Oil and Gas Investing

What do you think of the Barnett Shale play and is your company involved?

The weekly average count for land and inland water rigs was 1,119 for 2003 and 1,704 for 2005.  The rig count is an excellent indication of the industry’s outlook on the future.  Increased prices for oil and gas have been driving more capital investments into drilling for future returns.  The future looks bright but the light will not blind me.

I remember very well how crude oil prices jumped between 1978 through 1981 as a result of the growth in global demand and deregulation of domestic oil pricing.  At that time analysts were predicting oil to go over $100 per barrel.  Many oil and gas companies lost sight of the potential for the price of oil to fall and began to pursue what I call price-sensitive projects.  Price-sensitive projects are typically considered lower risk-lower return and are feasible only as long as the price for product remains above a certain level.

The Barnett Shale Play has become a price-sensitive project area.  With all the hype that has been going on regarding companies’ and investors’ belief that this Play is a “gut cinch”, the demand has escalated prices for acreage, rigs and services to levels that exceed sound investment economics. With the recent decline in gas prices, companies and investors are beginning to experience this scenario.

Due to investor demand and the diminishing availability of “in the fairway” Barnett Shale leases, oil companies are extending the Play into less proven areas. If these companies and investors are heavily leveraged in the Play, they could be facing very difficult times if gas prices remain at current levels, which are double what they were three years ago.

The key to long-term success for oil and gas companies and investors is to consistently invest in oil and/or gas projects that make economic sense, even if spot prices drop to historic averages.

How does the price of oil and gas affect the economics of an oil deal?

Simple logic suggests that, as the price of oil and gas goes up, the rational for investing in oil and gas becomes more attractive. Yet this is not necessarily the case. Higher gas and oil prices mean increased competition among both major and independent drillers for drilling equipment and drilling crews. At the present historically high price levels, we are seeing lengthening delays in lining up drilling rigs and crews. This means that the drilling part of the business is running flat out and can’t keep up with the demand. In this environment, the cost to hire crews and equipment is very high compared to historical standards. Since drilling and completion expenses are the major cost component of drilling projects, the price of oil and gas will have to remain well above historical levels for many projects to pay off for investors.

 

High oil and gas prices also mean that a great many previously unviable projects have now slid over into to the potentially viable side of the equation. Such investment projects will remain sound only as long as the price of oil and gas remains high. If prices decline substantially, many who invested in these previously marginal deals will be out of the money, regardless of whether the deal produces the expected volumes.

 

Given the current environment of high drilling cost and the availability of more and more marginal projects entering the market, any substantial decrease in oil or gas prices is going to generate a surge of unhappy investors.

 

My best advice to potential investors is to carefully scrutinize offerings to make certain that they provide an adequate potential return even if the price of oil drops as low as $30 per barrel or gas as low as $3 per MCF. 

Lawmakers Slam Energy Company Profits

Reacting to record third quarter energy industry profits, the senate called executives from five major oil companies to testify during a joint meeting of the Senate last week.  The Commerce, Science, and Transportation Committee and the Senate Energy and Natural Resources Committee came together to look at what could be done about  what some called obscene profits.  Senators mulled a number of options including passage of a new federal price-gouging law, a windfall profits tax, and a reworking of this year’s energy bill to remove tax incentives to oil production companies.  While the executives valiantly defended their behavior citing supply/demand pressures and the need to invest the additional profits in new exploration in order to relieve the pressure, liberal Senators went forward with Senate Bill S.1631 which calls for a 50 percent tax on profits earned on oil over $40 a barrel.  Perhaps the Senators have forgotten the lessons of supply and demand offered by Adam Smith, in “The Wealth of Nations”, 1776: “…for if a producer made excessive profits, others would enter the same field, and the mutual competition would keep prices and profits within fair limits.”  As I’ve pointed out in earlier blog entries:  Our current oil supply/demand imbalance is mainly due to increased worldwide demand versus production.  So long as that imbalance continues, oil and gasoline prices will remain high.  Faced with the obvious need to increase investment in order to increase production industry executives are right to seek more profit…it is needed.  “Since 2002, our company has invested $32 billion in our business.  During that same time period, our earnings were $32 billion.  In other words, we invested what we earned,” said Chevron Corp. CEO David O’Reilly.

A large share of the costs of drilling for new oil and gas in the US is born by independent drillers, most of whom are funded by individual investors who join together to purchase a working interest in individual drilling projects.  Personally, I’ve observed a significant increase of interest on the part of individual investors considering the idea of participating in domestic oil and gas drilling projects.  What could possibly cause this spike in interest if not the opportunity to make greater profits?  Supply and demand is alive and well…and will remain so, at least so long as Congress gives it the opportunity to work itself out.

