Companies must cosy up to new accounting standards

Asish K Bhattacharyya / New Delhi March 23, 2007


In accounting, an asset is said to be impaired if its recoverable value falls below the value at which it is carried in the balance sheet. How can this happen?

Initially, an enterprise acquires an asset only if it finds it economically viable to do so, that is, if the net present value (NPV) from acquiring the asset is zero or positive. Hence, on the acquisition date, the recoverable value of the asset would generally be higher than its acquisition cost.

However, subsequent events, such as increase in competition in the market or reduction in demand for the product or service, might adversely affect the service potential of the asset, causing its recoverable amount to fall below the carrying amount. This results in impairment of the asset and requires changes in the carrying amount to reflect the new reduced value of the asset.

Accounting standards require enterprises to test assets for impairment, whenever events that lead to a fall in their recoverable value occur. If the carrying amount of an asset is higher than its recoverable amount — defined as higher of its ‘value in use’ and ‘net selling price’ — the enterprise recognises an impairment loss and writes down the carrying amount to the recoverable amount.

Goodwill and intangible assets that are not put to use (for example, patent or licence not put to use), are tested for impairment at least annually. On reversal of events that caused recognition of impairment loss, subject to certain conditions, the enterprise writes back the impairment loss. For impairment loss on account of goodwill, these conditions are so stringent that impairment on account of goodwill is written back only rarely.

The ‘value in use’ component in the definition of recoverable amount requires us to attribute cash flows generated by a firm to specific assets. This is difficult to do if assets are defined too narrowly.

For example, a particular piece of equipment in a factory does not produce cash flows independently from other facilities in the factory; it is the factory as a whole which generates cash flows. To deal with this, the recoverable amount is computed for a group of assets, and impairment loss, if any, is then allocated to individual assets that constitute the group.

A group of assets tested collectively for impairment is known as a ‘cash generating unit’ (CGU). A CGU is the smallest identifiable group of assets generating cash inflows from continuing use that are largely independent of the cash inflows from other assets or groups of assets. Identification of CGUs involves judgement and there is the possibility of a difference of opinion arising between auditors and management. Deviations are possible on both sides.

The management may be tempted to group assets at a higher level than appropriate, in order to cover impairment loss of some assets by the healthy performance of other assets in the group. On the other hand, auditors, who are averse to risks and avoid situations that might attract criticism or litigations for negligence, may insist on grouping assets at a level lower than appropriate.

Once the CGUs have been correctly identified, ‘value in use’ of an asset (or a group of assets) is calculated as the present value of estimated future cash flows expected to arise from the continuing use of the asset in its present condition and from its disposal at the end of its useful life. The present value is determined by discounting pre-tax cash flows by an appropriate pre-tax discounting rate.

The other source of recoverable amount, ‘net selling price’, is the amount obtainable from the sale of an asset in an arm’s length transaction between knowledgeable and willing parties, less the costs of disposal.

The best evidence of an asset’s net selling price is a price in a binding sale agreement, in an arm’s-length transaction, reduced by costs of the disposal. If there is no binding sale agreement, the net selling price is the asset’s market price (current bid price) in an active market, reduced by costs of disposal.

In case current bid prices are unavailable, the net selling price is estimated with reference to the price of the most recent transaction. There might be situations where neither a binding sale agreement nor an active market for an asset is available.

In such a situation, the net selling price should be based on the best information available regarding the amount that the entity could obtain, at the balance sheet date, for the disposal of the asset. Outcome of recent transactions for similar assets within the same industry should be used as the basis for estimating the amount.

Some experts take a restrictive view of the concept of net selling price stipulated in the accounting standards by not accepting the appraisal method — which is an otherwise well-accepted method to determine the value of land, buildings and other assets — as an appropriate method to determine the net selling price. It is inappropriate to take such a restrictive view of net selling price. Let us consider a hypothetical case. Suppose, a company has three divisions, one of which is making losses.

The company has decided to continue running the loss-making division due to strategic reasons. Therefore, there is no binding contract for sale. Further, let’s assume that there is no active market for the purchase and sale of the same or similar businesses. There is no merger or acquisition in the industry.

