Developmental Oil Drilling

DEVELOPMENTAL DRILLING:

THE OIL INDUSTRY’S MOST OVERLOOKED SECTOR

DEVELOPMENTAL DRILLING: THE OIL INDUSTRY’S MOST OVERLOOKED SECTOR

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Contents Introduction................................................................................................................................................................4 Part I: Background & Basics Oil Drilling & Production: Key Definitions................................................................................................................8 U.S. & Global Oil Outlook.............................................................................................................................................10 The Permian Basin..........................................................................................................................................................13 Part II: Developmental Drilling Why Developmental Drilling? Why Now?................................................................................................................16 How Developmental Drilling Works............................................................................................................................18 Note on Environmental Impact....................................................................................................................................19 Part III: Investing in Developmental Drilling Getting Exposure............................................................................................................................................................25 Limited Partnerships......................................................................................................................................................27 Costs & Returns.............................................................................................................................................................30

3

Introduction

T

he world is in the midst of an extraordinary boom in

oil-rich basin in Western Texas and Eastern New Mexico that

the discovery and production of oil, bolstered by rapid

has been a key component of U.S. oil production since the first

technological innovation, favorable economics, and the

half of last century, the Western section is currently a hotbed of

highest levels of investment in decades. Much atten-

wildcat drilling for shale oil and gas, as well as developmental

tion has been paid recently to the role of newly discovered reser-

drilling within established, producing fields; while its Eastern

voirs of so-called unconventional oil, particularly in the Western

Shelf region offers excellent opportunities for lower-risk devel-

hemisphere: in the last decade, we’ve seen the discovery of massive

opmental drilling of conventional reserves, and to a lesser extent

shale and tight oil plays in the U.S., tar sands in Canada, extra-

oil shale plays.

heavy crude in Venezuela, and so-called pre-salt oil off the coast of Brazil. These discoveries have revived economies, made huge

As developmental drilling and reserve growth are functions of im-

returns for investors, and helped allay the “peak oil” fears that have

provements in technology and economic conditions, it is essential to

hung in the public’s and investor’s minds for years.

understand those two pieces of the equation, including the two most important drilling innovations of recent years: horizontal drilling

Overlooked in this narrative, however, is another key component

and hydraulic fracturing (or fracking). Both of these methods were

of the revolution: reserve growth, or the growth in size and produc-

first employed decades ago but were revisited and vastly improved

tivity of already proven reserves. A substantial proportion of the

in the last decade in the context of exploration and production

growth in output in the last decade and the projected growth in this

(E&P) of unconventional oil and gas in the U.S., and they continue

decade come from long-established reserves that, far from having

to be perfected by the day. Though they were developed mostly in

become depleted, have only grown and improved, due to a combi-

the context of unconventional plays, they have been used to great

nation of improved analysis, new drilling and production technolo-

effect by E&P companies with a developmental drilling focus for

gies and methods, and economic factors (in the form of high crude

accessing and producing new quantities of conventional oil. One of

prices) that have freed up previously inaccessible oil.

the factors that make developmental drilling so attractive is that it is able to apply such effective technologies to low-risk, high-potential plays.

This process of drilling in or near known reserves in order to grow them is called developmental drilling. It can be done “in-field,” that is, between wells within an already defined oil field, or as an exten-

This report is a basic guide to investing in developmental drilling,

sion to a field; and it can be done in currently producing fields or in

showing why the current confluence of technology and economics

fields that were drilled in previously and then abandoned. Unlike

make low-risk, high-potential developmental drilling investments

exploratory (or “wildcat”) drilling, where companies seek out new

so attractive.

discoveries in unexplored regions or formations, and which is gen-

derstanding developmental drilling in the current technological and

erally high-risk and high-return for investors, developmental drill-

economic context. Part II explains in more detail what develop-

ing involves much lower risk, lower costs, and more dependable

mental drilling is and how it works. And Part III discusses how

returns. Indeed, with a universal success rate of about 80% -- as

investors can get exposure to this important element of the current

opposed to exploratory drilling’s success rate of 9-13% -- devel-

boom in U.S. oil, with particular focus on the limited partnership

opmental drilling is an important method that companies use to

model. The report’s geographic focus is the oil-rich Permian Basin

“de-risk” their operations/portfolios.

of Texas and New Mexico, where current investment opportunities

Part I gives some background and basics for un-

in developmental drilling are particularly strong; though most of Successful exploratory and developmental drilling often occur

what we say about developmental drilling applies to other areas of

in the same area. For example, in the Permian Basin, a massive,

the U.S. and the rest of the world as well.

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Part I: Background & Basics

Drilling & Production: Key Definitions

T

here are certain key terms and technologies that investors

fluid characteristics permit the oil and natural gas to readily flow to

should understand correctly when approaching the oil

the wellbore.” Unconventional oil and gas are those that don’t fit

sector generally and developmental drilling specifically.

this definition. They include shale oil and gas, tight oil, oil shale (which is distinct from shale oil), tar sands, extra-heavy oils, and pre-salt oils, among others.

