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Investing in Oil and Gas: Treasure Hunting

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How Operators Explore for Oil, Drill Wells and Produce Oil

Step 1: Survey

While it’s hard to imagine sitting here in my cubicle in Houston, there are thousands of feet of Earth directly below my feet. (For reference, the Earth’s radius is more than 3,000 miles, but most oil and gas deposits lie in the first miles beneath the surface.)

Oil and gas deposits formed millions of years ago when organic organisms (think plankton-like) died and accumulated, thousands of feet beneath you.
Some oil and gas deposits expand over hundreds of square miles of land, and some are small, scattered and localized pockets.

You may have heard of famous US oil and gas fields covering large areas or multiple states. With the activity in unconventional resource plays, the most active areas in the US over the last 10 years include the Permian Basin (Texas & New Mexico), Bakken Oil Field (Montana & North Dakota), SCOOP/STACK (Oklahoma) and Eagle Ford Shale (Texas). These oil and gas reserves require millions of dollars to utilize horizontal drilling and produce high volumes of petroleum.

While these are exciting, the majority of US wells are “stripper wells” or vertical oil and gas wells producing small volumes (less than 10 BOPD). There are tens of thousands of new wells to drill and old vertical wells to work over that can deliver value to investors.

Exploring for hydrocarbons (oil and gas) involves geoscientists (petroleum geologists and geophysicists) searching for deposits of oil and gas beneath the Earth’s surface. Most exploration for oil and gas involves highly sophisticated technology that detects the location and size of these deposits. When they detect underground “features of interest” or “leads,” they can collect more detailed seismic surveys.

Seismic surveying is a method (on the surface of the Earth) to measure the time it takes for sound waves to travel underground and through rock of varying densities.

Oil and gas exploration is an expensive, high-risk operation (so we recommend working with a team top-tier oil and gas experts). The maps that geoscientists create of an area are the first steps to finding whether there are oil and gas deposits thousands of feet below the surface of the Earth.

Step 2: Aquire Rights

Oil and gas is a treasure hunt. The first to put the stake in the ground gets the valuables. Much like sports teams “acquire rights” for a new teammate, oil and gas companies acquire rights to drill, test and (hopefully) produce oil and gas.

Most companies lease the land. After the well is finished producing, operators seal the well, remove the equipment and return the land to its original state.

A landman negotiates, researches and completes land use and leasing deals. The most commonly leased types of land:

  • Fee acreage = Privately owned land negotiated privately between land owner and operator
  • State acreage = Land owned by the state and leased in public auctions
  • Federal acreage = Land owned by the federal government, managed by the Bureau of Land Management (BLM) and leased in public auctions

How to Calculate Your Net Revenue Interest

The negotiation of a lease involves giving owners a one-time payment (lease bonus) and a piece of the production, called a royalty, in exchange for time (usually 3-5 years) to explore for oil. In most instances (exception: “continuous drilling clause”), as long as there is one well producing hydrocarbons, then that one well will hold larger amounts of acreage and leases. This is called “held by production” or HBP.

The goal when exploring for petroleum-bearing reservoirs is to acquire the rights to land, drill a well and hold the acreage while you plan your full development or master plan.

After securing the lease, an oil and gas operating company has typically 2-5 years to begin production. This includes drilling new wells, working over old wells and installing facilities on the surface for processing the production. This requires upfront capital months (sometimes years) before the first oil goes to market.

Learn our formula for calculating net revenue and working interest in four steps.

Step 3: Test

Operating companies take big risks (money and time) to acquire and test for oil. To reduce the risk of drilling wells without payback, companies test prospects before drilling.

Geoscientists help pick the location to drill with the highest chance of success, and engineers create the plan for drilling, completing, producing and testing the first well.

Reservoir engineers and geologists estimate how much oil could be produced from the reservoir.

With these factors, management decides how to procure the money (e.g. debt or equity) to develop these wells and strategize the budget and timing of the wells.

Finally, after all planning is complete, it’s time to raise money to develop and test the well(s).

Several terms are important to understanding drilling for new oil and gas reserves.