The book value of the assets of the division (which is a CGU) is Rs 26 crore. Their value in use is Rs 12 crore. These assets include a large freehold plot of land, which is carried in the balance sheet at Rs 3 lakh (the historical cost), and buildings.

While the division itself has been running at a loss, its land and buildings have appreciated beyond their book value, with the appraisal method providing an estimated net sale value of Rs 41 crore. There is no way to take into account this significant economic fact if we reject the appraisal method, and the company will have to provide a misleading impairment loss of Rs. 14 crores.

On the other hand if we accept the net selling price determined through the appraisal method, no impairment loss is to be recognised. Here rejection of the net selling price determined through the appraisal method is inappropriate, more so since another accounting standard permits upward revaluation of fixed assets based on value determined through the appraisal method. In this situation, the management might want to use the appraisal method to estimate the net selling price, while auditors might argue against it based of a restrictive interpretation of the standards.

In most situations, it is the auditor’s view which ultimately prevails since managements and audit committees of the board of directors have traditionally been averse to adverse comments in audit reports. This mindset of managements and the audit committees should change. Implementation of new accounting standards and revised accounting standards involve judgment. Moreover, accounting practices for new accounting standards, such as accounting for impairment, are yet to evolve.

Therefore, managements should assert their position on interpretation of new accounting standards, provided they are confident that their interpretation of the accounting rule is based on sound accounting principles and the spirit of the accounting standards. This also increases the responsibility of audit committees. Instead of passively going with auditor’s view, they should provide an independent review of the accounting policy of the company.

The writer is professor of finance and control at IIm-C

Real estate prices in Mumbai

R Ravimohan / New Delhi March 16, 2007



Over the medium term of a few years, real estate prices in Mumbai should become competitive against other cities.

Real estate prices in Mumbai, and most cities around the country, have skyrocketed in the past one year. Since Mumbai still remains the price-setter for the rest of the country, let us understand the dynamics of real estate prices in this city. The market is rife with razor-sharp speculations on the expected direction of property prices, with almost an equal probability of prices staying at current levels, or going up even further, or coming down. Is there any methodical conclusion we can reach on the future direction of realty prices?

Several factors have combined to push prices up in Mumbai. For the past four years—backed by soft real estate prices, easy availability of finance, lower interest rates, liberalising construction rules, and better houses being constructed—there was a sustained buying trend that kept growing steadily. The wealth effect of rising income levels due to better wages, combined with the relentless growth of services (financial services, technology, BPO, retail, etc.), spawned a huge unmet demand for quality office space. Additionally, continued buoyancy in the stock markets diverted a lot of funds to the real estate markets. Private equity and venture funds also started taking strong positions on real estate, which infused large fresh funds into real estate. Then came the conjecture about the large-scale rollout plans by Indian and global retail Goliaths, which gripped the market in a frenzy of speculation. During all this time, the retail homeowner’s demand continued unabated, given the easy availability of home loans, and perhaps even spurred by the fear that if they did not buy they might miss the bus. The high prices are also a result of the failure of developers to bring new areas under development fast enough to counter this price hike.

The factors that can moderate prices are obviously the opposite of what have been identified as the drivers above. Most importantly, prices are completely out of whack with global trends, and have now reached a level where services are no longer competitive and have begun seeking alternative locations. Further, the high prices have attracted a new frenzy of construction, which on completion over the next few months will exert pressure on prices. The Bandra-Worli sea link, which is going full steam ahead, is expected to open up more areas on the Western corridor to access downtown Mumbai faster, thereby increasing supply. But the real benefit of this project is the encouraging prospects for the Trans-Harbour link, which will vastly increase the supply from the mainland to the hitherto land-locked paradigm of Mumbai. The provisions in the latest Budget proposals to withdraw Section 801b from March 2007, service tax of 12.5 per cent on lease rentals, and rising costs will dampen demand for residential property.

