Analyzing Oil And Gas Companies Part 1 - Well Economics

July 7th, 2014

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This blog post was originally published on the blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

Up until a couple of years ago, I used to work as an analyst at a hedge fund. Although I analyzed different types of companies, I mainly focused on oil and gas exploration companies.

During my time, I came across many oil and gas companies that I felt were rather overvalued. I also felt that the overvaluation persisted because many investors misunderstood oil and gas companies. I believe that many of these investors will lose money on their investments.

In this series, I'll explain how to analyze such companies, so that we can build on this knowledge in future articles to understand exactly why many oil and gas companies are overvalued. This will help you, the reader, to avoid making the same mistakes.

In this article, we'll cut to the heart of the oil and gas operation; I'll talk about the economics of each well.

Broadly speaking, we need to keep four different factors in mind when we talk about well economics. Those are: Costs to drill and complete a well, Revenue from selling the oil and gas, Royalties and Operational costs. Let's talk about each one in more detail.

Drilling And Completion

Once an oil and gas exploration company has decided on the drilling location, the company will hire a services company to drill the spot. The services company will bring a massive rig that can drill up to a few kilometers at the location, and its workers will drill the hole for up to a month.

Once the drilling is done, another team will come in and "complete" the well, which nowadays include fracking (see this article to understand what fracking is). Once the wells are completed, the company can start pumping up the oil and/or gas.

Today, unless they're very shallow wells, drilling and completion costs a few million dollars per well. Oil and gas companies usually give their future drilling and completion cost estimates in their presentation, which you can corroborate using financial statements. Companies will detail how many wells they drilled, and how much they spent drilling them on their financial statements, so you can back out how much they spent per well.

Usually, I find that historical drilling and completion costs are a bit higher than the estimates they give on their presentations. Partly, this is because companies become more efficient over time as technology improves and they increase their know-how. But if there's a big discrepancy between the presentation numbers and the numbers from financial statements, I would watch out.


Once companies pump out oil and gas, they can sell them into the open market. How much they receive depends on the commodity, and on the grade.

Since they're different commodities, oil and natural gas fetch different prices. Roughly speaking, 6 mcf (thousand cubic feet) of natural gas contain the same amount of energy as a barrel of oil. Because of this, each mcf of natural gas went for roughly one sixth of the price of oil in the past. However, this relationship broke down recently because a huge supply of natural gas came online thanks to fracking, making natural gas much cheaper.

Not all oil and gas are created equal. Some need more processing than others before they're useful, so the ones that need more processing go for less than ones that don't. For example, oil or gas with high sulphur content fetch lower prices compared to those with low sulphur content. Heavy oil needs to go through more refining before they're turned into gasoline, so heavy oil fetches lower prices as well compared to lighter oil. You can find the price that an oil and gas company was able to get in their financial statements.

A new well will produce a large amount of oil and/or gas during its early days. This rate of production will drop quickly initially, and then it will continue to drop more slowly. The description of this decline rate over time is called the 'type curve'.

For traditional wells, the initial rapid drop in production only last a few months. For example, a well may produce 100 barrels a day in the first month, and then produce 50 barrels a day by the sixth month. But then, the decline may have slowed down so that a year later, it produces 40 barrels a day.

The newer fracked wells generally produce much more per day than traditional wells initially, but the initial steep decline in production lasts a lot longer. For example, a fracked well might produce 400 barrels of oil per day in the first month, but then that may decline to 250 barrels per day in the sixth month, and then to 150 barrels per day by the twelfth month, and 100 barrels per day a year after.

Having a good estimate of the type curve is very important, as it tells us how much oil or gas the well will produce over its lifetime. For example, let's say we had a well that produced 30,000 barrels in the first year. If you assumed a very simple type curve where the rate of production declined by 10% per year, then this means we expect the well to produce 300,000 barrels during its lifetime. If, however, we assume that production will decline by 20% per year, then this means we expect the well to produce 150,000 barrels during its lifetime.


Even if oil and gas companies own the surface area of the land, they don't actually own the resources underneath it. Instead, they must obtain permission to extract them from the entity that actually owns it: the government.

Once a company sells the oil or gas, the company must pay the provincial government a percentage of the proceeds. This is known as the royalty. The amount of royalty varies from province to province. They also vary depending on the type of well, as well as the age of the well.

Royalties are a huge income stream for provinces, so they want companies to drill more. To encourage companies to drill more, some provinces structure royalties in a way that gives companies more cash flow early in the life of the well. That way, these companies can recoup their cash quickly and reinvest them into new wells.

Operational Costs

It would be nice if oil and gas could pump itself and transport themselves, but reality doesn't play so nice.

Once oil is pumped up to the surface, companies will often have to transport the oil to the nearest storage facilities, and then to the markets.

Even if the well is tied in to a pipeline, as is usually the case with natural gas wells, companies have to pay workers to maintain the wells. Also, if the company doesn't own the pipelines, they'll have to pay for the pipelines as well.

Oil and gas companies therefore incur costs directly in proportion to the amount of oil and/or gas they produce. These operational costs usually amount to a few dollars to high teens per barrel of oil. You can find a company's operational costs in the company's financial statements as well.

Putting It All Together

Once we obtain all the numbers we need, we can put them together in a spreadsheet like this to find each well's Net Asset Value (NAV).

Sample Well Economics Spreadsheet

The NAV of each well indicates the value of each well location. Everytime an oil and gas company drills a well, as long as our assumptions regarding costs and revenues are correct, we can estimate that the company gains the NAV amount of value. For example, if the NAV of an oil well is $1 million, then everytime the company drills, we can estimate that the company will make $1 million.

If the company claims to have 200 such potential well locations in its land, then we might be tempted to say that the company has 200x2 = $400 million of potential value locked up in the land. This however, would be overstating the case because we have to take other cost considerations into account. We'll take a look at these costs in part 2.

This blog post was originally published on the blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

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