Phelps Oil Wildcatters plc has leased property on which oil has been discovered. Wells on this property produced 36,000 barrels of oil during the past year, which sold at an average sales price of £65 per barrel. Total oil resources of this property are estimated to be 500,000 barrels. The lease provided for an outright payment of £1,200,000 to the lessor (owner) before drilling could be commenced and an annual rental of £62,000. A premium of 4% of the sales price of every barrel of oil removed is to be paid annually to the lessor. In addition, Phelps (lessee) is to clean up all the waste and debris from drilling and to bear the costs of reconditioning the land for farming when the wells are abandoned. At the time of the lease, the estimated fair value of this clean-up and reconditioning is £50,000.

Instructions

a. From the provisions of the lease agreement, compute the cost per barrel for the past year, exclusive of operating costs, to Phelps.

b. Compute the impact on Phelps’ current-year profit and loss of the operation of the leased property.

c. Phelps is considering putting in a bid to lease an adjacent tract of land for development, based on some preliminary geological surveys and exploratory drilling. Advise Phelps on how to account for these exploration and evaluation costs.