The floor space index (FSI) too impacts real estates prices. The higher the FSI, the larger the floor space that can be constructed per square foot of ground area, and therefore the lower the real estate prices. Currently the average FSI for Mumbai is less than 2. To put this in perspective, Hong Kong is now running well above 14! Admittedly Mumbai's infrastructure, as it stands now, does not give much scope for increase in the FSI. But large integrated developments, which have become the trend, are now able to achieve a considerably higher FSI. This gives rise to the hope that the pressure on the land area and, effectively, prices will ease progressively as the FSI gets liberated in tandem with improvements in road infrastructure.

Ultimately market forces will prevail. Sensible businesses will look for alternative locations. Any major ITeS or IT company now operates with big delivery centre operations somewhere else in the world other than in India. While India is still the fountainhead of talent, companies are not going to find homes and offices at viable prices in India at these levels. Unless prices moderate, the trend to set up delivery and off-shore centres in faraway locations such as South America and East Europe will gather momentum. Retail demand will sag if prices do not ease. Overseas markets such as Singapore and Dubai have become favoured destinations for Indian investors in real estate, because those are more attractively priced and the quality of those properties and the environment are also far superior. Interest rates on mortgages will move up significantly, choking off the smaller home buyers. Government policies on FDI on real estate are likely to be delayed, and probably be incremental, given the political sensitivities. Given the high prices, it will really be a brave foreign heart who will now bet billions on Indian realty! These are fundamental reasons why I believe prices will moderate.

However, I do expect continued buoyancy in the economic growth of both India and Mumbai. Thus, the salary push and attraction of foreigners to invest in India will continue. Indeed, buying continues till now unabated. Funds are still being generated in sumptuous measures in the overseas market, targeting real estate investments in India. Surely this inflow will keep the prices up, at least in the short term. I also believe that the developers and land ownership have a strong influence on the market, which is yet to get the full effect of the buyer’s power. We are far from the perfect market; so leaving the prices of real estate entirely to the market is not going to moderate the prices quickly. However, over the medium term of a few years, I expect real estate prices in Mumbai to become competitive against other cities, which are vying for businesses to shift to their cities. The prices in these cities are at considerable lower level than in Mumbai today. This slow moderation could be accelerated if the government decides to step in and step up city development plans, which is good, or if the money supply growth is sharply yanked, giving rise to deflationary expectations, which might be ill-advised, as it can potentially choke off the larger economy itself. The scope for any further sharp increase in real estate prices appears limited, with no further good news left for the market to rise up on.

The author is managing director and CEO, Crisil, a Standard and Poor’s company

Travel Guides for business

Business travel has witnessed a huge growth. With extensive expansion of multinationals in emerging markets, people are not just restricted to North America and Western Europe and are exploring new markets previously unknown to them. I have a habit of buying country travel guides whenever I visit a new country be it on leisure or business. But, what I have noticed is that there are no guides which exclusively cater to business travellers. I would definitely invest in any company which make such products. Moreso, the famous guides like Lonely Planet, Frommers, Frodders, GKT, all have their own shortcomings.

These are some of the topics that can be covered in the business travel guides:
1) History*
2) Places to stay and eat*
3) Detailed section on economy
4) Directory and description of prominent companies
5) Section on how to do business in the country
6) Section on politics

The House of Morgan: An American Banking Dynasty and the Rise of Modern Finance by Ron Chernow

I have been wanting to write a review on this book since a while. In this fascinating book, Chernow portrays the great influence that the Morgan banks had on the American economy and further since the late 18th century. It is a great book for individuals working in emerging markets and for others as well. It vividly describes how George Peabody started the banking house being a banker for the American states in London. Today, most emerging markets are in the same state (if not better) as America was earlier. Indeed, at that moment, the credit profiles of most of the American states didn't look good. This book describes how the British bankers harassed the states and how over time the financial centre changed from London to New York.

Chernow divides the 700 page book into several sections. The first section called the Baronial era in banking, is the most fascinating of the lot. After George Peabody establishes the bank, he died fairly young and brought in Junius Morgan from the US to be his successor. Junius Morgan scaled new heights, and then his son JP Morgan Sr. (Pierpont) took over. Pierpont is the name associated with the Morgan banks. He had a very powerful character which has been very colourfully described in the book (along with his comical physical traits). This was the infamous age of "Robber barons" where the banks, railroads, big steel and oil industry were very closely associated, if not owned by the same.

