The Structure of an Oil Interest
August 3rd, 2006 by Grant in: Oil & GasI’ve had a few emails requesting more information about how to invest in oil and gas fields, so I thought I’d put together a series of posts on that very subject.
If you haven’t already read it, take a quick read through my Crash Course on Natural Resources post, as it will help understand the rest of the posts in the topic.
If you were going to drill an oil or gas well, you set out finding the location. As in many businesses, it’s all about location, location, location. Finding the heart of the reserves in the most prolific formation is 90% of the work, and takes the most time.
Once you’ve found that sweet spot you need to make a deal with the owner of the land. This requires signing a lease with the land owner which outlines his royalties and the operators’ responsibilities in the operation. This may include building a road to the well, compensating the owner for any lost livestock, etc.
The owner has the best part of the deal. He gets a royalty right off the top, but shares none of the expenses. A typical owner may get as much as 20% of the production! This means the net revenue interest (NRI) is only 80% in this case, meaning 80% of the revenue goes to the owners of the well, and 20% goes to the farmer whos land you intend to punch a hole in.
While you negotiate a lease with the land owner, you may be looking for additional investors to go in on the deal with you. To lay it out, there is a total of 100% working interest (WI) in a well. Typically, the person (or company) with the largest percentage working interest is considered the operator of the well, meaning he is responsible for operating the well, lining up transportation of the produced oil and gas, dealing with landowners, negotiating oil and gas contracts, etc.
You may go out and find 49 of your best friends and solicit investment for your well. You offer to sell them 1% of your well, which means they’ll be responsible for 1% of the drilling and completion costs of the well, as well as any monthly expenses associated with the well operation. However, they will only receive 1% of the 80% NRI, so they’ll only receive 0.8% of the monthly production revenue. Remember, 20% off the top goes to the land owner!
You are taking a 51% working interest in the well, meaning you’re responsible for 51% of the drilling, completion and operating expenses, and receive 40.8% of the revenue.
For your buddies who only own 1% of the well, the operator (in this case, you) send them a bill every month with a breakdown of the expenses for the well. You also send them a check for their 0.8% of the monthly production revenue. You buddies turn around and send you a check for their portion of the expenses. For them, it is a completely passive investment.
Remember, much like a business partnership, he with the most invested gets the most pull in how the company works. Since you own 51% of the well, you can generally do whatever you wish (within the law of course) with the well. So keep this in mind when you’re offered a working interest in an oil partnership!
There is significant risk in investing in oil and gas, as the upfront costs are very large and the oil patch itself poses inherent risks that can threaten your investment at any time.
I’ll continue on this topic in the future, but this should be a primer on how an oil interest is structured.
Additional Resources
Oil Partnerships: How to protect your investment
Schlumberger Oilfield Glossary
A Valid Warning from the USPS!
Investing in Oil and Gas (white paper)
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August 3rd, 2006 at 10:11 am
Excellent post. How do you go about finding patches of land with hearty oil? What kind of gross revenue can be realized from a typical independent well? Exxon, as you stated in one of your previous posts, posted rather puny margins. What kind of margins are you and your investment team seeing?
August 3rd, 2006 at 10:34 am
One way to find land with oil reserves is through public auction. Many times you’ll find estates being liquidated or parted out that have royalties associated with it already.
The problem is that with current oil prices, these estates are going at a premium. Oil men are seeking these estates for their oil reserves and nothing more. They could care less if the 90 year old house stands or falls, but either way they’re paying a premium for the land.
Once in a blue moon will you find a land owner that doesn’t know what he’s sitting on and the land goes for next to nothing. If that’s the case, prepare for a shark fight. Those “in the know” will be bidding up the land, and those that are left in the dark will be wondering why anyone would pay a million dollars for Aunt Gertrude’s house and 100 acres.
Once you find a property for sale, you can look through the local courthouse records for any interests associated with the land.
In regards to our margins, they vary widely month to month. Naturally we don’t have the production that Exxon does to spread expenses over, so some months we have margins of 50% and others we take losses of 50%. It really depends on how many wells go down and for what reason. Rig rates have increased by 300% due to availability in some areas, so once you’ve done a workover (or repaired a well) it takes significantly longer to recoup your costs than it did a year ago.
We’re also spending a lot of money on developing injection wells for salt water. It’s costing a fortune up front, but in the end we’ll eliminate our water hauling costs.
Remember, there is a difference between profit and profit margin. Exxon had a profit margin of 9% that equated to $10 million per quarter. My investment has a profit margin of 50%, but on a few thousand dollars.
Grant
August 4th, 2006 at 5:57 pm
Nice write up. I think the most difficult thing is convincing people to give YOU money. While I think oil prices are high and here to stay, I don’t think that most people know enough about the indistry to invest money there.
Sounds like you’re on your way though! Keno
August 22nd, 2006 at 9:27 pm
[…] They may offer you a 1% working interest in the well(s) for anywhere between $10,000 and $80,000 up front. (Remember what a “working interest” means?) Depending on the program, this is just to drill the hole. After they log the hole and convince themselves it’s worthwhile to finish, they’ll come in and complete the well. At that point in time, they’ll ask you for more money. In this case, 1% of whatever it costs to complete the well. […]
October 8th, 2006 at 12:28 pm
Excellent article. I would have to spend some time on your blog to learn this oil stuff. You are going in my blog roll…Cheers.
October 8th, 2006 at 9:10 pm
Thanks MDCD, there is a lot to learn about investing in oil and gas. There are a lot of people that get their clock cleaned in the oil industry, because quite frankly there are a lot of people that look to scam people trying to make a quick buck.
I’ll check out your site.
-Grant