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Detecting Fraud and Mitigating Risk for Natural Resources Companies
By Jeff Harfenist
The natural resources industry is often noted for three things: the mercurial nature of a commodities-based market; pressures from myriad national and regional regulations; and the inherent challenges presented by disaggregated operations in high-risk areas. Oversight of risks related to operational and financial reporting decision-making – primarily through exposure to corruption and fraud – is top-of-mind for executives and their advisors. And amid the rapid pace of globalization and the growth in compliance obligations in the natural resources sector, resources are stretched further than ever. The risks stemming from today’s heightened regulatory environment are significant and demand that organizations take action sooner rather than later.
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National Practice Leader - Advisory
Tell us a bit about your practice area, especially in the Natural Resources industry.
I lead BDO’s Advisory practice, helping clients manage risk with internal audit, internal controls, technology and business solutions. Our team consults with clients to improve their business performance through the design and implementation of comprehensive global compliance programs, as well as evaluation of their existing policies, procedures and controls. We enjoy creating a positive change for companies facing issues where process, people and technology meet.
The natural resources sector is constantly changing and faces an ever-evolving threat environment. The industry also brings together a diverse group of businesses and people, each with a unique set of challenges. Risk advisory work in the natural resources sector is exciting simply because no two client problems are exactly the same, and we can bring a wide variety of tools to the table to help solve them.
What do you see as the biggest opportunities facing the industry today? The biggest challenges?
The industry’s biggest challenge – low oil prices – is also its biggest opportunity. Though the markets may feel uncertain now, companies can take proactive steps to protect their assets and gains until oil prices improve. For example, now is a great time for companies to think about acquiring new assets. Some of the supermajors with stronger balance sheets are already growing quite acquisitive, looking for solid investment opportunities in productive shale plays. But this opportunity also extends to the middle market and smaller companies who also enjoy strong balance sheets.
Given the longer term outlook for WTI and Brent crude, many E&P and oilfield services companies are facing cost-reduction challenges, threatening their long-term cash flow. By investing in the right portfolio, clients may be able to weather the ongoing price volatility by improving efficiencies and diversifying their businesses.
What do you see as some of the biggest risks facing energy companies, and what can they do to mitigate them?
Energy companies cannot control volatile oil and gas prices, but they can control how they manage their operations to gain the most efficiencies and prevent surprises.
Companies must have the right internal checks and balances in place to effectively address risk. If they don’t, they’ll have a difficult time sufficiently gathering and processing information, limiting their access to the insights that facilitate better decision-making. By implementing robust internal processes and systems to detect fraud, inefficiencies and other internal threats, companies can improve their businesses’ performance in a market plagued by uncertainty.
Cybersecurity is a growing concern across numerous industries. How can natural resources companies protect themselves against cyber threats?
There are a number of cybersecurity risks that can significantly impact natural resources organizations. For example, they could lose sensitive customer data to a breach or see declines in organizational efficiency if resources aren’t available to handle an attack. Companies could also receive fines from government bodies or experience a rise in insurance costs if they don’t implement proper security measures.
Though the situation of “perfect security” does not exist, there are a number of measures an organization can take to minimize the impact if a breach were to occur. For example, companies should establish comprehensive policies and procedures that outline how to respond to a breach, and train their employees and contractors regularly on these policies and procedures.
Additionally, implementing firewalls on externally facing networks and using a deny-all policy that authorizes and monitors inbound and outbound communications are critical steps companies should take. This way, they can quickly identify and close the gaps where attacks have occurred. Moreover, performing regular cybersecurity risk assessments can refine an organization’s specific threat profile. Companies must establish strategies that mitigate both severe and moderate risks, and test the solutions on a regular basis.
The 2015 BDO Oil & Gas RiskFactor Report, unsurprisingly, found that volatile commodity prices were the most-frequently cited risk in publicly traded oil & gas companies’ 10-Ks. As you noted earlier, no one can control commodity prices, but how can BDO help companies facing cash flow issues or those trying to reduce expenses as a result of recent price fluctuations?
We can help companies identify practical and sustainable risk management solutions to help them remain resilient in times of uncertainty. For example, we assisted a publicly traded natural gas company with its vendor audit program. In the initial stages of the project, we identified recoveries resulting from overbillings related to labor, transportation and other expenses. As we conducted the audit, we found there were contractually required discounts certain vendors had not provided or inaccurately calculated. Our professionals worked alongside the client’s ethics and compliance department to carry out an investigation in conjunction with our audit, and as a result of our coordinated efforts, we helped the client quickly recover claims while assisting with rebuttals and negotiation with vendors. In a market with low commodity prices, finding savings or, in some cases, refunds, is more important than ever.
By Jonathan Forman & Chai Hoang
Generate Tax Savings from Past and Future Investments with R&D Tax Credits
Companies operating in the oil and gas industry could be missing out on millions of dollars in the form of federal and state research and development (R&D) tax credits. Whether in the upstream, midstream, or downstream sectors, companies operating in this industry are potentially performing activities that qualify for these credits.
The R&D Tax Credit provides the potential for significant benefits for oil and gas companies. The most recent data reported by the IRS shows that over $10.8 billion in R&D Tax Credits from all sectors were claimed in 2012. However, the total credits claimed by petroleum and coal manufacturers made up only $80 million of those credits. With only 54 manufacturers within this industry claiming the credit, the average claim was $1.48 million. These statistics illustrate the possibility of significant benefits but also point to the large number of oil and gas companies that might not be taking full advantage of the credit.