The second era is the "Diplomatic era", where Pierpont was succeeded by his son JP Morgan Jr (Jack). Jack was not as influential as his father and he was overshadowed by other bankers such as Dwight Morrow. This era is where the bank plays a very large international role rescuing the Bank of England and also helping finance the Nazis, Mussoline and Japanese nationalists. The other important event was the depression and how the bank was resilient inspite of it. This section was less vibrant compared to the first one and had very few fascinating characters.

The third era covered was called the "Casino era" and this was the birth of modern finance. With the Glass Steagle Act, the bank split into Morgan Guruantee and Morgan Stanley. This section describes a lot of the takeover battles that Morgan Stanley and Guarantee get involved in.

The book intertwines the history of the bank with the political and societal aspects very well. It also describes how the banking world was filled with groupism since the early days - the bank filled only white male protestants and both Jack and Pierpont hated jews. In fact, each bank had their own religious and social affiliations.

An excellent book! Must read.

Guru

Just watched the box office hit movie "Guru" by Mani Ratnam. The movie was very articulately made and depicted the life of the late Dhirubhai Ambani. The story of the lead character, Gurukant Desai (played by Abhished Bacchan) follows that of the business scion in every step. Scenes of his initial years in Yemen (shown as Turkey in the movie), where he sold cans of petrol and then returning back to his village to start his own venture trading in polyester. Overall, the movie was very entertaining and motivating to see the rags to riches story of the greatest Indian tycoon.

Inspite of being a book buff, I never happened to pick up a biography of Dhirubai (probably because they are not well written!). Here are a list of the books on Dhirubai and Reliance:

Dhirubhai Ambani: The man behind reliance by K Bhushan (Unknown Binding - Jan 1, 2002)

Dhirajlal Hirachand Ambani (Great personalities: life sketch series) (Paperback - Dec 1, 2005)

The Polyester Prince: The Rise of Dhirubhai Ambani by Hamish McDonald (Paperback - Sep 1999)

Guess many more are in line...

Let’s pass on the alphabet soup

By Gillian Tett

Published: December 28 2006 22:01 | Last updated: December 28 2006 22:01

When bright sparks at ABN Amro, the Dutch bank, recently invented an innovative debt product, it triggered a wave of Star Wars jokes. For the eggheads christened their brainchild – which has taken credit markets by storm this winter – a CPDO.

It stands for constant proportion debt obligation but, with a name like that, some bankers quip, it might be a new friend for R2D2 and C3PO, the robots from the films.

Welcome to the world of complex finance, a sector now so rich in abbreviations it leaves even seasoned financiers, as well as investors, scratching their heads.

A couple of decades ago, when new financial products hit the markets, banks gave them names. A host of new words crept into the investment bible over the years, such as “options”, “swaps” or “puts”.

These days, it seems, bankers cannot be bothered to name their creations. Instead, the trend is to wrap financial products in sets of initials almost as unwieldy as the products themselves. Thus the credit markets are full of CDOs (collateralised debt obligations), ABSs (asset backed securities), CDSs (credit default swaps), LCDSs (loan CDSs) and even the ABCDS (a CDS of an ABS).

Then there are CLOs (collateralised loan obligations), ECOs (equity collateralised obligations) and the recently arrived CDO2 and CDO3 (CDOs of CDOs of CDOs).

A longer-standing abbreviation is the CMBS (commercial mortgage backed securities) or its cousin the RMBS (residential mortgage backed securities), not to mention Reits (for real estate investment trusts).

This month Bank of America produced the Aldo (adjustable liabilities debt obligation), which is designed to compete with the CPDO. Bankers, however, sometimes call these “reverse CPPIs” (standing for constant proportion portfolio insurances) just to be more confusing still.

Some investors blame the “alphabet soup” on the fact that many bankers in complex finance have been trained in science and mathematics. Others suspect that bankers are just making life complicated to exude an aura of mystery – and justify fat fees.

