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Investing in Oil and Gas

Chapter 6:

There are three main forms of investing for the typical oil and gas investor, which are listed below.

Publicly Traded Exploration / Production Company

The easiest way to invest in oil and gas is through a publicly traded company. Here you are betting that the company will be able to effectively find, develop and maintain oil and gas fields.

Production Projects

Purchasing producing oil and/or gas properties allows immediate income from your investment. However, it takes a trained petroleum geologist or engineer to give a reasonable expectation of how long the oil and/or gas will continue to be produced in order to make a sound investment.

Drilling Projects

Many investors are looking for opportunities to invest in drilling projects as a means to diversify their portfolio. Drilling projects offer high net-worth / high-income investors tax deductionsoil rig and income potential. But drilling for oil and gas is a risky business as a substantial portion of the wells that are drilled either do not hit commercial reserves or the well experiences unexpected problems.

Sophisticated oil and gas investors realize that they may have to participate in several projects in order to obtain a paying interest in a well. So, the rewards of a producing well will essentially have to make up for losses on past projects as well as future projects that may prove to be dry. This being the case, it is important to invest in deals that offer a promising chance for success and an excellent return on your investment. There are three key areas to evaluate when considering an oil and gas drilling project: the People, the Deal Structure, and Projections.

Who Am I Doing Business With?

Look first at the people who originated the deal. When oil prices are high, more and more people enter the oil business and start assembling and marketing oil and gas deals. Therefore, look first at the company offering the project to determine how long they have been in the oil business and in what capacities. Look for experience in managing projects. This criterion will help keep you out of deals with people who are inexperienced and less likely to manage the project properly.

Next, make sure there is a petroleum geologist on the project manager's staff. This is the person who will look at the geology and related data on a project and give their evaluation of its likeliness for success. While prospect-generating geologists are almost always reputable, they will have a certain natural bias toward their project. But, while they may be focusing on a good prospect, there may be even better prospects elsewhere. A full-time, in-house petroleum geologist has the latitude to select from many projects.

When looking at the project management company, also ask to speak with prior / existing investors. It's important that investors be kept well informed as to the drilling status, which includes receiving timely progress reports as well as monthly well production and year-end reports. Sadly, not all companies are prompt in providing monthly progress reports or supplying essential year-end information that's needed for filing timely tax returns. With that in mind, I suggest talking with the project manager's investors who have participated in prior drilling and production projects.

How Is The Project Structured?

There are nearly as many ways to put together an oil and gas investment in a drilling or production project as there are oil companies in the industry. However, regardless of the project's structure or complexity, each can be boiled down to answering two simple questions: Who gets what percent of the revenue over the life of the project? And, are the anticipated costs within a reasonable range?

Most oil and gas projects have the following parties involved when it comes time to share revenues from a producing well - the mineral owner (owner of the oil and gas rights), the project manager, and the investor group which is financing the cost of drilling, completing, and producing the well.

Traditionally, the mineral owner receives a royalty interest of 12.5% to 25% of the total production revenue of a producing well without paying any costs. The remainder of the revenue interest is divided up between the project manager and the investor group. When the deal is structured with a royalty interest greater than 30%, someone has carved out an overriding royalty interest that is exorbitant. This cuts into the investor's rightful revenue interest. Therefore, it usually doesn't make good investment sense to get involved in an deal where the royalty interest is greater than 30%.

On the cost side, we are looking at the cost of generating the prospect, buying the lease, and drilling and completing the well. Some deals are structured in a manner that the project manager can come back to the investors with additional investment demands in the event of unexpected additional drilling and/or well completion costs. For the investor, I am wary of this type of deal because the investor's risk is not certain or capped. When a deal is capped or turnkeyed, the prudent project manager should add a reasonable allowance to the drilling and completion budget to cover unexpected expenses. If costs overrun this additional padding, the project manager is responsible for any overruns. If the well drilling and completion costs come in below budget, the project manager will keep the difference. At first, this may seem unfair, but in this way the padding acts like an insurance policy paid for by the investor group. The investor has a cap on his liability and the project manager assumes the added risk. The project manager should provide the drilling and completion costs estimate, called an AFE (Authorization for Expenditure), to the investor. A few calls to service companies and the drilling contractor used by the project manager can reveal the extent of the markup.

Does the Projected Monthly Production Justify the Money You Are Investing?

In an established oil and gas area, the petroleum geologist makes the production projections on a payout based on the production histories of nearby wells. My simple rule of thumb is that you want to see projections that (at current oil and gas prices) will return your entire investment in 24 months or less. If the projected production doesn't support a 24-month return or better on the investment, the investment risk is too high given the expected return. Allowing for the fact that a good portion of all wells drilled will be non-producing, you want to make certain that the ones that do produce make up for the ones that do not.

Additional Considerations

Be wary of the project manager that claims to have hit nine of the last ten wells or anything similar. If that were true, they would not need your money to help spread the risk since there wouldn't be any risk. In addition, be careful of multiple well projects on the same acreage. Only by completing a well and establishing production do you gain the necessary information you need to determine if a second well should be drilled on the same acreage.

Acid Test: Evaluating Oil and Gas Projects

Potential investors are cautioned to look at oil and gas projects carefully. Investors need a reasonable opportunity for reward versus their investment. My advice is to look at the potential payout of a proposed project versus your investment. You'll need to do a little math to compare the risk/rewards associated with various project offerings: Say you are being offered a .7% net revenue interest in a project for $100,000. For your investment to break even, the well will need to produce a total of $14,285,714 in revenue ($100,000/.007 = $14,285,714). If oil averages $50 a barrel, your well will have to produce at least 285,714 barrels of oil over its productive life ($14,285,714/$50 = 285,714 barrels) for you to break even. You can do the same math for gas or a combination of oil and gas projects using the anticipated price per thousand cubic feet of gas. Now here's the acid test: look at the wells in the area and see if any have yielded the amount of gas and/or oil your project will need for you to get a substantial return on your investment. You always want to use a conservative price for oil and gas when doing the acid test. If you buy into a project as a speculative bubble is growing for oil and gas, you don't want to get caught when the speculative bubble pops. Of course, if the project does pass the acid test, you still need to examine the geology to evaluate the risk.

Investing in a single oil and gas drilling project should not be looked at as a one-shot proposition. Most investors will have to experience a certain number of non-producing projects before they hit a producing project. When you do hit that producing well you want to be in a project with people you trust, and you want to be in a project that's fair, and one that has is likely to pay back your investment in short order. I believe the above guidelines will go a long way toward helping you achieve those objectives.

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