Oil and Gas Investing

Correlation Between Crude Oil and Natural Gas Prices

Is there a strong correlation between the spot prices for natural gas and crude oil? As the chart below illustrates there would seem to be one. 

While it’s true that as the price of oil goes up, gas is soon to follow, and visa versa. However, on closer examination the prices of the two commodities are not directly linked. The US currently imports 58 percent of its oil needs versus only 16 percent of natural gas needs in 2002, making oil more sensitive to increasing international demand: think China and India. Natural gas prices are more a function of US/Canadian Supply (we get 15 percent of our natural gas from Canada) and US demand. Less than two percent of our natural gas needs are supplied by imported LNG. But now both oil and gas supplies are tight. OPEC is running flat out, Iraq's exports are down from pre-war levels, and world demand for oil continues to increase. The vast majority of our imported oil goes to run automobiles and trucks. On the natural gas side, new US domestic drilling production is not keeping up with increasing US consumption/demand.  Canada is using more natural gas itself and sending less to us and with only 4 LNG gas terminals operational there won’t be any relief via LNG for several years. It’s interesting to note that 16.4 percent of all US electrical production is generated using natural gas while 56 percent of all US homes cook and heat with natural gas. Natural gas demand rockets up from November through March each year. The peak auto driving season is during the summer months of June, July and August. The fact that both oil and gas prices are going up is a result of the fact that we (and the rest of the world) are using more of both commodities to the point where demand is closing on supply. Since one commodity is not easily substituted for the other the fact that both have been going up in price is a function of coincidental shortfalls in supply versus any direct correlation. Speculation in oil can account for some of the current record prices for oil but the US natural gas supply / demand imbalance is very real and likely to become even more pronounced. That’s one reason why we look for oil and gas drilling investment projects that have a strong gas production potential.

Acid Test: Evaluating Oil and Gas Drilling Projects

With oil and gas prices reaching all time highs, something like a feeding frenzy is taking place across the entire oil and gas exploration and production industry. Nowhere is this more apparent than in drilling project partnerships being offered to individual investors. The number of people looking to make direct investments in drilling projects is increasing with every upward tic of the price of oil. As a result, drilling companies are raising their costs to independents and many royalty owners are raising their required stakes in new projects. At the same time new partnership offerings are coming out every week. Many are put together by new and inexperienced project managers. Oil and gas drilling projects have always come with risk. But in this hyper-environment, more and more high-risk deals are appearing. Potential investors are cautioned to look at these deals 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 1.25% net revenue interest in a project for $90,000. For your investment to break even, the well will need to produce a total of $7,200,000 in revenue ($90,000/.0125 = $7,200,000). If oil averages $60 a barrel, and I don’t believe it will stay that high, your investment well will have to produce at least 120,000 barrels over its productive life ($7,200,000/$60 = 120,000 barrels). You can do the same math for gas or combination oil and gas projects using an anticipated price for thousand cubic feet of gas. 

Now here’s the acid test: Look at the surrounding wells and see if any have yielded the amount of gas and/or oil your well will need to produce to return your investment. In this example we used some very optimistic valuations for oil and gas. It probably makes more sense to use pricing numbers like $30 per barrel oil and/or $3 gas. You may want to be even more conservative with your expected price for oil and gas. When the speculative bubble pops, and it surely will, you want to be in deals that still make sense.  Of course, if the project does pass the acid test, you still need to examine the geology to evaluate the risk of whether the proposed well is likely to produce at all. And you’ll want be very comfortable that the managing partner has the reputation and industry experience to be a good partner.

Oil Field Terminology

Every industry has it’s own set of terminology and ours is no exception.  No matter how long you’ve been investing in oil and gas drilling projects or how knowledgeable you are about the oil and gas industry there’s always a new term popping up.   On our Lone Star Securities website we offer a link to a short glossary of terms.  This is a good place to start if your oil field terminology is limited to basic terms like wells, drilling platforms, mud, and rigs.  In about 20 minutes you can go through this entire glossary and get the basic idea about what the most common terms mean.  A much more comprehensive glossary of oil field terminology is found on the Schlumberger website.  There you will find:

·                       Comprehensive: definitions for major oilfield activities

·                       Accessible: definitions for both the technical generalist and the expert

·                       Accurate: definitions reviewed by technical experts

·                       Illustrated: full-color photographs and illustrations clarify many definitions

·                       Thorough: citations of significant technical papers for further reading

If you have a question about oil and gas terminology or investing in oil and gas drilling projects, I’d like to hear from you.  We’ll do our best to give you a straight forward answer.  Just email me or comment on this blog.

2005 Energy Policy Act’s Effect on Oil & Gas Drilling Projects

Last week the U. S. Congress passed the Energy Policy Act of 2005.  The bill now awaits President Bush’s signature.  Key provisions of the act that directly affect oil and gas are outlined below:

¨      The energy bill includes provisions to streamline oil and gas development on existing federal lease sites to bring the fuels to market sooner. ¨      The bill permanently authorizes the Strategic Petroleum Reserve and authorizes the DOE Secretary to fill the reserve to 1 billion barrels. ¨      Calls for a DOI inventory of oil and gas resources on the Outer Continental Shelf to enable to the federal government to better assess the extent of these resources. ¨      Facilitates the construction of needed gas infrastructure by improving and streamlining the process to permit pipeline infrastructure with FERC as the lead agency and with a consolidated record ¨      Provides coastal impact assistance of $1 billion over four years to energy-producing states to encourage ongoing production by assisting in coastal enhancement and conservation programs. ¨      Ensures an adequate supply of natural gas in the coming years, including clarification of FERC’s exclusive authority to site LNG facilities. The bill further ensures supply by creating a clear process for siting natural gas infrastructure such as pipelines and storage. Source: U. S. House Committee on Energy and Commerce

As you can see there is nothing in the bill that makes oil and gas drilling projects more or less expensive.  Other provisions of the bill encourage conservation in homes and automobiles and encourage new technologies such as hydrogen and alternative fuels.  To me it looks like these provisions mainly encourage research and implementation of these technologies and can be expected to take many years to bear fruit.  There’s no doubt that Congress tried to take some steps towards reducing dependence on foreign oil and gas.  But, for the most part, these were baby steps like helping to facilitate the development of clean coal technologies, encouraging automobile efficiencies, and pushing hydrogen fuel cell technology.  The most likely provision to affect U.S. oil consumption is a provision for 5 billion gallons of renewal fuels to be introduced into the marketplace by 2010. Other provisions in the bill have goals with dates like 2012 (federal government goals for the use of renewable energy) and 2020 (hydrogen fuel cell cars on the road).  So it’s going to be awhile before these measures begin to affect oil and gas supply and demand.  One interesting provision establishes a task force to make recommendations on a national oil shale and tar sands leasing program in western states and directs the DOI (Department of Interior) Secretary to conduct a commercial lease sale for oil shale in states where the Secretary finds support and interest for do so.  Perhaps some of the newer production technologies will help unlock some of this oil, assuming that exploration and productions companies are willing to risk it. 

My bottom line is that it’s going to be years, perhaps many years, before the provisions of this bill stint our ever growing demand for oil and gas. 

In the meantime, as investors in oil and gas drilling projects, we should all be pleased that the very generous tax deductions for oil and gas drilling projects were left in place.