Another factor driving the trend is broader acceleration
of the global financial innovation cycle. Low interest rates have left investors scrambling to find new ways to earn returns – and banks are responding by inventing products at such a furious pace, they barely have time to think up names.

“There is greater investor demand for products using derivatives – that drives the alphabet soup,” says Bob Pickel, head of the International Swaps and Derivatives Association (best known as the ISDA).

The soup is expected to thicken in 2007. Satyajit Das, a former derivatives trader who is now a consultant, says he is tempted to produce a spoof product called an unspecified fund obligation – or UFO.

Oil & Gas 101 - ABC of Industry

In this article, I will examine one of the most relevant industries of our era - petroleum. We will review the basics - constituents of petroleum, geology and then explore how oil drilling works and the later stages of completion and production. The content on the processes and geology have been extracted from several books and websites.

I have come across a lot of professionals working on specific segments of the industry - economists, investment bankers, consultants. These professionals provide some valuable advice to the industry participants, but many fail to understand the basics of the industry - like, what are the traps in the sedimentary basins where petroleum is found or the different types of technologies used in the drilling. Ofcourse, you can create your fancy financial models even without knowing the nitty gritty details, but it is always useful to have this knowledge and to speak in the language of a person in the industry.

Further articles will also explore the deal making process in the industry - how the land rights are allocated and the different types of deal structures among the industry partners.

Oil ExplorationOil is a fossil fuel that can be found in many countries around the world. In this section, we will discuss how oil is formed and how geologists find it.

Forming Oil
Oil is formed from the remains of tiny plants and animals (plankton) that died in ancient seas between 10 million and 600 million years ago. After the organisms died, they sank into the sand and mud at the bottom of the sea.



Over the years, the organisms decayed in the sedimentary layers. In these layers, there was little or no oxygen present. So microorganisms broke the remains into carbon-rich compounds that formed organic layers. The organic material mixed with the sediments, forming fine-grained shale, or source rock. As new sedimentary layers were deposited, they exerted intense pressure and heat on the source rock. The heat and pressure distilled the organic material into crude oil and natural gas. The oil flowed from the source rock and accumulated in thicker, more porous limestone or sandstone, called reservoir rock. Movements in the Earth trapped the oil and natural gas in the reservoir rocks between layers of impermeable rock, or cap rock, such as granite or marble.

These movements of the Earth include:

Folding - Horizontal movements press inward and move the rock layers upward into a fold or anticline.
Faulting - The layers of rock crack, and one side shifts upward or downward.
Pinching out - A layer of impermeable rock is squeezed upward into the reservoir rock.

Finding Oil
The task of finding oil is assigned to geologists, whether employed directly by an oil company or under contract from a private firm. Their task is to find the right conditions for an oil trap -- the right source rock, reservoir rock and entrapment. Many years ago, geologists interpreted surface features, surface rock and soil types, and perhaps some small core samples obtained by shallow drilling. Modern oil geologists also examine surface rocks and terrain, with the additional help of satellite images. However, they also use a variety of other methods to find oil. They can use sensitive gravity meters to measure tiny changes in the Earth's gravitational field that could indicate flowing oil, as well as sensitive magnetometers to measure tiny changes in the Earth's magnetic field caused by flowing oil. They can detect the smell of hydrocarbons using sensitive electronic noses called sniffers. Finally, and most commonly, they use seismology, creating shock waves that pass through hidden rock layers and interpreting the waves that are reflected back to the surface.



In seismic surveys, a shock wave is created by the following:

Compressed-air gun - shoots pulses of air into the water (for exploration over water)
Thumper truck - slams heavy plates into the ground (for exploration over land)
Explosives - drilled into the ground (for exploration over land) or thrown overboard (for exploration over water), and detonated
The shock waves travel beneath the surface of the Earth and are reflected back by the various rock layers. The reflections travel at different speeds depending upon the type or density of rock layers through which they must pass. The reflections of the shock waves are detected by sensitive microphones or vibration detectors -- hydrophones over water, seismometers over land. The readings are interpreted by seismologists for signs of oil and gas traps.
Although modern oil-exploration methods are better than previous ones, they still may have only a 10-percent success rate for finding new oil fields. Once a prospective oil strike is found, the location is marked by GPS coordinates on land or by marker buoys on water.

