnished to the Conmlsslon, whichever
occurs first. In no event will the obligations of oultlple Letters of Credit securing
the sane Operators Agreement be cumulative or In excess of the total aggregate sum
of $10.000.
Me hereby agree with the drawers, endorsers and bona fide holders of all drafts
draun under and in corrollance vrtth the term of this. Letter of Credit that such drafts
will be duly honored upon presentation to the drawee.
yours very truly,
- V4.ce.
II-5
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capital for expansion or investments. In some cases, the bank
may require up to 100 percent collateral, applying the same
terms to a LOG as to an outright loan. If collateral is re-
quired, the opportunity cost will rise considerably. Although
Federal regulations limit the amount of credit a lending
institution can make to any one company, this should not be a
problem for injection well operators since the costs of
plugging typically are relatively modest.
3. TRUST FUNDS
A trust fund is an arrangement whereby the operator de-
posits sufficient funds for regulatory compliance with an
independent trustee. The trustee then bears legal responsi-
bility for managing the fund for the benefit of the regulatory
authority in accordance with the designated terms of the trust.
These terms may include investment of the funds as well as
eventual disposition of the funds for plugging and abandon-
ment. The operator pays the trustee a management fee that is
generally specified as a percentage of the size of the trust
and varies with the duties of the trustee.
Once established, the trust fund cannot be terminated with-
out the consent of both the trustee and the beneficiary, in
this case the regulatory authority. Trust funds are widely
used to isolate funds for government mandated programs, and are
included as an option for financial responsibility assurance
for EPA's hazardous waste program.
(1) Types of Funds
Trust funds may be established either by individual
operators or by industry groups. All aspects of the trust
such as costs, fund management, and fund disbursement can
vary and will be defined in the trust agreement. The trust
agreement will set forth the trustee's role and any limita-
tions on his investment of the trust funds. The objective,
for both individual and industry trusts, is to make invest-
ments which at least keep up with, and even exceed,
inflation. Investment of trust funds intended for assuring
regulatory compliance is generally limited to low-risk
securities such as U.S. Treasury bills. Since commingling
of funds from several companies within an industry for
investment purposes is prohibited by law,* the SEC must
authorize exemptions for investments of industry wide trust
funds.
The Glass-Steagall Act of 1933.
II-6
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The regulatory agency may establish the trust terms
that it will find acceptable. EPA has not established such
terms in the UIC rules and intends to leave that task up to
each Program Director. Thus, operators participating in
trusts will want the attorney who draws up the agreement to
consult with the appropriate regulatory officials in order
to ascertain the acceptable terms.
(2) Cost of Trust Funds
The cost of a trust fund may vary according to manage-
ment fees, payment schedule, and whether the trust is an
individual or industry fund. Typical annual management
fees run about 1.0 to 1.5 percent of the value of the
trust.
In establishing an individual trust, the operator
usually can choose from two different payment methods. The
terms of the agreement may require either a lump sum pay-
ment upon establishment of the trust or may allow an annual
payment into the fund. The latter approach considerably
lightens the operator's financial burden by spreading
payments over several years; however, the regulatory agency
may be reluctant to accept the annual payment approach,
because it provides less assurance that sufficient plugging
funds will be available when needed. For example, if the
operator goes bankrupt or ceases his operations prematurely
and fails to comply with his plugging plan, the trust fund
may not be sufficiently large to make adequate plugging
funds available to the agency. Furthermore, as the
revenues from the well decrease and the likelihood of
abandonment increases, an annual payment scheme provides
less assurance that the operator will be able to fulfill
the trust agreement. Operators should consult regulatory
agency officials before having an attorney draw up the
trust papers. In some cases, the Program Director may
decide to require initial establishment of a surety bond,
which is gradually reduced in value as the amount in a
trust fund with annual payments rises.
For industry-wide trusts, the payment schedule is
always an annual one dictated by the number of participants
and anticipated rate of noncompliance. These assessments
are likely to be lower than those to an individual trust
fund, since the probability of noncompliance for all wells
covered by the fund is considerably less than that for any
single well. Industry trust assessments are non-refundable;
in other words, the operator cannot use such funds for
plugging. Funds become available to the trust's
beneficiary (i.e. regulatory agency only in the event of
the operator's failure to carry out his performance
obligation.
