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How to Understand Oil Deal Structures

blocks falling on table

(If You Are Vetting Oil and Gas Investments on Your Own)

Understanding the deal structure of an investment opportunity can be challenging since not all oil deal structures are the same. Weighing the integrity of the geological features of the prospect vs. your net revenue interest is one way to offset some of the geological risk.

Working Interest and Net Revenue Interest

Simply put, the working interest is a breakdown of interest from all paying partners in the project, otherwise known as the expenses. This is not to be mistaken for a royalty interest. Royalty owners usually do not have to pay a dime in the project. They are carried by the working interest owners.

Net revenue interest (NRI) is the percentage of production that each party receives after all burdens, such as royalty and overriding royalty.

As a general rule, you do not want to take on an oil deal with less than a 75% NRI. There are of course exceptions to consider (such as great geology, low buy-ins and your ability to spend time finding and researching quality operators and projects).

Dig deeper: learn our four simple steps to calculate NRI vs. working interest.

Project Ownership Breakdown

When investing alongside other firms, take a look at the other working interest owners. Are they known and respected industry professionals? Are there other respected operators participating in the deal? This could be a good sign.

Also look at the operator/project generator.

A great rule of thumb is to never invest in a project where the people or company who brought you the project doesn’t invest their own money. If they don’t believe in the project enough to invest their own money, why should you?

Make sure the operator has a decent sized chunk of the deal he or she is paying for; otherwise, run for the hills.

What’s in it for the Operator?

The operator usually takes a “promote” for bringing together the project and to cover the cost of generating the geology and land. This is called a prospect fee. These are typical, but investors need to understand how to spot a higher-than-normal fee and how to factor that into the economics of the prospect.

Operators can also take a promote in the form of an overriding royalty interest. This is a royalty against the working interest owners.

Carried interest is common as well. As compensation for discovering, packaging and running the project, operators sometimes give themselves a “no risk” carry. Basically, the other working interest owners agree to pay a small percent of their net revenue interest (NRI) to the operators. This payment is usually triggered after the successful completion of the well and/or after the investors are paid back.

When considering these options, the most favorable is through casing point. The operator starts paying his or her share of costs right after drilling to total depth, then testing the mud in the pipe for hydrocarbons. The operator starts paying before deciding to set casing in the hole to attempt completion of the well.

This helps assure the operators’ interests are aligned with the investment partners’.

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