Preparing to Drill
Once the site has been selected, it must be surveyed to determine its boundaries, and environmental impact studies may be done. Lease agreements, titles and right-of way accesses for the land must be obtained and evaluated legally. For off-shore sites, legal jurisdiction must be determined.
Once the legal issues have been settled, the crew goes about preparing the land:

The land is cleared and leveled, and access roads may be built.
Because water is used in drilling, there must be a source of water nearby. If there is no natural source, they drill a water well.
They dig a reserve pit, which is used to dispose of rock cuttings and drilling mud during the drilling process, and line it with plastic to protect the environment. If the site is an ecologically sensitive area, such as a marsh or wilderness, then the cuttings and mud must be disposed offsite -- trucked away instead of placed in a pit.
Once the land has been prepared, several holes must be dug to make way for the rig and the main hole. A rectangular pit, called a cellar, is dug around the location of the actual drilling hole. The cellar provides a work space around the hole, for the workers and drilling accessories. The crew then begins drilling the main hole, often with a small drill truck rather than the main rig. The first part of the hole is larger and shallower than the main portion, and is lined with a large-diameter conductor pipe. Additional holes are dug off to the side to temporarily store equipment -- when these holes are finished, the rig equipment can be brought in and set up.

Setting Up the Rig
Depending upon the remoteness of the drill site and its access, equipment may be transported to the site by truck, helicopter or barge. Some rigs are built on ships or barges for work on inland water where there is no foundation to support a rig (as in marshes or lakes). Once the equipment is at the site, the rig is set up. Here are the major systems of a land oil rig:



Power system
large diesel engines - burn diesel-fuel oil to provide the main source of power
electrical generators - powered by the diesel engines to provide electrical power

Mechanical system - driven by electric motors
hoisting system - used for lifting heavy loads; consists of a mechanical winch (drawworks) with a large steel cable spool, a block-and-tackle pulley and a receiving storage reel for the cable
turntable - part of the drilling apparatus

Rotating equipment - used for rotary drilling
swivel - large handle that holds the weight of the drill string; allows the string to rotate and makes a pressure-tight seal on the hole
kelly - four- or six-sided pipe that transfers rotary motion to the turntable and drill string
turntable or rotary table - drives the rotating motion using power from electric motors
drill string - consists of drill pipe (connected sections of about 30 ft / 10 m) and drill collars (larger diameter, heavier pipe that fits around the drill pipe and places weight on the drill bit)
drill bit(s) - end of the drill that actually cuts up the rock; comes in many shapes and materials (tungsten carbide steel, diamond) that are specialized for various drilling tasks and rock formations

Casing - large-diameter concrete pipe that lines the drill hole, prevents the hole from collapsing, and allows drilling mud to circulate

Circulation system - pumps drilling mud (mixture of water, clay, weighting material and chemicals, used to lift rock cuttings from the drill bit to the surface) under pressure through the kelly, rotary table, drill pipes and drill collars
pump - sucks mud from the mud pits and pumps it to the drilling apparatus
pipes and hoses - connects pump to drilling apparatus
mud-return line - returns mud from hole
shale shaker - shaker/sieve that separates rock cuttings from the mud
shale slide - conveys cuttings to the reserve pit
reserve pit - collects rock cuttings separated from the mud
mud pits - where drilling mud is mixed and recycled
mud-mixing hopper - where new mud is mixed and then sent to the mud pits

Derrick - support structure that holds the drilling apparatus; tall enough to allow new sections of drill pipe to be added to the drilling apparatus as drilling progresses

Blowout preventer - high-pressure valves (located under the land rig or on the sea floor) that seal the high-pressure drill lines and relieve pressure when necessary to prevent a blowout (uncontrolled gush of gas or oil to the surface, often associated with fire)