II-7
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4. ESCROW ACCOUNTS
An escrow account, like a trust fund, is an account into
which the operator deposits sufficient funds in advance to pay
for proper plugging and abandonment. The funds may be depos-
ited in full upon establishment of the account or over any
stipulated period during the life of the well, and are dis-
bursed to the operator either as payment for abandonment or as
a reimbursement upon completion of his responsibilities. The
funds may be used only to meet the costs of abandonment. An
account administrator verifies deposits and disbursements.
Typically, the account administrator is a financial institution
or other independent third party, for whose services the
operator pays an annual management fee on the order of one
percent of the value of the account. Alternatively, the
account may be administered directly by the regulatory
authority.
Unlike a trust fund, which transfers legal title for the
funds to the trustee and requires him to protect the interests
of the beneficiary, the escrow account administrator is respons-
ible only for specifying the terms of the escrow agreement and
for administering the account accordingly. The operator
retains legal title to the funds, and unless prohibited by the
terms of the escrow agreement, may initiate the use of the
funds for abandonment. Maintenance of operator title implies
that, in the event of operator bankruptcy, the funds may be
subject to creditors' claims. Because it is difficult to draft
an escrow agreement that addresses all of these contingencies,
escrow accounts have not been allowed as a financial respons-
ibility assurance mechanism for some other regulatory programs,
including EPA's hazardous waste program.
5. CORPORATE FINANCIAL TEST
A financial statement summarizes the operator's current
financial position. It provides the regulatory agency with an
indication of liquidity or stability but does not guarantee
that sufficient hands will be available for future plugging and
abandonment. Moreover, the financial data provided will not
enable to the agency to predict the operator's long term
financial position.
Program Directors are likely to be quite cautious in
allowing operators to use financial statements as evidence of
financial responsibility, since the operator does not have to
set aside funds for plugging and abandonment. Thus, the
acceptability of the financial statement will depend upon
whether the regulatory agency is confident that a relationship
exists between the value of the operator's assets and his
II-8
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future willingness and financial capability of carrying out
plugging and abandonment obligations.
(1) Preparation of Financial Data
Generally, the financial statement includes the
following tables of financial data:
Income statement
Balance sheet
Statement of sources and uses of funds
Accumulated retained earnings statement.
The income statement presents the firm's revenues, expen-
ditures, and profits for the preceding year. It is thus a
record of the operating activities for that year. The
balance sheet, in contrast, presents the firm's total
accumulated assets and liabilities at the end of the
reporting period, indicating the firm's net worth and
liquidity. The statement of sources and uses of funds
breaks down information from the income statement and bal-
ance sheet to show the firm's income sources, including
operating income and sale of assets, the uses to which this
cash was applied, and the resulting net change in working
capital, or net current assets. This may be followed by an
analysis of changes in net working capital for the report-
ing period, describing changes in current assets and
current liabilities. Finally, the accumulated retained
earnings statement indicates how much of the firm's profit
for the year was retained for reinvestment and new growth
after payment of stockholders' dividends.
(2) Interpretation of Data
The income statement, balance sheet, and statement of
sources and uses of funds are likely to be the most useful
parts of the financial statement for analyzing the firm's
ability to meet well plugging and abandonment requirements.
Not all states relying on financial statements to assure
financial responsibility require extensive data. Exhibit
II-3 presents the financial statement format currently used
in Oklahoma. This essentially is a balance sheet. Income
statement and balance sheet data are generally provided for
two or more years, allowing analysis of trends in the
firm's financial performance. Cash flow analysis based on
the statement of sources and uses of funds has become
II-9
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EXHIBIT II-3
Example of Financial Statement
^foum'V00" OKLAHOMA CORPORATION COMMISSION
CONSERVATION DIVISION
M Jim Thorp. BuiUinf
OKLAHOMA CITY. OK:_AHOMA 7)10}
FINANCIAL STATEMENT
Thau — Operator,
Mailing AHHt»««
_Zip Code.
hereby attests lhac he has a total net worth of S The description and value of assets and
liabilities are as shown below. A statement reflecting a net worth of leu than SI0.000.00 is not acceptable and
partial Financial Statements will be returned to the operator. If Accounts Receivable are listed, they must be
accompanied by a statement attached and made a pan hereof of the dollar amount of delinquent accounts. The
value of producing oil and gas leaseholds for which this statement stands as security, will be deducted from
total net worth unless the Financial Statement is accompanied by the written appraisal of a recognized indepen-
dent appraiser of oil and gas properties showing the fair market value of the leasehold interest owned by the
operator.
