How oil industry works just a brief overview of it.

1. DETERMINANTS OF OIL AND GAS
EXPLORATION ACTIVITY
By
NIKHIL SINGH
&
NAVEEN GUPTA

2. 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

3. 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.

4. 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).

5. 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

6. 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 .

7. BACKGROUND ON OIL & GAS
EXPLORATION

8. 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 approxmiately
spent 37% on exploration and 52% on
development,rest of them went for acquiring
undeveloped oil & gas properties.

9. 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.

11. 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)

12. 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

13. EXPLORATION PROCESS AND WELL
COSTS
Some terms to know
Royalty interest:-landowner usually receives a per
acre fee and a production bonus.Operators
commonly 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.

14. Some terms to know
• Override royalty:-some lease contract also invlove
third 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.

15. Major drilling expenses
Drilling
expens
es
Intangi
bles
Tangibl
es
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%)

16. 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.

17. 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.

18. INVESTMENT PROCESS
AND
FINANCING OF OIL AND GAS FIRMS

19. 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.

20. 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.

21. 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.

22. 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.

23. 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

24. 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.

25. Continued
 Outside oil & gas investors finance
because of following reasons
1. Capacity constraints
2. Bankruptcy Risks
3. Tax incentives
4. Common pool problems

26. 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.

27. 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.

28. 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.

29. 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.

30. 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.

31. 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.

32. 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.