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Oil & Gas Cradle to Grave – The Economics

The Oil Business According to Steve!

 

Oil & Gas Cradle to Grave – The Economics

In a prior blog we identified an oil and gas “prospect” … a location we think contains significant oil and gas reserves … so now what? Before any leases are negotiated, before any wells are drilled, before any oil and gas royalties are paid, we first need to crunch some numbers to see if the investment makes economic sense. Does the potential financial reward justify all the costs and risks and make the prospect “economic”?

The term “economic project” means different things to different people; it also varies by industry.

Take real estate, for example. In real estate, income-generating properties are often bought and sold for ten times the net annual income. Say it’s a rental property, maybe a rental house: if it rents for $1,300/month and the maintenance and property tax expenses average $300/month, then the property’s net income is $1,000/month or $12,000/year. Ten times the net annual income gives us a sales price of $120,000. If you bought the property for $120,000 and net income was steady at $12,000/year, then you would realize a 10% annual return on your $120,000 investment. As the owner, your biggest risk is that the tenant moves out and the house remains vacant for an extended period of time. Of course you will have standard maintenance issues, an occasional big ticket item (the a/c dies), and some insured risks (fire, hail damage), but for the most part the net income and return are fairly predictable.

“So how about our oil and gas prospect?” Well, there are many costs associated with developing an oil and gas prospect: land leasing, drilling, well completion and production facilities to name a few. Plus, there is a nasty little thing called “risk” that must be accounted for … there is risk that the company will lease all the land, set up the oil and gas royalty owners for future payment, drill the well, and then discover … nothing! The oil and gas reserves they expected to find are simply not there. Oil and gas prospects are extremely expensive to develop … typically millions of dollars … and sometimes very risky, so the oil and gas company will demand a much higher return than the 10% return you may find in real estate. Why take the chance of losing everything unless the potential reward is great? It’s a high risk / high reward (or loss) business.

Now back to our prospect … In order to determine if it is economic, we have to estimate all the costs, expected oil and gas reserves, future oil and gas prices and future revenues. The process usually involves input from geologists, engineers and oil and gas commodity forecasters (people that are good at guessing and making it sound believable). The geologist and engineer will work together to determine risk (chance of success) based on their experience with similar projects. Then, you stir it all together and “Voila”! Out pops the answer (well, sort of)!

Since we are so smart and savvy, let’s assume that we found a good one and that the economics look great! In fact, the economics are so good the boss assigns it “Priority 1” and tells the team to drop everything else and jump on it … time to start “leasing”!

 

Steve Smith is the founder and president of Legacy Royalties. Since 1994, Mr. Smith has worked as an independent oil and gas operator, mineral manager and petroleum engineering consultant.

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