ASSETS LIABILITIES
Total Net Worth 5_
I. the undersigned, being duly swom upon oath, state that this Financial Statement is a true and full state-
ment of assets and liabilities.
Sitiulura (Ooeratori
Title
Subscribed and sworn to before me ""« *°" of. |9_
My Commission Expires:
11-10
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recognized as a valuable tool for interpreting the income
statement and balance sheet.*
The Program Director may choose from among several
available measures of financial health. Some of these may
be read directly from the balance sheet, while others are
best interpreted in ratio form from information contained
in the balance sheet, income statement, and statement of
sources and uses of funds. Unfortunately, no single
measure or set of measures can be regarded as best in all
cases, nor can specific threshold values be established as
meaningful indicators of good financial health for firms of
all sizes in different industries and circumstances.
Exhibit II-4 summarizes several different approaches the
regulatory agency may use in analyzing financial data.
Although other indicators of financial health are
available, these are perhaps the most commonly used and
have been successfully employed in other Federal regulatory
programs. It should be clear from the preceding discus-
sion, however, that no standard values can be relied upon
to discern the healthy from the unhealthy firm. The
regulatory authority may choose to set the requirements so
high as to exclude some financially viable firms from this
option in order to assure the mechanism's reliability.
(3) Cost
From the operator's perspective, submittal of a finan-
cial statement is the simplest method of demonstrating
financial responsibility and involves a negligible incre-
mental cost. Federal securities regulations require that
all publicly-held companies prepare a complete set of
financial statements annually, although these may be
presented in consolidated form for all company operations.
Most private companies prepare comprehensive financial
statements for their own purposes, and hence would incur a
limited incremental cost.
A useful introduction to cash flow analysis can be found in
Techniques of Financial Analysis by Erich Helfert, DBA,
Fourth Edition, 1977, Chapter 1.
11-11
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EXHIBIT II-4
Approaches to Financial Data Analysis
Type of Measure
Description
Advantage/
Disadvantage
Data Sources
Ability to Fiannce
Obligations
Gross measures of size
- Net worth (or stockholder's
equity)
- Total assets
Large firms have more assets
and lower probability of
bankruptcy
Easy to read directly
from balance sheet
Balance sheet
Dependence on
Creditors
Extent to which operator
relies on debt financing
Highly leveraged firms usually
are more vulnerable, but it
depends upon cash flow
stability
Requires calculation of
several ratios:
- Total debt/total assets
- Total debt/net worth
- Long term debt/capital-
ization
- Long term debt/net worth
Necessitates trend analysis
(including cash flow
volatility)
Balance sheet
Statement of sources
and uses of funds
Liquidity
Adequacy of assets to meet
obligations as they come
due
Requires calculation of
several ratios:
- Current ratio (current
assets/current liabil-
ities)
- Quick ratio (cash +
current receivables +
marketable securities/
current liabilities)
- Necessitates comparison
with other firms
Balance sheet
Type of Analysis
Common Size
Measures
Trend Analysis
Description
Compares permittee's financial
performance with other firms
of a similar asset size, in
the same industry
Ascertains positive/negative
trends in permittee's financial
position over several years
Advantages/
Disadvantages
Not comprehensive
Proper interpretation
requires familiarity
with economic cycles,
industry-specific
factors and their
impact on individual
operators
Data Sources
. Annual surveys (e.g.,
Robert Morris Associates,
Annual Statement Studies;
Troy Leo, Alamanac of
Business and Industrial
Financial Ratios
. Computerized services
(e.g. , Compustat)
Financial statements for
multiple years
11-12
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III. SELECTION OF FINANCIAL
RESPONSIBILITY MECHANISM
-------
III. SELECTION OF FINANCIAL REPONSIBILITY MECHANISM
The guidelines in this chapter are not meant to specify
which alternative is most suitable in all cases. Their purpose
is to identify the key questions that the operator should ask
in order to determine which mechanism best fits his situation.
