DETERMINANTS OF OIL AND GAS EXPLORATION ACTIVITY

By

NIKHIL SINGH

&

NAVEEN GUPTA

INTRODUCTION

• 1981-Domestic oil companies spent $55.7 billion for developing oil and gas reserves

• 1986-Less than one half that US amount $26.6 billion

Factors responsible for this precipitous decline in exploration and development expenditures:-

• 1978-1981 world events such as Iran-Iraq War • Increased cooperation within OPEC As a consequence of which oil price jump from $8-

$35 per barrel

Continued

• As world oil prices rose, so did domestic

exploration: large onshore and offshore projects were planned and

undertaken.

• During the latter half of 1981 & early 1982 oil prices softened.

• Some companies cut back their exploration whereas many continued to issue new shares and long term debt.

Continued

Reason for cutback

• Areas affected by hardest hit were Texas,Louisiana,oklahoma,Kansas,Colorado & Alaska.

• 1978-1983 – prices for newly found gas rose from less than $1 -$2.70 per mcf(thousand cubic feet).

Continued

Increase occurred

• But this increase was not forever due to mild winters and severe gas glut dropped the price from $2.70-$1.65 per mcf.

Natural gas price

Pipeline deregulation

End user substitution from oil to natural gas

Why do we need to know all this and how it is helpful for economists?

• Structure of oil and gas industry also provides opportunity to study the input and output of investments projects.

• Accounting standards in this industry require firms to release detailed information on their capital structures.

• Not only different measures of the returns to investment but also detailed information on firm’s finances.

• It has price taking firms ,each producing a relatively homogeneous good .

BACKGROUND ON OIL & GAS EXPLORATION

Expoloration vs Development

• Oil and gas firms divide their exploration & development expenditures into three categories:-

1. Exploration

2. Development

3. Property acquistion

Eg:-Out of $30 billion in 1986 firms approxmiatelyspent 37% on exploration and 52% on development,rest of them went for acquiring undeveloped oil & gas properties.

Continued

• “Exploratory” or “wildcats” drilling takes place on unexplored land or at depths.

• In addition to drilling expenses,expenditures include :-

1. Basic geologic research

2. Applied geologic research

Stats :-In 1958->12,208 exploratory wells were completed in US .Kansas(4174) and Texas(1503).

On an average from 1978-1986 only out one in four exploratory wells yielded commercial quantities of oil and gas.

Continued

• “Development” takes place on properties proven to contain oil or gas. Development drilling usually involves locating a series of wells that “step out” from the initial exploratory play or find.

• Development wells are required to improve the recovery of oil from nearby wells.

• These expenditures include those for drilling and completion(exclude expense assosciated with the actual pumping or transportation of oil & gas)

Firms

Firms explore for oil & gas

MAJOR(Rank among top 10-15 firms in industry )Eg:-Texaco,Mobil

DIVERSIFIED(Somewhat smaller than the majors,typically have a much smaller fraction of their operations in oil and gas)Eg:-Pacific lighting & union pacific.

INDEPENDENT COMPANIES(Range in size from several person firms to large producing firms ,they mainly explore and develop onshore properties ,tend to emphasize natural gas exploration over oil exploration.)Eg:-willard pease oil co,adobe oil and gas

EXPLORATION PROCESS AND WELL COSTS

Some terms to knowRoyalty interest:-landowner usually receives a per

acre fee and a production bonus.Operatorscommonly grant landowners a one eighth(12.5%) in the gross revenue generated by wells.

Large firms use their in-house staff and public and private

geologic data bases to identify prospects.

Smaller firms typically rely on independent geologists and lease

brokers.

Some terms to know

• Override royalty:-some lease contract also invlovethird parties who put together the deal ,such as geologists or lease brokers . These dealmakers receive without cost ,an override royalty. It may amount to between 1/32-1/16 of gross revenue.

• Standard lease agreement:-operator incurrs all drilling and production costs the so called “working “or “operating” interests in wells.

• Net revenue interest:-operators term the remaining interest.

Major drilling expenses

Drilling expens

es

Intangibles

Tangibles

Site preparation(5-15%)

Drilling contact work(45-55%)

Logging and testing(5-10%)

Consultant fees (5%)

Miscellaneous equipment,piping&casing head(1-15%)

Drilling ,mud,water & chemical(5-15%)

Continued

• Exploratory wells:-sunk set up cost=>lease infection,drilling platforms , geophysical research and site development.