R&D Tax Credits in Oil and Gas
Companies attempting to develop or improve the functionality, performance, reliability or quality of products, processes or software are likely eligible for the credit. The R&D Tax Credit is an activity-based credit and represents a dollar-for-dollar offset against income tax liability.
Businesses of all sizes can use these benefits generated from spending on past and future investments to increase their cash flow to hire employees, invest in equipment and expand their operations. Even more, incremental improvements may be enough to qualify for the credit and the research and development does not have to be successful.
In general, if a company has or is attempting to develop more effective and efficient ways to explore for oil and gas, extrude and produce it, transport it and/or refine it, then the company may be eligible for the R&D Tax Credit. In addition to large oil and gas companies, small and mid-size companies that provide services to the oil and gas industry are also potentially eligible for these credits.
Specific examples of eligible activities within the oil and gas industry include attempting to develop or improve the functionality, performance, reliability or quality of components such as drilling techniques, chemical reaction processes, conversion and treating, coiled tubing technology, product optimization technologies, and geological and geophysical interpretive methods.
Eligible costs that qualify for the R&D Tax Credit include wages paid to employees engaged in qualified research as well as for directly supervising or directly supporting qualified research and a percentage of payments to consultants or contract laborers for qualified research. Additionally, tangible, non-depreciable property used in the process of research and development may also be eligible.
Extending the Credit
Since the R&D Tax Credit (also commonly referred to as the Research Credit) is a temporary credit, it is not surprising that it’s currently expired. The credit has in fact expired many times previously and has subsequently been extended each time. At the end of July this year, the U.S. Senate Committee on Finance voted to approve a tax-extenders package that would extend various tax items, including the Research Credit. This package is now pending a vote from Congress.
Possible Changes to the R&D Tax Credit
As mentioned above, a tax-extenders package has been passed by the U.S. Senate Committee on Finance and is currently with the House of Representatives, which can consider the current bill or introduce its own.
Possible changes within the current bill can be beneficial for oil and gas companies, especially for smaller businesses or startups. Under this bill, small businesses can claim the Research Credit not just against their regular income tax liability, but also against their payroll taxes, an option not available in the past. Additionally, some companies would be able to claim the credit against their Alternative Minimum Tax, allowing previously excluded companies to potentially be able to claim it. If the past is prologue, the credit should be extended once again. If the current legislation is passed as written, then the R&D Tax Credit would be extended retroactively for 2015 and also through 2016. If companies in the oil and gas industry haven’t done so already, this is a good time to consider whether they’re leaving significant benefits for their past and future investments unclaimed.
Other Recent Developments
Additional taxpayer-friendly developments in the Research Credit area have made the potential for tax savings even greater.
Earlier this year, the IRS released proposed regulations that help clarify what is considered internal use software (IUS). Software developed for a company’s internal use has had to meet a higher standard than other activities that qualify for the credit. The proposed regulations narrow the definition of IUS and thus broaden the software development activities that do not need to meet this additional standard.
Another major development came last year, where the IRS released regulations allowing a taxpayer to elect the Alternative Simplified (ASC) method on an amended return. There are two types of methods, the Regular Credit Method and the ASC method. Previously, the ASC method had to be claimed on an originally filed tax return. With the new regulations, companies can claim this method that generally requires more recent financial information than the Regular Credit and, as its name suggests, is a simplified method.
With an extension of the R&D Tax Credit likely to come soon and in light of these recent developments, oil and gas companies would be wise to re-evaluate whether they’re one of the many companies leaving money on the table by not claiming the credit.
Jonathan Forman is a tax principal and managing director with BDO’s Global R&D Center of Excellence. He can be reached at email@example.com.
Chai Hoang is a senior associate with BDO’s R&D Tax Services practice for the Northeast U.S. region, and can be reached at firstname.lastname@example.org.
PErspective in Natural Resources is a feature examining the role of private equity in the natural resources sector.
PErspective in Natural Resources
Deal activity in the oil and gas sector continues to be sluggish as commodity prices remain depressed. However, private equity investors may see some opportunity in the alternative energy market. Continuing a trend from Q1, oil and gas deal activity was down in terms of volume during the second quarter of this year, but was the highest by dollar value since the fourth quarter of 2012, according to the Energy Information Administration (EIA). This is thanks to Royal Dutch Shell’s acquisition of British rival BG Group for $83 billion, which accounted for a whopping 73 percent of second quarter M&A, Oil and Gas 360
reports. Without that megadeal, the value of Q2 deals would have totaled just $31 billion. The transaction is not likely to spur a megadeal M&A boom, however, because companies in the sector have been unable to agree on prices for buying and selling assets, Oil and Gas 360 reports.
Did you know...
The Energy Information Administration’s
August 2015 Short-Term Energy Outlook predicts that West Texas Intermediate crude oil prices will average $49 per barrel in 2015 and $54 per barrel in 2016.
According to the BDO 2015 Global Energy Middle Market Monitor
, publicly traded North American middle market oil & gas companies’ reserve replacement rates reached a median of 182 percent in 2012, 268 percent in 2013 and 175 percent in 2014.
Economic and market analysis firm BMI Research
estimates that oil & gas companies owe about $550 billion in debt repayments over the next five years.
The number of U.S. oil company bonds yielding greater than 10 percent – a signal of distress – has more than quadrupled in the last year, reports Bloomberg Business
According the American Petroleum Institute
, U.S. demand for oil reached its highest August levels in five years in August 2015 – up 0.8 percent to an average of 19.6 million barrels per day.
The International Energy Agency’s
August Oil Market Report finds that global oversupply reached 3 million barrels per day in the second quarter of 2015, the widest gap between supply and demand in 17 years.
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