To meet this objective the chapter focuses on three selection
criteria which should be considered:
Availability of mechanism
Cost of mechanism
Acceptability of mechanism.
Following a brief overview of the selection process is a
discussion of each selection criterion.
1. OVERVIEW OF THE SELECTION PROCESS
EPA's financial responsibility regulations are designed to
meet three specific objectives:
Proper well plugging and abandonment
Minimum compliance costs to operators
Minimum implementation burden to both operators and
regulators .
In general, surety bonds best meet all three criteria; the
effectiveness of the other three mechanisms varies with the
specific requirements of the regulations each Program Director
has issued and the vigilance of enforcement personnel. Never-
theless, another approach may be preferable or required in
certain circumstances.
The first step for the operator is to determine which
agency regulates well abandonment and within that agency who is
responsible for reviewing and approving permit applications.
Key regulatory personnel can provide valuable assistance in
applying and balancing the following three decision criteria:
Availability: do applicable state and Federal
regulations authorize use of all alternatives and are
there any restrictions based on financial status or
estimated plugging costs?
Cost; which mechanism is most costly in terms of fees
or lost investment opportunities?
III-l
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Acceptability; does the regulatory agency regard the
operator's preferred mechanism as effective in
promoting proper abandonment and likely to impose a
minimal administrative burden on the agency?
A general discussion of each criterion is provided below.
2. AVAILABILITY OF MECHANISMS
The first question to ask is "which financial respon-
sibility mechanisms are legally acceptable in the state where I
operate?" Most states currently regulating underground
injection activities already require assurance of financial
responsibility for plugging but limit the acceptable mechanism
to a surety bond or collateral (cash/ certificates of deposit,
government bonds) deposited with the state. The oil and gas
industry almost universally uses this approach. A few state
agencies have accepted irrevocable letters of credit, generally
submitted by Class I operators. Recently drafted amendments to
the regulations explicitly recognize the acceptability of
mechanisms other than surety bonds. The operator should
ascertain the provisions of "the state or EPA rules applicable
to his wells .
A related question is whether all mechanisms authorized
under the applicable regulations are equally available and
acceptable. The regulatory agency may impose special
conditions upon the use of a particular mechanism. For
example, it may refuse to accept financial statements from
companies below a certain size or require some collateral.
Similarly, surety companies or banks may set special conditions
on the execution of surety bonds or letters of credit. For
example, the surety company may be reluctant to issue bonds
below a certain value or for a long duration. Banks may
require collateral for issuing a letter of credit. Accept-
ability to the agency is discussed at greater length below.
3. COST OF MECHANISM
The costs of financial responsibility mechanisms discussed
in this manual vary widely. Cost considerations include not
only the fees (such as premiums or management fees) and
opportunity costs of isolated capital but also whether the
alternative provides the actual abandonment funds or a post-
closure reimbursement.
The cost of a given financial responsibility assurance
mechanism varies with the terms of the agreement, the amount of
collateral required, and the difference between the rate of
interest received on .invested collateral and the rate
obtainable from alternative investments. Because small,
III-2
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independent operators are unlikely to qualify for the best
terms, their costs are likely to be the highest, as is the
impact relative to their resources. Nevertheless, while the
cost of the mechanism is their main consideration in choosing
among alternatives, well operators indicate that the burden of
demonstrating financial responsibility is rarely prohibitive.
The cost elements of the five mechanisms being considered here
are summarized and compared in the appendix.
(1) Financial Statement
Reliance upon financial means tests, demonstrated via
the operators' financial statements, is undeniably the
least-cost method of assuring financial responsibility.
Because most companies routinely prepare a complete set of
financial statements and because no capital is tied up in
the process, the incremental cost of submitting financial
statements is likely to be negligible.
(2) Letter of Credit
The letter of credit is another fairly low-cost
approach. The operator sets aside no funds to pay for
closure, and thus incurs only administrative costs. Oper-
ators who are favored customers of the issuing institution
are likely to pay an annual management fee of only one
quarter of one percent of the value of the credit line.
