Understanding the Risks of Oil Drilling Investments

Posted on December 2nd, 2014 at 5:16 PM
Understanding the Risks of Oil Drilling Investments

From the Desk of Jim Eccleston at Eccleston Law Offices:

Current pricing for oil has dipped below $70 per barrel, off from June highs of over $100 per barrel.  What does that mean for domestic oil producers, investors and their financial advisers? 

The Wall Street Journal observed on December 2nd that oil production price declines “concerns about these companies’ ability to operate expensive shale-oil fields and plunging prices.”  The Journal also observed that bonds of “low-rated energy companies also sank, reflecting fears that some producers will default if prices fail to recover.”

While the risks of oil (and gas) drilling investments always have been substantial, those risks have increased due to the current pricing environment.  Investors, and their advisers, cannot sit still.  FINRA Rule 2111 relates to recommendations made by a financial adviser’s firm.  While historically the application of the rule was limited to recommendations to buy or sell securities, the current rule adds recommended investment strategies involving securities, including the explicit recommendation to “hold” securities.

In satisfying that suitability obligation, financial advisers must understand the increasing risks of an oil (and gas) investment.  Let’s highlight those risks.

            First, and as discussed above,there is a macro level of price risk and volatility as determined by the economic balance of crude oil and natural gas in world markets.  Factors associated with this price risk include: competition; the quality of product; the amount of imports; the availability and cost of transportation facilities; the success of marketing substitutions; regulations, 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 for continuing production, and making a profit on production.

            Second, there are limitations associated with geology.  Geology is not an exact science, and conclusions reached by geologists are drawn from the limited information available.  The geologist cannot see what is under the surface.  As a result, the geologist must study 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, only that the structure under the drilling site is of the type in which hydrocarbons can accumulate.

            Third, there are significant differences in the type of wells chosen for drilling.  Investors are investing in a “blind pool” of wells, because of the uncertainly of where the wells will be drilled.  Moreover, wells are categorized in two ways: “exploratory”; or “developmental.”  An exploratory well involves the highest degree of risk because it is drilled in an area where there are no previous drills or production.  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 to the same formations that already have produced oil or gas.  Important factors to study are the drill zones and depths, and the “targeted pay zone.”  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, 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 treated to increase its potential production using acidizing.  The next steps include employing in-hole equipment, installing equipment and building roads.  However, they include depletion risk, which is the rate of decline in production from any proven well.  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.

            A fifth and final risk relates to production expenses, which typically include labor, fuel, repairs, hauling, pumping, and insurance, storage and supervision and administration.  Production expenses can influence the decision of well operators to 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 work which the operator previously has performed.

            In conclusion, investors and their financial advisers need to do their homework before investing in oil (and gas) deals.  In the current oil pricing environment, all of the significant and increasing risks must be re-examined!

The attorneys of Eccleston Law Offices represent investors and advisers nationwide in securities and employment matters. Our attorneys draw on a combined experience of nearly 50 years in delivering the highest quality legal services.

Related Attorneys: James J. Eccleston

Tags: Wall Street Journal, FINRA, Gas

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