Understanding the Basic Risks Associated With Oil and Gas Drilling Investments

Posted on August 23rd, 2012 at 9:58 AM

Investors considering an oil and gas investment will be warned that oil and gas exploration is “speculative”.  But what does that term mean?  If speculation means uncertainty as to return on principle, or even return of principle, that hardly distinguishes “speculative” oil and gas investments from any number of other “speculative” investments, like stocks, bonds, structured products, even money market funds that “break the buck.”  So what do investors really need to know in evaluating the true risks associated with oil and gas drilling investments?  Let’s highlight the basic risks.

            First, there is a macro level risk that applies to all oil and gas investments.  That risk is price (and the volatility in price), as determined by the supply and demand balance of crude oil and natural gas in world markets.  Factors associated with this price risk include: competition; the quality of the oil and gas produced; the amount of imports; the availability and cost of adequate pipeline and other transportation facilities; the success of efforts to market competitive fuels like coal and nuclear energy; the effect of federal and state regulation of production, refining, transportation and sales; the laws of foreign jurisdiction and U.S. regulations affecting foreign markets; weather; and conservation efforts.  Price risk affects not only the economic justification for beginning production, but also continuing production, and making a profit on production.

            Second, there are inherent limitations associated with the science of geology.  How does one know where to drill?  Geology is not an exact science, and conclusions reached by geologists are drawn from the best, but limited, information available to the geologist.  The geologist cannot see what is under the surface.  As a result, the geologist must study other nearby wells, through well logs and production records.  The greater the amount of information available, the greater the likelihood that the conclusions drawn by the geologist are correct.  Nonetheless, a geologist never can say that oil or gas production will be obtained.  All that a geologist can say is that the structure under the drilling site is of the type in which hydrocarbons can accumulate or collect.

            Third, there are significant differences in the type of wells chosen for drilling.  Begin with the fact that investors effectively are investing in a “blind pool” of wells, because they do not know in advance where or exactly where the wells will be drilled.  Moreover, wells themselves are categorized in two basic ways: wildcat or “exploratory”; or “developmental.”  There are major differences.  An exploratory well involves the highest degree of risk because it is drilled in an area where there are no previous drills or production from a target formation or zone. Specifically, such wells are at least one mile from producing wells.  By comparison, a developmental well involves less risk because that it is drilled near other wells (within one mile) and to the same formations that already have produced oil or gas.  Important factors to study are the drill zones, the drill depths, and the “targeted pay zone.”  All that said, even developmental drilling is risky.  So, investors need to determine whether, in so-called “proven reserves”, the drill operator will reduce risk by drilling multiple wells and in multiple pay zones.

            Fourth, even when drilling is successful, because the well appears to be productive, there are numerous risks associated with the completion phase.  Geologists will study an apparently productive well through reviewing well logs, conducting seismic tests and drill stem tests, and studying samples of sands.  Should the completion phase begin, a well first may be stimulated or treated to increase its potential production using acidizing or fracturing.  The next steps include employing in-hole equipment, installing a well-head and other equipment and building roads.  However, investors face significant risks.  They include depletion risk, which is the rate of decline in production from any proven well (the “reservoir”).  No one can predict with certainty how many years a well will produce oil or gas in commercial quantities.  As depletion occurs, the value of the investment will decline.

            Fifth, another risk in the completion phase results from production expenses.  Production expenses typically include labor, fuel, repairs, hauling, pumping, insurance, storage and supervision and administration.  As one would expect, production expenses can influence the decision of well operators to shut-in or abandon a well, reduce operations or cease operations altogether.  As a result, investors should consider the “field remedial work” in the general drilling area, as well as the level and quality of the field remedial work which the operator previously has performed.

            In conclusion, investors (and their financial advisers recommending the investment) need to do their homework before investing in oil and gas deals!  


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