When investing in oil & gas, it’s important to know certain information before making your decision to invest in any oil & gas project. Novice investors often get caught up in the excitement of oil & gas, because they have heard about the big returns on an investment from a friend who happened to hit it big on an exploratory venture. In their excitement, they often invest in the first project that is presented to them, and unfortunately, that project may not be suitable for them.
There is a natural human tendency, for casino gamblers and oil well investors alike, to brag about their winnings and neglect to talk about their losses. One major difference between these two “games” is that the average casino gambler, if he has played long enough, statistically should be in the “losing category”. If this were not the case, then, the beautiful city of Las Vegas would not even exist. On the other hand, the average oil well investor statistically should be in the “winning category”. This is also true of the petroleum industry.
Large companies are in a position to take extraordinary high drilling risks, because the mathematical probabilities are in their favor. They can afford to drill a wildcat well with a 10% probability of success, because, if the well is successful, the company would make more than 10 times their invested capital. (If it were exactly 10 times their investment, then that would be a “wash’, meaning that if they continued to play this “game”, they would not make any financial progress.) Companies like Exxon have become great because they have drilled many high risk projects. When Exxon plays the game, the math was always in their favor.
Even though the mathematics of a particular project highly favors the investor, this does not mean that this project is suitable for all investors. My advice to novice investors is that they should not play the oil exploration game at all, unless they have money that they can afford to lose. They should expect to lose all their money, each time they participate in a “wildcat well”. To be successful, an investor that plays this strategy must be prepared to “stay in the game” and subject himself to multiple losses until the odds smile upon him. A comparison can be made between the Casino Industry and the Petroleum Industry. While both industries are based on the mathematics of probability, one should be viewed as “entertainment” and the other should be viewed as “investing”. In a casino, some games have significantly better odds, particularly if the player understands the game. This is also true in the petroleum industry.
In this report we outline some of the pitfalls that you should avoid as you play the oil game:
1. First of all, you should be investing through a company or someone who has years of experience in the oil and gas business.
2. The oil company, whether large or small, must be credible. This company, often called the “Operator”, should have well educated and experienced technical advisers (petroleum engineers, geologists, and landsmen.)
3. While not essential, these technical professionals should have a successful track record, showing that they have a proven ability to select successful projects.
4. It would be an advantage if you could get an opinion from a technical professional that is not a principle in the project. The old adage that “Every mother thinks that their baby is beautiful” also applies to the geologist who generates the drilling prospect. Often, a geologist will generate a drilling prospect that he honestly loves. This does not mean that it is suitable for a novice investor.
5. If you have a plumbing problem, you don’t call a carpenter — you call a plumber. Petroleum investors do this by having a geologist or petroleum engineer review the project before they invest. Just keep in mind that your independent geologist may have his own prospect that he is trying to get funded. He will always like his project better than anything you may show him.
6. Look for common sense reasons to invest in the project. If there aren’t other successful wells in the area, then you should consider the prospect to be risky — and possibly a highly risky “wildcat” well (5 to 25% possibility of success). Unless you are prepared to lose all of your money, do not participate in these projects. You may hear statements like “I know there are no other successful wells in the area, but our geologist believes that this well will be a home run.” Of course the geologist believes this – he would not be a good geologist if he did not believe in his own work. But the fact remains, that even the very best exploratory geologists are wrong most of the time.
7. Beware of the fancy glossy packaging. The old adage, “Color Sells,” applies here. As in all industries, the lack of merit in a project being sold can often be overcome by dressing the homely gal in fancy clothes.
8. It may be said that there are basically two types of “Deals” offered in the petroleum industry. These are “Promoted Deals” and “Industry Deals”. The fact is that Industry Deals are, almost without exception, also promoted to the extent that the originating company gets compensated for putting the deal together, whether or not the well is successful. The exception to this rule is usually when one large company desires to reduce their risk in a particular project by offering a huge percentage ownership in a project to one or more other large oil companies.
9. Speaking of “Promoted Deals”, there are basically two types of these – the “Reasonably Promoted Deal,” and the “Over-promoted Deal”. The Over-promoted deal is one where the Operator plans to hit a financial home run whether or not the well is successful. There are many cases where the drilling operator has increased the price of his offering ten times or more. Occasionally, there is a crooked operator that deliberately oversells the well, meaning that the operator deliberately sells more units of ownership in wells, than he legitimately has units to sell, and plans to plug the well even before it is drilled. If he were to complete the well, then everyone would find out that he sold over 100% of the working interest. When found out, this operator will go to jail for fraud.
