Oil & Gas Investing

Investing in Oil & Gas Based on Cash Flow & Costs Versus Recoverable Reserves

Investing in oil & gas programs based on reasonably projected cash flows, and true costs, plus getting recoverable reserves out of the ground in timely fashion are extremely important questions to get answered when evaluating any oil & gas investment program.

Here's why. Making money in oil and gas isn't about how much a company can establish in barrels of oil per day, or thousand cubic feet of gas (mcf's), or barrels of oil per day of equivalent production (boe). Exxon for example just breaks even on it's production, however it makes lots of money with it's lease holdings, licensing arrangements with other companies developing on Exxon acreage, and it's pipelines, refineries, and retail out-lets, etc.

Making money as a small producer is far more about keeping it's costs and over-head low. A more important, and critical question to find-out, is what percentage of the 'lifting costs' 'production costs', or recovery costs there are to find commercial quantities of oil & gas and then be able to market them in any given deal. If you can establish a true lifting cost of say $5.00 per barrel of oil and the price is $100 per barrel, gross profit looks attractive, and you can do the math pretty easily. You have a nice multiple on your capital invested...or do you? Continue reading to determine if this spread in cost, and gross sales revenue is enough to justify doing an oil & gas deal, and thus getting a fair chance to be successful as a private oil & gas investor.

The most important considerations an investor ought to look at are; the 'total costs for each well', plus the infra-structure a company must build to exploit the oil & gas being targeted, such as pipelines, or gathering systems needed to market your gas for example, just to name a few important considerations. Certainly the 'time' it takes to evaluate a potential oil & gas target, and then fund, drill, and complete a new well, and finally hooking-up an oil & gas well which is going to be commercially productive are just some of the key issues & concerns any investor should have, and where a good portion of the effort should be spent by every company when looking for oil & gas. Two years is probably an average time line to bring a successful oil & gas program to fruition. I've accomplished it and seen it happen sooner, but this is a reasonable time for an oil & gas drilling program to work. Circumstances are different for every company, but I get worried when some sort of activity and success doesn't occur after two years. Just remember, you do get substantial tax write-offs during your waiting period. Most, if not all of your capital invested is going to be written-off during the first two years you hold the oil & gas investment.

The most important question any investor should determine when evaluating any oil & gas drilling program is to find-out what percentage of the gross the investor is going to get after all deductions. Deductions will be taken out for royalty, or landowner overrides, lease operating costs, and the management, and in most states, but not all, the 'well-head' tax. Once you arrive at the actual percentage you are entitiled to in an oil & gas deal, you can start calculating what you may receive, IF, and only IF the assumptions by the oil & gas company you are planning to invest are correct. I'm talking about projections of production, recoverable reserves, and value of the net assets after the oil & gas company completes it's development plan. This takes some study, and by the way, if this is too hard to gleam from the company's private placement memorandum, or there seems to be reluctance to get into the numbers by sales people, or company officials, just avoid the company. It's just too hard to properly evaluate an oil & gas deal when a company is being too clever. If it's too hard to figure-out, don't invest.

You must find-out something about production history in a targeted development area where a company is planning to drill for oil & gas. State county offices have this information about all of the wells drilled in their county. Research with the state production records can be very revealing when comparing these results with what a promoter is telling you is possible. The reservior qualities are studied by geologists, and petroleum engineers among others in our industry. The geologists are lovers of rock, or oil bearing sands. They are the 'dreamers' in our business. The petroleum engineers are the 'top of the food chain', or most practical in our business. PE's want to know about downhole pressures, decline curves, porosities, permeability, and a variety of indications of what an oil & gas well will ultimately produce, and what recoverable reserves will be found. Banks hire PE's to do reserve studies, and banks typically discount by 50% the reserves the PE's estimate when evaluating oil & gas properties as part of their due dilligence when making loans on oil & gas production being sold.

Getting answers to all of your questions are super important when you are trying to get to the bottom line when deciding to drill for oil & gas. Remember, you are trying to decide if the company providing you with information is going to be able to establish production revenue, and recoverable reserves, all while effectively managing costs, and not letting the time-line to achieve production goals get away from them. You rarely hear discussed the 'time value of money', or receive 'internal rate of return' calculations when evaluating most oil & gas deals. Reporting, or the lack there-of can also give you a valuable clue as to how organized, and good a plan the oil & gas company has to find oil & gas reserves. If management can't be reached, after you make your investment, and you rarely hear from them, this is almost always a bad sign.

It's real exciting to talk about finding big oil & gas reserves. Promoters, and industry people typically use six color print, and pretty pictures and geological cartoons showing wonderful diagrams, anomalies, or structural closures, and traps which you are led to believe are going to be found containing massive amounts of oil & gas, and when found this is how you will subsequently become rich. 3-D seismic has been the big buzz word for awhile now, but this simply quantifies, and maybe cuts the risk of drilling a marginal producer, or dry hole. You still have to establish production with a successful well at a reasonable cost relative to the eventual commercial production you'll receive. Another point, can these so called big, or gigantic reserves a company thinks it is sitting on, be recoverable with the 'specific development plan' they offer and at the cost you will be required to invest to participate, to achieve the results being projected? The reserves might actually be there, but would you have to spend 100 million for 10 million in production to get there?

I've seen many companys over the years play the game of bragging about the oil & gas reserves they expect to find in a given area. These companies either don't realize what they are talking about, aren't telling the whole story, or the people it hires to try to sell you are choosing to ignore telling you as investors... they only get to tap a small amount of what is likely to be recoverable from a single borehole, even when the drilling attempt is successful and no substantial and serious technical problems are encountered.