  • Drilling = physically drilling a hole to a certain depth to facilitate the movement of oil and gas fluids to the surface
  • Completion = making a well ready for production (or injection). This includes running casing, cement, perforating the casing, stimulating the formation, production tubing and wellhead.
  • Facilities = surface equipment used to collect, measure, transport, store and separate oil, gas, water and solids. This includes flowlines on the surface, tanks, separators, compressors, et al.
  • Production/operation optimization = maintaining, measuring and monitoring the produced oil, gas and water. Fixing and tweaking production equipment in the wellbore and on the surface to optimize and maximize efficient production from the well. The work is typically associated with recurring expenses rather than capital expenditures.

Step 3.5: Succeed in the Test

Finding oil and/or gas in commercial quantities is exciting, much like finding buried treasure. You discovered resources trapped for millions of years and distributed them on the surface.

Step 4: Produce Oil

If the pilot program succeeded after drilling the first well(s), we are now armed with data (logs, core, production, etc.) we can use to update the seismic and nearby well data. Each new data point improves the geologic understanding of an area.

It’s time to develop the field and ramp up production. Some questions arise from management:

  • How many drilling rigs do we need?
  • How much money will we need to raise?
  • What midstream companies are nearby to process the oil and gas that we produce?
  • How much oil and gas production can we expect from these wells?

Specialized software solutions (e.g. reservoir simulators and production analysis), geologic maps, seismic data, data from the pilot (logs and cores), nearby well data (offsets), mathematical equations and published studies can help bring it all together.

After finding the best drilling locations, it’s time to look at the big picture. Geoscientist, engineer and land teams determine the number of wells needed to optimally drain the reservoir. The strategy involves starting with the most likely to succeed locations and working toward the edge of the acreage or formation. Landmen may acquire additional acreage to drill more wells following a successful pilot and ensure the leases are maintained and properly held by production.

During this time, oil production is happening and wells are generating revenue.

At the end of the day, operators want to make the most revenue for the lowest cost in the quickest way. They achieve this through efficient operations:

  • Balance of lowest costs for the highest quality drilling, completions and facilities
  • Most effective and efficient spacing and drilling plans for the acreage
  • Receiving benefits of optimization and overcoming the “learning curve” from drilling and completing new reservoirs in new areas, e.g. drilling one well after another, instead of one well every three months
  • Testing and monitoring producing wells as they’re drilled to ensure that shareholders are receiving value

Step 5: Divest

Every reservoir depletes over time (some slower than others). When the well is at the end of its useful life, it’s time to divest the wells to another operator or plug and abandon the well.

For example, the operator developed the acreage with many wells, and the field’s production is declining. A year ago, the operator made 2,000 barrels of oil per day (BOPD), and this year it produces 1,800 BOPD.

After large amounts of capital are spent on the main or primary production, it’s time to optimize the well’s production and minimize production decline rates.

Primary production leaves valuable reserves in the ground. The recovery factor (RF) is the amount of oil or gas produced over the total amount of oil or gas in the reservoir. Unless the operator implements reservoir maintenance or enhanced oil recovery (EOR), production declines until the end of the well’s life.

The term for wells that produce small volumes of petroleum is “stripper wells.” A majority of US producing wells are stripper wells that make less than 20 BOPD, so maximizing production and minimizing operating expense is paramount.

A generalized way to calculate the profit of an oil well:
(Oil production) x (Oil price) = Gross oil revenue

Note: Depending on the state, you pay a “severance tax” to the state for every barrel of oil or MCF of gas.

Gross oil revenue – (Cost to operate wells) = Net oil revenue (before tax)

Net oil revenue – (Taxes) = Net oil revenue (after tax)

The cost to operate wells includes expenses related to lease operators, workover crews, electricity, repairs, water disposal and other overhead. The revenue from the production of the well should exceed the cost to operate it.

Conclusion: What This Means for Investors

These five steps — survey, acquire rights, test, produce oil and divest — provide an overview of a well’s life cycle and revenue production.
If you’re interested in investing in oil and gas, we created a strategy for investing in oil wells in each life cycle phase.