10. There is a term frequently heard in the oil patch, usually between two oil companies, that goes something like this: “This deal is being offered on industry terms.” What that typically means is that the funding company (the one that is putting up all the money to drill the well) gets 75% of the revenues after costs (including landowner royalties), and the operating company gets 25% of the revenues. After investing, this percentage often reverts to where the operator gets a much larger share of the profits. Another way to express this mark-up is usually said this way: “This is a third for a quarter deal.”
11. Industry players like to take advantage of what the big oil companies have already proven in an area. The small companies can usually snoop around in an already proven area and generate their own drilling projects; whereas, large companies can drill wells in areas where small companies cannot afford to play (i.e., offshore and overseas). Small companies can frequently make a profit in areas where it is not profitable for large oil companies to play (i.e., old mature oil fields that are mostly depleted). An analogy is “When the King leaves the dining room, there is still plenty of food left on the table.” This is the current condition of the American onshore petroleum industry. The larger companies have publicly announced that they cannot continue to explore onshore in the USA, as they have done in the past – because, in their own words, “… the chance of making a major discovery onshore is unlikely.” (This exodus of the large oil companies from the USA has been accelerating since the BP oil spill in the Gulf of Mexico – they are concluding that the United States is not a favorable place to drill.) Although there are thousands of small oil companies in the USA, these small oil companies do not collectively have enough strength to alleviate the upcoming energy shortages in the USA. While this situation is not good for the average person on the street, the fact that the big oil companies are moving offshore and overseas is a bonanza for the small oil companies and the investors who provide the funds to drill the wells that the large oil companies have chosen not to drill.
12. Small companies can very effectively compete with the major US oil companies. If a major oil company wants an oil lease, there is always a good geological reason for them to secure that lease, so the smaller operators can gain an advantage just by buying leases drilling close to major company leases, because the bigger company has already paid to research the area. Normally, smaller companies like to focus in areas where a major company already has successful wells.
Wholesale (Industry) VS. Retail Oil & Gas Projects
Projects offered from one oil company to another oil company may be thought of as being “Wholesale Offering”; whereas, projects offered from an oil company to a non-petroleum industry participant may be thought of as being a “Retail Offering.”
1. What is typically in a package on a poor retail package:
A. Glossy folder where they printed thousands of fancy packages that cost $75 each to print and Fed-X to a huge number of potential investors. Investors should recognize that they are the ones who are paying for the fancy stuff. This is just one of the many things that contribute to an over-promoted project.
B. There is a lot of information in the Fed-X package as to why you should invest in oil & gas. While the information may be factual, Industry Players already know this information.
C. Tax information that over emphasizes the fact that, if the well is a dry hole you get a huge tax write-off. While this may be true, Industry Players are focusing on finding oil & gas.
2. What is typically NOT in a poor prospect package:
A. Rarely will the technical data show offsetting well cumulative production information. It may show the Initial Production (IP) of each well, and while IP is important, the cumulative production is a better indicator of the profitability of surrounding wells.
B. RARELY will you find sufficient information on nearby wells.
C. RARELY will you find information on how the well will be completed, or who will be the driller and their experience in the area.
D. INDUSTRY PLAYERS MAY NOT SEND ANY PACKAGES AT ALL! They simply provide all the necessary documents via the power of the internet.
3. What is typically in a good drilling prospect package :
Industry style projects typically have the complete geology package. This package would include an oil field cumulative production report, electric logs and various maps showing leases and surrounding wells. This is all the information that an industry participant needs. It will also have well written legal documents outlining all the risks, telling you exactly how they plan to spend your money and what you get in return if the well is successful.
VARIOUS INVESTMENT TYPES:
A. Real Estate. You will always get the demographics info, area occupancy rates, area incomes, ethnic make-up and who has been moving in and out of area.
B. The Stock Market. You or your stock broker will do the due diligence on the companies you invest in. (Heck, if you get insider info when investing in stocks, they throw you in jail!) In oil & gas investing, if you get insider information (legally, of course), they just call you a successful oil investor!
C. Oil & Gas Industry. Investors typically know the important info before they pull the trigger. Completing oil wells is somewhat like a doctor who is about to perform surgery. A surgeon will do a better job if he looks at the x-rays before he begins cutting. Likewise, industry oil well investors typically have proof of what is below the surface before they lease the acreage. They often feel like they are betting on the game after the game is over.
David H. Mangum
Petroleum Engineer, Geologist, MBA
Originally Posted: Texasenergyexchange
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