Buying oil and/or gas drilling deals through a registered broker/dealer

I would like to know why some oil deals are done through securities dealers and some are not.  Is there a benefit of one over the other.    Doesn’t it still come down to who you do business with? – Keith H.

Keith – In 1934 Congress passed the Securities and Exchange Act requiring the sale of oil and gas interests in drilling projects to be sold as securities by a registered Broker / Dealer.  Congress further went on to define the types of investors that could be solicited by Broker / Dealers (see Accredited and Sophisticated Investors).  Broker / Dealers are also required to provide potential investors with full-disclosure of the project including potential adverse risk factors, as well as who is behind the project, who is participating the project and how. As with any law there are loopholes.  Without delving into the details there are ways to market oil and gas deals without becoming a registered Broker / Dealer.  We want all our drilling project partners to know as much as possible about our projects not only because that’s the right way to approach a potential business relationship but because that’s the only way to create a successful long term relationship.  That’s why we have undergone the additional steps and scrutiny to become a Registered Broker / Dealer.  And of course you’re right about the importance of knowing who you are doing business with.  Trust is the most important factor in any business deal.  When you buy into deals through Broker / Dealers your trust level starts at a higher plane.

Is Natural Gas a Component of Your Drilling Project?

When deciding between various drilling project opportunities it makes good sense to make certain that the project has a healthy natural gas as well as oil potential.  Industry observers continue to expect oil prices to abate somewhat in the coming months and years.  Natural gas prices, on the other hand, are likely to remain high and could go much higher.  Even before hurricanes Katrina and Rita, US natural gas supplies were already tight and trending tighter.  Unlike oil that can be easily imported, 95 percent of all natural gas consumed in North America is produced here.  This means that, for better or worse, we are stuck with the supply of natural gas we can produce.  Here’s why: We currently import around 5 percent via LNG terminals.  While new terminals are coming on line, the EIA projects LNG imports to increase slowly over the coming years.  Planned new LNG terminals in California, Maine and Massachusetts have been experiencing strong resistance.  Perhaps the new energy bill and the folly of locating more LNG terminals in the gulf region will push these efforts along.  But constructing new LNG terminals will take years even if they receive an immediate green light.   In the meantime even though the number of producing natural gas wells in the US has increased the total production volume has continued to decline.  At the same time Canada, which has been exporting 20 percent of the natural gas consumed in the US is projecting lower export volumes for the next few years.  While some utilities can switch to coal electricity production and consumers can turn down their thermostats thus reducing demand somewhat, it’s unlikely that it will be enough in the near term to bring demand in line with supply.  Add it all together and we are looking at a situation where natural gas prices have no where to go but up.  This is why we look for a strong natural gas component in every potential drilling investment project.  It just makes good sense!

Katrina and Oil Prices

In a worldwide situation where oil production and consumption were already close to equilibrium, Katrina couldn’t have hit in a worse place at a worse time.  More than two weeks after the storm’s slamming of the Gulf of Mexico’s oil and gas production and distribution infrastructure 57 percent of the region’s crude oil output and 5 percent of the country’s refining capacity remains out of commission.   The US government’s reaction to the resulting run-up in gasoline prices has been to release oil from the country’s strategic oil reserves – some 1.3 million barrels a day over the next 30 days.  The country’s remaining operating refiners can probably squeeze a few more gallons by temporarily suspending unnecessary maintenance and delaying seasonal fuel mix changeovers.  At the same time the post-storm run up in gasoline prices combined with an end to the summer driving season is taking a bite out of demand.  Already we spot crude prices dropping back to pre-Katrina levels. 

For the potential investor in domestic oil and gas drilling projects the key question now is what will be Katrina’s long-term impact on oil and gas prices.  While no one can predict this with certainty, it seems obvious that there will be an immediate slowing of the US economy with a secondary negative ripple on the major economies outside the US.  Shrinking economies will reduce worldwide demand for oil and gas.  How long this will last is anyone’s guess.   Some economists see a rebound in the US economy in the fourth quarter of this year or the first quarter of next.  Certainly, the government’s potential infusion of over $100 billion with similar payouts by insurers will help fuel the domestic economy.  At the same time high gasoline prices will probably continue because of the pre-Katrina refinery bottleneck and that alone will cut into the US demand for oil as most of the US drivers decide to use their better gas mileage vehicle, carpool, combine shopping trips, etc.   Personally, I think we can expect world oil prices to stay in the $55 to $65 range for the next 12 months.  But prices could test the lower end of this range depending on speed of economic recovery.  As I noted in my previous blog, domestic natural gas prices are on a different track from oil and should remain at current levels or even rise somewhat. 

My best advice to the potential investor continues to be to look for oil and gas drilling projects that make sense at $30 a barrel and/or $3 gas.

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.