• Development wells:-offsets , work-overs , secondary extension and step out.

Depending on the drilling process used and the well test results , completion costs can double or triple the cost of a well.

Continued

• $1-$2 million for a successful well (does not include additional costs of abandoning wells or completion costs.)

• On an average exploratory well is successful one out of four or five tries.

• Operators require substantial financial capital to obtain a successful well.

INVESTMENT PROCESSAND

FINANCING OF OIL AND GAS FIRMS

Empirical Model of Oil & Gas Exploration and development

• Empirical model describe the investment process, how capital investment for oil & gas firms changes with swing in oil & gas prices.

• It does not, however, consider how a firm finances its exploration & development investments.

The model states, why firms choose to hold large reserves

Large Inventories will reduce firms extraction cost.

Large inventories improves the chances of recovering significant reserves through secondary or tertiary drilling.

Increase in the level of reserves , increases the productivity of exploration and developments.

Continued

To examine investment process, financial data were assembled in between 1978-1986.

Sample data of 44 oil & gas firms were collected

from the list of top 400 oil & gas firms.

During this investment process, several firms

were acquired or merged with other firms.

continued

If a sample firm acquires another large oil & gas firm, the firm data were pooled for prior years.

When firm acquires small firm or the acquired firm’s assets were sold off, no adjustment were made to the data.

This investment process comes out with the information that the average firm in the sample drilled between 15-30 net wells per year and in this process investment was $10-$20 million on exploration and development.

FINANCIAL ARRANGEMENTS IN OIL AND GAS

In general, most of the oil and gas firms drill well with financial backing of outside investors.

OIL & GAS FIRMS INVESTORS

Financial Service companies

Pipelines Companies & Refiners

Bank Loan

OIL AND GAS INVESTORS

When the outside investors are other oil & gas firms, these outside firms typically have an active interest in operators & operators wells.

For Ex:- In a farm outs, a lease holders allow

another firms to drill well on its leases in return for

an override or revenue interest. Typically the

leaseholders uses this kind of arrangements when

it needs extra drilling rig capacity or when it wishes

to purchase expertise in drilling a particular

geologic horizon.

Continued

Outside oil & gas investors finance because of following reasons

1. Capacity constraints

2. Bankruptcy Risks

3. Tax incentives

4. Common pool problems

CONTRACT ISSUE

Firms & Investors face two major problems when signing contracts:-

1. In many instances the operator has private information about what contingencies might arise & the operator need not have incentive to reveal.

2. Lenders face substantial monitoring & verification costs, when trying to enforce contracts.

STORY LINE OF THE CONTRACT

o One operators warns investors “They make them clearly understand that if they can’t afford to take their money then they can’t afford to be in the oil business.

o Curiously, there must be other mechanism by which outside investors affects on operators drilling plan

o The terms on which outside equity investors participate in drilling projects differs across deals for variety of reasons.

continued

o Relationship between operators and inventors is through bonds or debt contracts.

o Debt contracts in this industry also recognize agency problems & then attempt to control them by limiting operator discretion.

o Debt holders also have difficult time in securing their loans.

o Bank & Insurance companies provide most of the oil companies debt capital.

Terms of Debt Contracts

1. In the agreement, Debt holders formally attach a firm’s primary source of collateral, its reserves, outsiders have a hard time in determining the market value of firms reserves.

2. These institutions rarely make loans for specific drilling projects, instead, they issue lump sum amount of credits or revolving lines of credit.

Continued

3. To mitigate incentives problems, they often place

covenants & penalties in their debt contracts.

4. These contracts defines trouble as the failure to

maintain certain financial ratio.

5. Debt covenants also limits the flexibility of both

lender & borrower.

Conclusion

1. This presentation aims to explain the effects of liquidity & other financial factors may have on the exploration and development activities of oil & gas firms.

2. It started with by noting that there were dramatic changes in oil & gas industry between 1978-1986 that affected both firms investments opportunities & their financial viability.

continued Using an investment model that controlled for firms

investment opportunities, we found that financial factors such as cash flow & current maturities of long-term debt explained some variables in investment spending.

Further we’ve seen role of debt contracts in placing constraints on the firms. In particular, use of oil & gas reserves as collateral.

Clearly, the availability of finance depends not just on availability & cost of external finance but also on the internal conditions that determines how a firms allocate its own resources.