Drilling
The crew sets up the rig and starts the drilling operations. First, from the starter hole, they drill a surface hole down to a pre-set depth, which is somewhere above where they think the oil trap is located. There are five basic steps to drilling the surface hole:
Place the drill bit, collar and drill pipe in the hole.
Attach the kelly and turntable and begin drilling.
As drilling progresses, circulate mud through the pipe and out of the bit to float the rock cuttings out of the hole.
Add new sections (joints) of drill pipes as the hole gets deeper.
Remove (trip out) the drill pipe, collar and bit when the pre-set depth (anywhere from a few hundred to a couple-thousand feet) is reached.
Once they reach the pre-set depth, they must run and cement the casing -- place casing-pipe sections into the hole to prevent it from collapsing in on itself. The casing pipe has spacers around the outside to keep it centered in the hole.
The casing crew puts the casing pipe in the hole. The cement crew pumps cement down the casing pipe using a bottom plug, a cement slurry, a top plug and drill mud. The pressure from the drill mud causes the cement slurry to move through the casing and fill the space between the outside of the casing and the hole. Finally, the cement is allowed to harden and then tested for such properties as hardness, alignment and a proper seal.

New Drilling Technologies
The U.S. Department of Energy and the oil industry are working on new ways to drill oil, including horizontal drilling techniques, to reach oil under ecologically-sensitive areas, and using lasers to drill oil wells.

Drilling continues in stages: They drill, then run and cement new casings, then drill again. When the rock cuttings from the mud reveal the oil sand from the reservoir rock, they may have reached the final depth. At this point, they remove the drilling apparatus from the hole and perform several tests to confirm this finding:

Well logging - lowering electrical and gas sensors into the hole to take measurements of the rock formations there
Drill-stem testing - lowering a device into the hole to measure the pressures, which will reveal whether reservoir rock has been reached
Core samples - taking samples of rock to look for characteristics of reservoir rock
Blowouts and Fires
In the movies, you see oil gushing (a blowout), and perhaps even a fire, when drillers reach the final depth. These are actually dangerous conditions, and are (hopefully) prevented by the blowout preventer and the pressure of the drilling mud. In most wells, the oil flow must be started by acidizing or fracturing the well.

Once they have reached the final depth, the crew completes the well to allow oil to flow into the casing in a controlled manner. First, they lower a perforating gun into the well to the production depth. The gun has explosive charges to create holes in the casing through which oil can flow. After the casing has been perforated, they run a small-diameter pipe (tubing) into the hole as a conduit for oil and gas to flow up the well. A device called a packer is run down the outside of the tubing. When the packer is set at the production level, it is expanded to form a seal around the outside of the tubing. Finally, they connect a multi-valved structure called a Christmas tree to the top of the tubing and cement it to the top of the casing. The Christmas tree allows them to control the flow of oil from the well.
Once the well is completed, they must start the flow of oil into the well. For limestone reservoir rock, acid is pumped down the well and out the perforations. The acid dissolves channels in the limestone that lead oil into the well. For sandstone reservoir rock, a specially blended fluid containing proppants (sand, walnut shells, aluminum pellets) is pumped down the well and out the perforations. The pressure from this fluid makes small fractures in the sandstone that allow oil to flow into the well, while the proppants hold these fractures open. Once the oil is flowing, the oil rig is removed from the site and production equipment is set up to extract the oil from the well.

Extracting the Oil
After the rig is removed, a pump is placed on the well head.



In the pump system, an electric motor drives a gear box that moves a lever. The lever pushes and pulls a polishing rod up and down. The polishing rod is attached to a sucker rod, which is attached to a pump. This system forces the pump up and down, creating a suction that draws oil up through the well.

In some cases, the oil may be too heavy to flow. A second hole is then drilled into the reservoir and steam is injected under pressure. The heat from the steam thins the oil in the reservoir, and the pressure helps push it up the well. This process is called enhanced oil recovery.

With all of this oil-drilling technology in use, and new methods in development, the question remains: Will we have enough oil to meet our needs? Current estimates suggest that we have enough oil for about 63 to 95 years to come, based on current and future finds and present demands.