However, an indirect cost is that less credit is available
for expansion or other investment.
(3) Surety Bonds
Bonding is incrementally more expensive than financial
statement preparation and letters of credit, but generally
less expensive than trust funds or escrow accounts. The
total cost of the bond may vary with the terms, collateral
required, and coverage of the bond. For operators with
multiple operations,, the average cost per well is likely to
be lower if a blanket bond is obtained.
Bonding is available to most applicants upon payment
of an annual premium of 1.0 to 1.5 percent of the face
value of the bond, although small or financially weak oper-
ators may be required to post collateral in the form of
cash, certificates of deposit, or a bank letter of credit.
The surety company retains this collateral until abandon-
ment is completed. If a letter of credit is accepted as
collateral, the operator must pay an additional 1.0-1.5
percent to the issuing bank, although this may be heavily
discounted for large customers. For other forms of
collateral, the operator incurs an opportunity cost equal
to the difference between any return on invested
III-3
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collateral and the return he could otherwise obtain by
investing it himself.
(4) Trust Fund or Escrow Account
The cost of a trust fund or escrow account is similar
to that of a surety bond backed by interest-bearing col-
lateral, assuming that the annual administration fees and
return on investment of the funds are similar to that of
the surety bond and that the funds are deposited as a
lump-sum upon establishment of the account. If the account
is accumulated over the life of the well through annual
deposits, the operator has greater use of the funds for
alternative investment. In that, case, the cost would be
lower than that of a surety bond with collateral, which is
generally posted at the time the bond is secured.
4. ACCEPTABILITY OF MECHANISM
The operator's choice of financial responsibility mechanism
must be acceptable to the regulatory agency in order to ensure
the success of his permit application. Acceptability is a
matter of effectiveness in promoting proper abandonment and
avoidance of the likelihood of an unreasonable administrative
burden on the agency. Although several mechanisms may be
available to operators, all may not be acceptable for all oper-
ators under all circumstances. In order to facilitate quick
processing of the permit application, the operator can try to
ascertain in advance of completing the application which
mechanism(s) the agency is likely to accept.
(1) Surety Bonds
Surety bonds are the most effective of the five
financial mechanisms considered here for promoting proper
well plugging and abandonment. The availability of funds
is guaranteed by the surety company, which assumes respon-
sibility should the operator fail to perform. In contrast
to trust funds and escrow accounts, the availability of
funds is not dependent upon establishment and maintenance
of an independent account. As long as the surety company
remains financially viable itself, it is legally obligated
to assume responsibility according to the terms of the
agreement. If performance of compliance activities rather
than payment of the face value of the bond is required by
the agreement, this mechanism guarantees not only the
availability of funds but the completion of proper abandon-
ment procedures as well.
Surety bonds are considerably easier for the regul-
atory agency to implement than most other financial
responsibility alternatives. Since most states which have
III-4
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well operations also have surety bond requirements which
predate the Federal UIC rules, state program managers are
often familiar with the mechanism. In addition, since the
surety company conducts the requisite financial analysis,
issues the bond, and notifies the agency of any change of
status, this mechanism poses no significant technical or
manpower demand on the agency.
(2) Letters Of Credit
Letters of credit provide almost as much assurance for
the regulatory agency as surety bonds. If the operator
fails to comply with the plugging conditions of his permit,
the agency can present documentation to the bank enabling
it to draw against the operator's line of credit in order
to obtain funds for abandonment.
Letters of credit may have a greater impact on the
agency than surety bonds do. Unlike surety bonds, under
which the surety company often carries out the plugging in
the case of an operator's noncompliance, letters of credit
place responsibility for plugging upon the regulatory
agency. Furthermore, the agency has the burden of trying
to recover costs from the operator. Consequently, letters
of credit may be marginally less acceptable to regulators.
