Oil and Gas Investment Basics

If you have been on the receiving end of an oil or gas production as a royalty or mineral rights owner, you may have wondered if there’s money to be made in direct participation in the drilling of oil and gas wells. Direct participation can be lucrative, but caution must be exercised when entering the world of drilling oil wells. This article explains how to be wise when it comes to your money and oil and gas investing.

Origins of the Oil and Gas Investment

“Why did this deal come my way”? This is an overriding question of primary importance. It speaks to a poignant underlying issue regarding any capital intensive project – the issue of matching appropriate capital with the venture. Appropriate capital comes from investors educated in the art of the proposed deal who understand the legal and technical issues at play, and are able to evaluate the risks properly, and who can afford total loss of capital. Make no mistake about it – many oil and gas investments, and certainly drilling oil wells, is a risky proposition – not for the faint of heart. “Oil men go to Vegas to calm their nerves” is no overstatement.

Thus, while there are a handful of legitimate answers to this question, one should always make peace with why a project demanding highly engineered analysis – technical, economic, geological, and mechanical – is looking to the man on the street for money. Sometimes, it’s because industry experienced people don’t see it as an attractive proposition. Thus it finds its way to the country club crowd, seeking takers who may not evaluate the risks properly. In fairness, the answer may simply be that one has ample capital to allocate to risky ventures, and as such, oil deals fit the bill. If so, so be it. One can get very well, very quickly in a soundly executed play (oilfield lingo for drilling projects). So, having considered both sides of the coin, lets look over some of the risks.

People Risk

Simply put, this should rank first in line of the judgment calls one must make. Not enough ink can cover the topic of confirming the honesty, integrity, professional ability, and history of the people involved in the deal. Is the proposed operator of the well an experienced operator? Has he operated in the area? Is there extraordinary environmental exposure? Is the company financially sound? Is proper insurance in place? Is he putting hard cash in the project? You’ve got plenty of additional risks ahead. The last thing you need are questionable characters at the helm.

Mechanical Risk

Drilling a hole in the earth thousands of feet deep, cementing steel casing in it, perforating it precisely

in the right spot (err… not where the salt water is), and outfitting it to bring that precious hydrocarbon to the surface is no walk in the park. Sure it’s done everyday, but often with expensive hiccups along the way. A poor cementing job can allow channeling of oil or water behind the casing, instead of inside where it belongs. Sometimes reservoir attributes demand sand screens, and even specialized chemicals, which often aren’t friendly to steel pipe – especially when combined with temperatures exceeding 200 degrees Fahrenheit.

In short, there is plenty that can go wrong mechanically between the start of drilling and putting the first 10,000 barrels in the tank. Reality is that the layman has no way to mitigate mechanical risk once the project is underway. You’ll be relying on the expertise of the operator and his chosen drilling contractor.

Oil and Gas Reserve Risk

The size (and producing characteristics) of the reservoir you tap into has a LOT to do with whether or not a project ultimately makes economic sense. If you’ve put a straw into something the size of a swimming pool, well… you get the picture. Remember, this is an oil deal – you’re looking for a greater than 5 to 1, and hopefully a 20 to 1 payoff. The point to understand is that recoverable reserves can vary widely, the determination dependent upon educated guesses – well control, seismic evaluation, and the area’s historical production to name a few.

This evaluation can be open to interpretation, especially if there are conflicting opinions among the investors about the results of the analysis. Some may get cold feet and drop out, leaving you a holding a heavier bag than you initially bargained for. Thus, striking an oil or gas reservoir does not an oilman make. It’s got to be of sufficient size to matter.

Oil and Gas Price Risk

OK, let’s say you’ve been fortunate enough to strike black gold. Now, it must be sold. Raw hydrocarbons are commodity products – meaning you’ll sell yours at exactly what the market will bare – no more, no less. As with all commodities, numerous factors go into determining their value, all of which you have no control over. The simple thing to remember is that you (nor the company operating your well) have no meaningful influence on the price at which you sell your product. Reasoned forecasts are the best you can do unless a price hedge has been put in place.

The “You” Risk

Are you able to manage yourself? A drilling project often demands decisions from you along the way. For instance: Do you agree to set casing on the well? This is usually the first and most fundamental of questions. You are making a call as to the estimated productivity of the well – electing either to continue spending more money to complete the well, or declaring it a duster. Other possible emotional strains can come in the form of decisions about going forward in light of lost items in the hole requiring expensive “fishing” procedures, or “squeeze” jobs to cut off unwanted water, or long waits for pipeline hookups, or… – you get the picture. Bottom line – go in with your eyes open. Be sure you understand the scope of decisions you may have to make.

Oil and Gas Investment Deal Structure Risk

Assuming all the planets have aligned thus far, take a hard look at the specific terms of the deal. How much of your entry capital is going to direct costs – is this clearly determinable? Who and to what extent are others getting “carried” (i.e. carried along as a participant without any obligation to put their money in the deal). Is the difference in your NRI (net revenue interest) and your WI (working interest) reasonable? Remember, all the paying partners have to bear their portion of the royalty paid to the landowner – he’s getting a free ride (after all, it’s his oil you’re after). Read the Operating Agreement (that should be provided you), which addresses ongoing operational terms, should you be successful. Is the monthly management fee reasonable? You’ll (hopefully) be paying it for a long time. And, don’t forget to consider how this project might affect your tax situation. Finally, take a look at the others in the deal. Little speaks louder than a sponsor’s money invested on similar terms as yours.

There is no doubt that the U.S. provides opportunity for the layman to transform himself into an oilman. And, there are reputable operators who are more than willing to let you join them. There are risks aplenty, but if you’ve got the stomach and the cash to play, you too might join in singing “Ole Jed’s a Millionaire”.

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