When you do the math based on true development costs the results can be shocking, and you can rapidly conclude the profits will never exceed the costs in deals where production cannot be established cheaply enough. This is magnified over time when it takes a long time to recover the primary production from a successful well. Lease operating costs, re-entry, and work-over costs can eat-up the profits in a marginal producer. This is my pet peeve actually.

I've confronted those individuals on many occasions promoting deals and using the top performing wells in the entire county, while inferring, and drawing conclusions about an outcome in a deal they are offering. Take the average production you get from county records for the exact type of well being considered, take in to account today's costs, and then see what you get. You will be shocked. Call me to go over the numbers in a deal you are considering.

By the way, the deeper you go to get the bigger reserves, the greater your technical risk to get to the finish line with a successful oil & gas producer. The fewer oil & gas wells you drill in a given program where investors can participate as a collective group owning fractional working interest ownership...the more difficult it is to make investors money, unless you are a big believer in luck. The reasons are many. Diversification is a must in my opinion, and this means investing, or receiving a relatively big 'working interest' in many profit centers, including mulitiple oil & gas wells, and pipeline revenue, etc. The really important thing in my opinion, is you need relatively low costs to establish production revenue, while 'booking' legitimate recoverable reserves of oil & gas. This is the challenge and the 'rub'.

THIS IS THE KEY! Investors ought to be getting a relatively large percentage of the 'pay-out' in a private oil & gas deal, and know the development costs are not too high to achieve an oil company's projected profits. How do you determine this in advance of making an investment? You either do your homework, or get someone who has no axe to grind, isn't afraid of losing you as an advisor, if you are his client, and isn't another competing company asking for your money.

Let me show you some math, and illustrate one idea of what I'm talking about. Let's say you find, and consistently establish 100 barrels of oil per day (bopd), or it's natural gas equivalent (boe). Let's say you spend $3,000,000 to establish 100 bopd. Using $95 oil, and multiplying by 100 bopd, times 360 days, or an oil year, you arrive at a gross sales revenue of: $3,420,000.

NOW, let's further assume you can spread the $3,000,000 cost out among 30 or more oil & gas wells in a well diversified program of oil & gas wells. Okay, you are spending about $100,000 per relatively shallow oil & gas well including all research, technical costs, management fees, infra-structure, pump jacks, tank farms, disposal wells, injection plants & flow lines, roads, electrical hook-ups, etc. etc. I could to a point use any number of wells based on a hypothetical oil & gas drilling program's cost. But in the case I'm using, this means an average well needs to be producing 3.33 bopd. Do you believe this would be 'easier' to achieve and sustain over time, than trying to find a single well doing 100 bopd, or two wells each doing 50 bopd? (I do because of my 25 years in the oil & gas industry.) What about the risk of drilling 1 or 2 wells with the requirement of getting 100 bopd between the two wells?

OKAY, now let's get to the really important stuff. If you can invest in an oil & gas program where you receive 60% of the gross revenue, after all deductions are taken out, the numbers can get real interesting. So, we go back to the gross revenue of $3,420,000 based on mulitplying 100 barrels of oil per day (bopd) times $95 per barrel of oil times an oil year with 360 days. Now mulitply .60 times $3,420,000 or the total gross revenue to get a yearly $2,052,000 net revenue, or a 68.4% unweighted yearly return. If you factor in the 85% to 90% first year write-off for intangible drilling costs (IDC), and dividing by .65 you can get an adjusted, or weighted rate of return of about 105.2% based on a maximum marginal tax rate for example. Typically, you get about $35,000 in direct reduction of your gross income for taxes based on an investment of $100,000 in oil & gas. You must consult with a knowledgeable and experienced tax professional to tell you how this all affects your particular tax situation, and what write-offs you can take, or carry forward.

If your tax preparer, CPA or broker, or any other advisor you are using doesn't have a familiarity with the current oil & gas tax code and write-offs, the oil & gas deal you are considering; or won't personnally discuss their opinions with the oil & gas company you are considering, either don't use them as advisors for your oil & gas investments, or in the case of the tax questions, get a different expert who has the experience to handle the relatively simple tax form needed for you to take your legitimate oil & gas tax write-offs. You can lower you gross income for tax purposes with an investment in oil & gas drilling programs. Make sure you have advisors who aren't afraid to lose their job...or your business when you ask them for oil & gas tax advice. Remember, CPA's, attorneys, and other 'so-called advisors' are not experts at knowing about a particular, or specific oil & gas deal, they don't thoroughly review, or further, they won't take the time to evaluate a proposition unless you hire them to do so...they will only know about the bean counting part, and the legal part, or in the case of 'well meaning friends', etc., they just want to be right. Remember, they are right if you win, and right if you lose, simply, because they are on the fence, and it isn't their money, or risk. However, if you are successful, you won't be writing them a check from your profits. This is based on my experience in almost all cases I've been involved in my 25 years in the industry.

November & December are the most active months of the year for investors to make investments in ongoing, and successful oil & gas drilling programs, particularly when an investor needs tax relief.)

Call or email me with questions, and to find-out more about oil & gas investing in the US today.

Dennis W. Stutes American Energy Developments Office: 408 975 0800 Cell: 805 701 7761 Email: This e-mail address is being protected from spambots. You need JavaScript enabled to view it Email: This e-mail address is being protected from spambots. You need JavaScript enabled to view it

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