(3) Trust Fund and Escrow Account
Both trust funds and escrow accounts offer an advan-
tage in that they isolate funds specifically intended for
abandonment in advance, when the operators' financial
interest in the well is greatest. Assurance of the
availability of funds is greatest if the entire cost of
abandonment is deposited in the account at the time the
well is drilled. Annual deposits ease the operator's
financial burden but increase the risk that the account
will never be filled, since the well may be abandoned when
annual profits fall below the amount of annual deposits to
the account.
Despite their similar approach to isolating funds for
compliance, trust funds are superior to escrow accounts in
that legal title to the trust fund is assumed by the bene-
ficiary (i.e., the regulatory agency), preventing the
operator from revoking the trust. The agreement generally
specifies that the operator will gain access to the funds
only after plugging is complete. If the size of an
individual operator's fund is greater than the actual cost
of abandonment, holding the funds until after abandonment
III-5
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is completed imposes an additional incentive to comply. In
case of nonperformance, the funds are payable to the state.
Thus, eventual availability and use of the funds is
assured. In the meantime, the trustee is obligated to
invest the funds in the beneficiary's interest.
In contrast to an individual trust fund, an industry
trust fund encourages compliance by reducing the size of
assessments in return for a high industry compliance rate,
and thus promotes industry policing of individual oper-
ators. Should the noncompliance rate exceed its antici-
pated level, however, sufficient funds may not be available
in the industry trust in any given year. For this reason,
industry trusts may have selective memberships to avoid
subsidizing unreliable operators by their financially sound
associates.
The implementation burden of trust funds and thus
their acceptability to the regulatory agency depends on the
type of trust and its specific terms. The agency must
monitor deposits to an individual trust or payment of
annual assessments to an industry trust to assure that
funds are being made available. Although the financial
burden to the operator is somewhat greater, the administra-
tion of individual trusts is made simpler by requiring a
lump-sum deposit of funds upon initiation of the trust,
rather than a gradual accumulation of the fund. The
regulatory agency may prefer the lump-sum deposit since it
provides a better guarantee of the availability of funds.
With regard to industry trusts, the agency must certify
compliance rates and determine the appropriate size of
assessments as well as monitor their payment by operators.
The use of escrow accounts to demonstrate financial
responsibility may prove cumbersome for the regulatory
agency, without offering specific advantages beyond those
of a trust fund. In addition to providing less control for
the regulatory agency, the operator's maintenance of legal
title encourages the account administrator to manage the
account in the operator's interest, subject to the con-
straints of the escrow agreement. The agency must
therefore monitor the account more closely than a trust
fund. Furthermore, in the event of operator bankruptcy,
the funds in escrow may be legally subject to creditors'
claims, endangering their availability for well plugging
and abandonment.
III-6
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(4) Financial Statement
Financial means tests, as portrayed via the operator's
financial statements/ provide the least assurance of proper
abandonment afforded by the five mechanisms considered here
and therefore are likely to be the least widely acceptable
to regulators. While operator financial health serves as
an indicator of impending bankruptcy and hence warns of the
need to establish a more dependable financial respon-
sibility assurance mechanism, it provides no direct guar-
antee of performance other than for maintenance of a good
relationship with the regulating agency in order to be able
to continue using this low-cost mechanism. No funds are
set aside for compliance and no -responsible third party
stands ready to assume financial responsibility should the
operator fail to perform. The agency is likely to bear the
burden of plugging and abandonment in the event of operator
nonperformance. Assuming that meaningful financial tests
could be devised and applied to all operators, agencies may
have neither sufficient manpower nor the technical exper-
tise to evaluate operators' financial statements or to
monitor their fluctuating status. In addition to burdening
agency resources, reliance upon faulty financial analysis
may defeat the purpose of financial responsibility require-
ments by certifying financially unqualified operators and
exposing the agency to unnecessary risk if the operator
fails to perform. The agency therefore is likely to set
stringent requirements and to require immediate establish-
ment of an alternative mechanism if the operator's
financial position begins to deteriorate, which is
precisely when such a change is least affordable.
While each of the alternatives discussed above has advan-
tages and disadvantages, surety bonds guaranteeing performance
appear to be the most consistent with EPA's objectives of
proper well abandonment and minimizing cost to the operator and
administrative burden to the state regulatory agency. Letters
of credit offer low cost to the operator, but the potential
requirement for greater regulatory agency activity in the event
of operator nonperformance reduces the likelihood of acceptance.
