Monday, August 4, 2008

Understanding An Existing Multi-well Oil Drilling Investment Opportunity

Overview of the project:
We are currently invested as lease a owner in a multi-well oil drilling project that will be drilled in Texas. This is a five well project that is being purchased by a foreign investor and slated for drilling to start very soon thereafter. Each of the five wells will be similar to the single well project written of in the previous article posted last week. This article will provide highlights of what a multi-well project looks like to provide readers with insights when considering investing in similar oil and gas drilling ventures. It is written for educational purposes only and is not a solicitation to invest or a prospectus. Some hypothetical situations have been added for purposes of helping the investor conduct his/her own systematic “what if” analytical approach when considering these types of investments.

This five well project involves re-entry into vertically drilled wells by Exxon in the mid-80s by using horizontal drilling upwards of a mile through the known pay zones to minimize the risk of failure while maximizing the potential flow of gas and oil (payout to investor). These wells were abandoned at that time since oil was too cheap to continue producing from the well.

An overview of horizontal drilling (repeat from last week’s single well article):
Horizontal drilling is a fairly new process for drilling where the drill bit can actually be steered sideways toward the highest concentrations of oil and gas. The drill operator usually has tools allowing logging while drilling (LWD) the hole. This means the operator can see what the formations in the ground are around the drill bit to know what the move toward or away from. This provides much better odds for a successful well than simply drilling vertical wells and logging the well after it is drilled to see whether the well will be a success or not. Also, another benefit of horizontal drilling is that the wells tend to produce strong for the first five years or so and then continue producing at a slower rate over the next 15 years or so. Over the life of this well, the investor may gain significant multiples of total return on their initial investment.

Understanding how the investment is structured:
- Investors ownership: This five well project is being sold to a single investor. The investor has a 75% working interest (WI) and 54% net revenue interest (NRI) in the well. This means the investor owns 3/4 of the well for tax purposes, and receive 54% of the revenues generated by the well since other percentages go to the land owner, lease owner, oil producer, and others involved outside of the investor.

- Cost of investment: This is an $11.2M investment.

- Projected return on investment: Conservative revenue models project a 56% annual internal rate of return (IRR) for ten years. This is much less than the projection from the single well described in last week’s article. The main reason is that this 56% return is over ten years where the projections in last week’s article was only covering the first year’s return. Another reason is that the 56% projection assumes three of the five wells are drilled the first year and one of those wells does not produce. It also assumes the last two wells are drilled the second year and one of those wells is bad. Therefore, the conservative projection assumes that two of the five wells are dry holes (non-producing wells). There are other differences you should look for between investments such as the Working Interest and Net Revenue Interest differing from project to project.

- Tax savings benefit: The projected return does not consider any added returns from tax savings due to write offs which could add an additional 25 – 50% to the first year return based on your tax bracket. As a reminder, all invested funds in domestic independent oil and gas drilling ventures are deductible against all income types with the intangible drilling costs (IDC) being fully deductible the first year and the remaining tangible costs being deducted over seven years. This project has a high percentage of IDC so a large portion of the total investment can be written off the first year against all other income. I don’t have the actual IDC percentage for this project. For purposes of this example I will assume 70% of the project is IDC (fairly typical for many projects). In this case, 70% of the $11.2M can be deducted the first year saving $7.8M in taxes. The remaining 30% tangible costs are deducted over seven years.

- Yearly tax free income benefit: In addition to the tax deductions, 15 – 23% of each year’s income is tax free for these types of domestic oil and gas drilling ventures. A projected first year income of $7.6M at $130 per barrel oil with a total 300 barrels of oil equivalent (BOE) daily production means the investor would receive a minimum of 15% tax free, or $1.1M. If you are in a 35% tax bracket, that is a savings of $385,000 in taxes that is additional income.

Putting it all together for expected 1st year return:
At $130 per barrel for oil and 300 BOE daily production, this project is projected to create $7.6M income + $7.8M tax savings (70% of invested funds from IDC 1st year deduction) + $385,000 income tax savings (1st 15% of the year's income is tax free) for a total of $15.8M the first year on a $11.2M investment. This is a projected 141% total return on the investment. As stated earlier, this return assumes 2 of the five wells are bad. Also, in general, horizontal wells provide stronger returns initially and over a longer period of time than vertically drilled wells. Therefore, this project could generate many multiples of the original invested funds over the life of the well.

Lets look at hypothetical high projection scenarios:
Recently another major oil drilling corporation has had several similar wells in the area come in at 500 to 700 BOE daily production.

For fun, let’s make assumptions that assume ideal situations concerning production from the associated wells. Again, these are hypothetical and idea situations provided to help the investor think about doing their own ‘what if” analysis of investments. As an investor, it is good to know your upper, as well as your lower boundaries of expectation before making an investment.

Scenario 1: Let’s assume each of the three wells come in at 500 BOE, that would be a total of 1,500 BOE daily (remember we also assume two of the five wells are dry holes). That would be five times the 300 BOE production shown earlier for this project. This would translate into a first year income of $38M at $130 per barrel oil instead of the $7.6M calculated for the original total 300 BOE projected daily production for the first year. That would be a 339% return ($38M/$11.2M) on investment in the first year of production from all three wells.

Scenario 2: Now lets assume all five wells are good and each producing 500 BOE daily. Total production from the five wells would be 2,500 BOE daily, 8.33 times the 300 BOE production. This translates into a first year income of $63.3M at $130 per barrel oil. That would be a 565% ($63.3M/$11.2M) return on investment in the first year of production from all five wells.

Again, these examples do not count the additional savings from taxes. Keep in mind that production will start dropping off each year for the wells so the income shown is not going to last through the life of the wells. However, if either of these first full year of production scenarios comes in, you can see why investing in oil and gas drilling ventures can be very profitable for investors in the right projects. The remaining years would be icing on the cake.

Low time required for an outstanding return:
As an investor, most of your time will be spent investigating the initial investment to consider participating in a oil/gas drilling venture and funding your share of ownership in the partnership. Once invested, you can sit back and watch the monthly payment checks come in. A good return for very low overall time commitment.

Again, information provided in this article covers projections on a multi-well horizontal drilling project. These are not to be considered actual returns. There are many factors that can cause the returns to vary from projections, including the possibility the well may not turn out to be producible (a dry hole - oil industry jargon). Each investor should always do his/her own due diligence before considering participating in any investment. This article is provided for educational purposes.

I hope this example of a multi-well oil drilling investment helps you understand some of the things I have discussed in previous articles to this blog. This is why the oil and gas can be very profitable for investors who know what they are doing and make calculated investments in this industry. I never suggest anyone invest more than they are willing to lose so seek advice of a professional if you are considering investing in oil and gas for the first time.

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Copyright 2008 Ole Cram. Ole Cram is President of Marcobe Investments, Inc., a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration to also participate. We are not licensed to sell any interest in a project, nor are we registered advisors. Feel free to email us at with any questions, thoughts, or requests for other topics to cover in future articles.

This article was posted at Accredited Investor Blog: Past articles can easily be found at This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision.

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