A few things to consider before investing.
Why Me Lord? Are you looking to join J.R. Ewing down
at the Petroleum Club? Or, maybe you're simply looking for an outsized
return to make up for the recent recession. With oil recently trading
at between $50 and $55 per barrel, more drilling prospects will be
looking for funding. If you're considering jumping in, read on for
further understanding of the risks.
"Why did this proposal come my way?" Having analyzed many an oil deal, this is an overriding question that I am convinced is of primary importance. For this question 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 of the business and are able to evaluate the risks properly, AND who are able to afford a total loss of capital. Let there be no mistake about it, drilling oil wells is an extremely 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 often don't evaluate the risks properly. In fairness, the answer may simply be that one has ample excess capital to allocate to risky ventures, and as such, oil deals fit within your portfolio. If so, so be it. One can get very well, very quickly in a soundly executed play (oilfield lingo for a drilling project). So, having considered both sides of the coin, let's look at some of the risks.
People Risk: Simply put, this should rank first in the line of 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 is having questionable characters at the helm. Do your homework on the people involved. Those who are currently doing business with the sponsor of the project are a great source of information.
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 every day, but often with expensive hiccups along the way. A poor cementing job can allow channeling of oil or water behind the casing, instead of uphole where it belongs. Repairing this can bring unexpected and significant costs. Lots of mechanical tools get run into and out of a well before it's completed and producing. Many dollars have been spent "fishing" for things dropped in the hole - sometimes forcing total abandonment of the wellbore. Sometimes producing aspects of the well 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. You should, however, ask specific questions about mechanical problems with any wells near yours.
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. In order to get any project funded, a geologist must construct a case that the target is of sufficient size to produce enough to pay back the drilling costs multiple times over, and then some. Remember, this is an oil deal; you're looking for a greater than five to one, and hopefully a 20 to one payoff.
The point to understand here is that recoverable reserves can vary widely, the determination being 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 analyses. 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. Accurate and valid data, and plenty of it, combined with reasoned evaluation, is the best remedy for mitigating reserve risk.
Price Risk: OK, let's say you've been fortunate enough to have struck black gold, or even better (in my view) some good ole natural gas. Now, it must be sold. Raw hydrocarbons are commodity products, meaning you'll sell yours at exactly what the market will bear-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 (or 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 on the production has been put in place. Determine if a reasonable price forecast has been used in predicting the economic payoff of your project.
The "You" Risk: Are you able to manage yourself? A drilling project often times 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 dry hole, thus losing your investment. 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 ...You get the picture.
The bottom line is to go in with your eyes open, something this article proposes to achieve. Be sure you understand the scope of decisions you may have to make. A simple rule of thumb: Don't invest any more than you would be willing to lose at the roulette table.
Deal Structure Risk: Assuming all the planets have aligned thus far, and you're still considering moving ahead, take a hard look at the specific business structure and terms of the deal. How much of a premium are you paying-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 in the well have to bear their portion of the royalty paid to the landowner-he's getting a free ride. Read the operating agreement (that should be provided to you), which addresses ongoing 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 personal 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.
This is the one area of risk that poses the most exposure of simply getting taken advantage of. There are norms within the industry, and one should be sure the terms of the proposed deal fall in the fairway of these norms. If you don't know what they are, get professional help.
There is no doubt that the U.S. provides the best environment available for the layman to get in the oil business. And, there are reputable operators in the marketplace 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 afford it, you too might join in singing "Ole Jed's a Millionaire." See ya at the cement pond?
© Kenny DuBose 2005. Kenny DuBose is a registered investment advisor with Sweetwater Financial Advisors, a petroleum engineer and president of Cheyenne Minerals, an independent oil and gas company in Houston. He can be reached at (713) 240-9275 or email@example.com.