Trust funds offer an attractive alternative for operators who
cannot obtain a bond even with collateral. Escrow accounts
offer similar advantages, but are relatively unattractive to
regulatory agencies compared to trust funds and serve no
additional useful purpose. Submission of financial statements
is likely to be the most popular alternative with operators,
but does not assure compliance and will probably be considered
only for firms that are very stable financially. .
III-7
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APPENDIX A
-------
EXHIBIT A-l
Cost Elements of Alternative
Financial Responsibility Assurance Mechanisms
Financial
Instrument
Financial
Statement
Surety Bond
(No Collateral)
and Letter of
Credit
Surety Bond
(100%
Collateral)
Trust Fund/
Escrow Account
(Lump Sum
Initial
Deposit)
Description of Cost Elements
Costs of abandonment incurred by operator when well is
abandoned. Total cost equals present value of abandonment
costs discounted at operator's real cost of capital.
Preparation of statement involves no incremental cost.
Costs of abandonment incurred by operator when well is
abandoned. Total cost equals sum of present values of
abandonment costs and annual premium charges,
discounted at operator's real cost of capital.
Costs of abandonment incurred by operator when bond is
purchased and held by surety as interests-bearing
Collateral. Total cost equals present value of abandon-
ment costs at time of abandonment, discounted at real
market rate of interest, plus present value of annual
bond premium charges, discounted at operator's real cost
of capital.
Costs of abandonment incurred by operator when interest-
bearing account is established. Total cost equals
present value of abandonment costs at time of abandonment,
discounted at real market rate of interest, plus present
value of annual account administration fees, discounted
at operator's real cost of capital.
Cost Discounting
Equation
TC "
U+r)n
TC c i "c r a+r) "-1
(l+r)n U(l+r)n
rr C + -r F (1+r) "-1
(l+i)n [_r(l+r)n
TC c ^c r n-i
(l+i)n [ r(l+r?
]
]
1
Key: r = Operator's real rate of return
i = Real market interest rate
n = Number of years until well abandonment
SC = Annual service charge (in dollars) on bond, escrow account, or trust fund
C = Cost at time of abandonment
TC = Present value of costs of abandonment plus financial responsibility demonstration
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APPENDIX B
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EXHIBIT B-l
Total Cost of Well Abandonment
Using Alternative Financial Responsibility
Assurance Mechanisms (1980 Dollars)*
Financial Statement
r** = 5.0% i*** = 2.0%
r = 7.5% i = 2.0%
Surety Bond (No Collateral)
r = 5.0% i = 2.0% SC+ = 1.0-1.5%
r = 7.5% i = 2.0% SC = 1.0-1.5%
Letter of Credit (No Collateral)
r = 5.0% i = 2.0% SC = .25-1.0%
r = 7.5% i = 2.0% SC = .25-1.0%
Surety Bond (100% Collateral)
Escrow Account
(Initial Lump-sum Deposit)
Trust Fund
(Individual Operator* Initial
Lump-sum Deposit)
r = 5.0% i = 2.0% SC = 1.0-1.5%
r = 7.5% i = 2.0% SC = 1.0-1.5%
One Year
Before
Abandonment
$9,524
$9,302
$9,619-9,667
$9,395-9,442
$9,548-9,619
$9,369-9,395
•i
$9,899-9,947
$9,897-9,944
Five Years
Before
Abandonment
$7,836
$6,139
$8,268-8,484
$7,371-7,593
$7,945-8,268
$7,067-7,371
$9,490-9,706
$9,462-9,664
Ten Years
Before
Abandonment
$4,810
$3,380
$6,911-7,297
$5,538-5,882
$6,347-6,926
$5,024-5,538
$8,975-9,361
$8,889-9,233
Twenty Years
Before
Abandonment
$3,769
$2,354
$5,015-5,638
$3,373-3,883
$4,085-5,015
$2,609-3,373
$7,975-8,599
$7,749-8,260
**
***
Assumes cost of abandonment equals $10,000 in 1980 dollars at time of abandonment.
r = Operator's real rate of return
i = Real market interest rate
+SC= Annual service charge on bond, escrow account, or trust fund, as a percentage of total value
-------
APPENDIX C
-------
GLOSSARY OF FINANCIAL TERMS
ASSETS
BALANCE SHEET
BENEFICIARY
BLANKET BOND
CAPITALIZATION
CASH FLOW
COLLATERAL
COMMON SIZE MEASURE
The items owned by a firm, the value of
which are shown on its balance sheet at
cost or cost less depreciation.
