Legal Definitions - cost depletion

Cost depletion is an accounting method used primarily by companies involved in extracting natural resources, such as oil and gas, to recover their initial investment in a property over time. It allows these companies to deduct a portion of their original investment (often referred to as their "basis") from their taxable income each year. This deduction is calculated based on the amount of the resource extracted and sold during that year, relative to the total estimated recoverable reserves from that property.

Essentially, as a company depletes its reserves by selling the resource, it gradually recovers its initial capital outlay for acquiring and developing the property. This method ensures that the cost of the resource property is expensed proportionally as the resource is consumed and sold.

• Example 1: Independent Oil Producer

  An independent oil company, Prairie Energy Inc., invests $15 million to acquire and develop a new oil field. Geologists estimate that this field contains 2 million barrels of recoverable oil. In its first year of operation, Prairie Energy Inc. extracts and sells 200,000 barrels of oil from this field. To calculate its cost depletion deduction for the year, Prairie Energy Inc. would determine the proportion of oil sold (200,000 barrels) to the total estimated reserves (2,000,000 barrels), which is 10%. They would then deduct 10% of their initial $15 million investment, resulting in a $1.5 million cost depletion deduction for that year.

  This example illustrates how the deduction directly corresponds to the portion of the resource that has been extracted and sold, allowing the company to recover a part of its initial investment as the asset is "used up."

• Example 2: Natural Gas Field Development

  Summit Gas Corporation spends $75 million to purchase and develop a natural gas field, with engineers estimating the field holds 10 billion cubic feet (BCF) of natural gas. In the first year of production, Summit Gas Corporation extracts and sells 1.5 BCF of natural gas. For tax purposes, Summit Gas Corporation would calculate its cost depletion by taking the ratio of gas sold (1.5 BCF) to the total estimated reserves (10 BCF), which is 15%. They would then deduct 15% of their $75 million investment, amounting to a $11.25 million cost depletion deduction.

  This scenario demonstrates the application of cost depletion to a different natural resource (natural gas) and highlights how the investment is systematically recovered as the resource is brought to market.

• Example 3: Fluctuating Annual Production

  Desert Sands Oil Co. invests $30 million in an oil well with estimated recoverable reserves of 3 million barrels. In Year 1, Desert Sands extracts and sells 300,000 barrels. Their cost depletion deduction for Year 1 would be (300,000 / 3,000,000) * $30,000,000 = $3 million. In Year 2, due to increased market demand and operational efficiency, Desert Sands extracts and sells 450,000 barrels. For Year 2, their cost depletion deduction would be (450,000 / 3,000,000) * $30,000,000 = $4.5 million.

  This example shows that the cost depletion deduction is not a fixed annual amount but rather fluctuates based on the actual volume of the resource extracted and sold in a given period. This dynamic calculation accurately reflects the rate at which the company's initial investment is being "depleted" as the resource is produced.