It’s both exciting and nerve-wracking to stand in a pasture in South Texas watching roughnecks rig up the head on a nodding-donkey so we can start producing from our first well in a new field (well, new for Sierra Pine but an established field that is nowhere near the front end of its decline curve).
We are confident in our models, and we are most interested in the production we will see from the secondary recovery methods we have planned. I still want to see oil coming out of the ground at a decent rate.
Getting to this point has been a process that not many investors understand – even those who may consider themselves casual oil and gas investors. While we are some of the best at vetting projects and performing due diligence before we invest in an oil or gas well (or advise clients to invest), there are a lot of potential pitfalls new investors should know about so they don’t get taken for a ride by less-than-reputable pitchmen looking to unload a dog of a well.
New or inexperienced investors should be aware of some pitfalls and red flags before investing in an upstream oil or gas well.
Any investment information – even a comprehensive roadmap – is not a substitute for the services of a qualified oil and gas lawyer or an experienced geological consulting firm.
With any investment, there is a potential for the investor to lose money. Oil and gas is no different and presents some unique risks apart from just losing money.
While it is easy to get caught up in the upside potential of investing in an upstream oil or gas project, a savvy investor should be acutely aware of the downside potential.
Plug and Abandon (P&A) Risk
After a well is drilled and completed, there is a need for P&A activities. This phase of the exploration and production project is necessary, but it costs money and offers no return. A plugged well either represents a well so far down its decline curve that its production was almost non-existent or that the cost of producing a barrel of oil was higher than what you could get on the open market.
Understanding your P&A risk is an important part when investing in an oil or gas well because you don’t want to be the person left holding the bag when the P&A bill comes due.
Understanding the Decline Curve
Similar to P&A risk, you need to understand where the well is on its decline curve. Is there enough production left to cover expenses? For all investors to make a decent return?
Are there economic secondary recovery methods that could give your potential well a second life?
Getting your head around the decline curve will give you a strong understanding of the potential investment and your expected ROI.
Understanding the Deal Structure
Investing in oil and gas projects in multiple phases and various rounds of investing requires you to understand exactly where you’re coming in on the project, what you’re entitled to and if you’re obligated to supply some of the operating expenses.
Investing in a large project with multiple controlling entities helps protect your investment if another project in the deal incurs larger expenses or produces less than predicted due to bad information or a poor reservoir model. This could also restrict your access to any returns made by other parts of the larger project.
Be sure you understand exactly what you’re investing in. Don’t take anything at face value. This is especially true if you visit the well sites; try to avoid getting sucked into the excitement of visiting “your well.”
Understanding the Pitchman
We’re all in business to make money. This is also true for the person pitching you on a project. While this person could be the principal operator, a lot of times this is a professional salesperson interested in closing a deal and moving on to the next prospect.
Understand the intent of the person you’re dealing with. Most people in the oilfield are honest, hard-working professionals. They understand that the oilpatch is a small world and people tend to gossip. They want to protect their reputation. Understanding the person behind the deal is an important part of understanding the deal itself.
Unrealistic Time Constraints
Be wary of unrealistic time constraints. While every investment has a realistic deadline, if you’re being pressured to rush your decision-making process, it’s probably best to walk away.
When investing, there is a real fear of missing out, but it’s good to remember another deal is just around the corner. There will always be opportunity in the oilfield, but throwing your money at a flashy sales pitch because you have limited time to analyze the deal is a good way to lose money and miss out on real opportunity down the road.
If your strategy is to invest in the most newsworthy sectors of the upstream oil and gas market, you’re probably riding the tail end of the opportunity. The more news a region, play or field receives, the higher the cost to entry (and thus a lower potential upside).
It’s fine to stay informed about the goings-on in the industry, but making money in oil and gas isn’t always about following trends. In fact, following the next hot thing is a good way to show up late to the party.
Ways to Protect Your Investment
I said it earlier, but it bears repeating, the best way to protect your investment is to invest in a good team on the front end.
A good oil and gas legal team will help you structure a deal that benefits you. You also need a strong geological team. No matter how good the data looks in the pitch meeting, you should always perform your own due diligence. It’s important to have every project vetted on the front end. The cost of study is a whole lot cheaper than investing in a project that can’t deliver on the promises of a flashy sales pitch.
If you need help understanding the ins and outs of your next oil or gas investment, we would be happy to help you get into a project that will help get you the returns you need. Send us an email at firstname.lastname@example.org.
For more information about what to look out for when investing in upstream oil and gas projects, the SEC has a list of “Red Flags” to be aware of.