A statement of a firm's financial
condition at a given date, as indicated
by the book value of assets and
liabilities.
The person or organization (in this
case the regulatory agency) designated
to receive the funds held in trust or
escrow.
A surety bond covering more than one
well within a state.
The total liabilities of a business,
including both ownership capital
(equity) and borrowed capital.
(1) Changes in a firm's cash account
over a given period caused by the
timing of revenues and expenditures.
(2) A measure of corporate worth that
includes net income after taxes plus
the value of tax allowances for
depreciation and depletion.
Property pledged by a well operator to
secure the interests of a surety
company or financial supporter in case
of failure of the operator to perform
as agreed.
Analysis of a firm's financial
performance relative to other firms of
similar size in the same industry, as
indicated by comparing values or trends
in values of financial variables or
ratios.
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CURRENT ASSETS
CURRENT LIABILITIES
DEBT FINANCING
DEPRECIATION
EQUITY FINANCING
INCOME STATEMENT
LEVERAGE
LIABILITIES
LIQUIDITY
LONG-TERM DEBT
Cash and other assets that are
reasonably expected to be realized in
cash or sold or consumed during the
normal operating cycle of the business
or within one year, whichever is
shorter.
Obligations whose liquidation is
reasonably expected to be satisfied by
the use of current assets or the
creation of other current liabilities,
or those expected to be satisfied
within the normal operating cycle of
the business or within one year,
whichever is shorter.
A firm's generation of capital by
borrowing, either from a bank or
through the sale of corporate bonds to
the public.
An allowance deducted from the cost of
a fixed asset to allow for aging, and
providing for a tax credit for the loss
in value.
A firm's generation of capital by sale
of ownership through new issues of
corporate stock.
That portion of a firm's financial
statement which indicates profit and
loss during a given time period.
The proportion of a firm's debts,
bonds, and preferred stock relative to
the value of its common stock.
Any direct financial obligation,
including current liabilities and
long-term debt.
The ease with which assets may be
converted to cash.
That portion of a firm°s obligations
that are not expected to be paid in
less than a year.
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NET CURRENT ASSETS
NET PROFIT
NET WORTH
OBLIGEE
OPPORTUNITY COST
PERFORMANCE BOND
PLUGGING BOND
RETAINED EARNINGS
STOCKHOLDER'S EQUITY
10-K REPORT
The excess of current assets over
current liabilities; equivalent to
working capital.
The income remaining from all sources
after deducting all expenses, including
corporate taxes and interest on loans,
and available for distribution to
stockholders or retained as earnings.
Total assets minus total liabilities
and is equivalent to stockholders
equity.
Individual or firm (the well owner or
operator) obligated to perform in
compliance with the requirements of a
surety bond, escrow, or trust agreement.
The value of the alternative
opportunities foregone in order to
achieve an objective. The opportunity
cost of capital in trust or escrow or
posted as collateral is equal to the
return that could have been earned from
that capital if invested elsewhere.
Surety bond.
Surety bond written to assure payment
for or performance of proper well
plugging and abandonment.
The accumulated total profits which
have been undistributed by a firm, and
included in the net worth or equity
section of the balance sheet.
The net worth of a firm after all
obligations have been paid.
Annual report required by the U.S.
Securities and Exchange Commission of
all publicly traded companies,
containing a complete set of financial
statements and summary of operations
for the past year.
-------
TREND ANALYSIS Analysis of changes in value of
particular financial indicators over
time for a single firm or for a group
of firms.
TRUSTEE An individual or company which manages
the assets of the obligee for a
beneficiary according to the
requirements of a trust agreement.
WORKING CAPITAL Funds available for general operations
and unforseen events, represented by
the excess of current assets over
current liabilities; equivalent to net
current assets.
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