To start, there is the distinction between reservoir, resource, and reserve. A reservoir is merely a coherent body or rock type (lime stone, sand stone, shale) capable of fluid transmission. A resource

The exploration and production process is commonly referred to as

is a reservoir that can technically be recovered. A reserve is a re-

E&P. It includes everything from exploring areas for new reserves

source that can be recovered profitably. A reserve, then, is funda-

or performing developmental drilling in known reserves, to the pro-

mentally a technical and economic quantity: it is a measure not of

cess of recovering those reserves and preparing them for market.

how much oil is there but of how much of the oil that is there can be brought to the surface under current technological and economic

Drilling is the process of boring and creating an oil and/or gas well.

conditions.

As we have seen, drilling in order to discover additional quantities of oil within or alongside a known reserve is called developmental

Thus reserve growth, which is simply a growth in the size of a given

drilling, while drilling in order to discover new reserves is called

reserve, will occur if and when (1) technology improves and/or (2)

exploratory drilling or wildcat drilling.

economic conditions improve and/or (3) additional profitably reVertical drilling is the process of drilling at a 90-degree angle to the

coverable oil is discovered in a reserve.

surface (more or less), directly downward. Historically, it has been Opposed to reserve growth is depletion, which is the exhaustion of

the most commonly used drilling method and remains so world-

a reserve over time. Depletion rate is another commonly used term

wide. Directional drilling is drilling at an angle less than perpen-

when discussing reserves.

dicular to the surface, including horizontal drilling, which is the process of drilling more or less parallel to the surface, after drilling

Some terms used to describe the size of reserves, and the general

vertically downward to a certain depth. Horizontal drilling, though

economics of oil, include the following:

first experimented with early in the 20th century, has been utilized effectively only in the last decade, and it is revolutionizing oil production by vastly increasing the reach and surface area of wells.

•

Barrel (equal to 42 gallons of oil)

•

BOE (barrel of oil equivalent, used to equate natural gas and oil)

•

BOPD (barrel of oil per day)

Drilling is a complex and rather amazing processes. The accompa-

•

Mbd Thousand barrels per day

nying diagram gives a sense of the many parts at work within the rig

•

MCF (Thousand cubic feet of gas)

and well. In short, the well is bored with a drilling string consisting of sections of hollow metal pipe, with additional sections added ac-

Then there is the distinction between conventional and unconven-

cording to the depth of the well. At the end of the drill string is a

tional hydrocarbons. According to the U.S. Energy Information Ad-

bit that bores through the earth and rock. Drilling fluid is pumped

ministration (EIA), conventional oil and gas are those “produced by

down the hollow drill string to the bit to facilitate drilling and cir-

a well drilled into a geologic formation in which the reservoir and

culate cuttings to the surface. When drilling is complete, to total 5

depth, a column of casing is positioned in the well to create struc-

nitrogen, steam or certain chemicals directly into the reservoir to

tural integrity, often with cement pumped between the casing and

make the oil less viscous and flow more easily. Experiments are

the drill string. When the production area is reached, perforations

being done with injecting microbes into reservoirs that naturally

are created in the pipe and through cement to allow hydrocarbons

loosen oil from its rock container. Acidizing – or injecting acid into

to enter the well.

wells to stimulate production – is also commonly used. Employing these techniques yields enhanced oil recovery (EOR).

Horizontal drilling can greatly increase the exposure (surface area) of a well to a reservoir, as well as increase the possible area

Investors should be aware of these recovery methods, and under-

for the employment of hydraulic fracturing and other well stimu-

stand that the technology of recovery is improving constantly. The

lation techniques. Horizontal drilling occurs in multiple stages,

most important improvements recently have been in packer systems

and much attention has been paid within the industry to reducing

and hydraulic fracturing technology, especially multi-stage fractur-

the time of each stage. Time per stage has dropped drastically in

ing in horizontal wells.

recent years.

Hydraulic fracturing, or “fracking” (sometimes spelled “fracing”), Well completion is the process of bringing a drilled well to produc-

has developed in tandem with horizontal drilling, and it is likewise

tion. In many cases, the natural pressure of the oil and gas trapped

a decades-old method that has only been used effectively – ex-

inside a rock formation pushes it to the surface of the well or if the

tremely effectively – in recent years. It was first performed in

pressure is not sufficient then the well has to be pumped to bring

1947, but the technology took a quantum leap in the late 1990s

the oil to the surface; this stage of recovery is known as Primary

when an oilman named George Mitchell pioneered its modern

recovery. In other cases, well stimulation (acidizing and fracking)

form, initiating a paradigm shift in the industry and was also re-

must be employed to coax the oil or gas from the rock. Secondary

sponsible for the Barnett Shale play becoming a commercial res-

Recovery is a water flood, when water is injected into the reservoir

ervoir.

to re-pressurize the reservoir to increase oil and gas movement to the wellbore and the surface. In Tertiary recovery, more technologi-

Fracking is performed by injecting fracking fluid at high pressure

cally advanced and tactically ingenious methods are used. Exam-

into rock formations in which hydrocarbons (including oil, natu-

ples of tertiary recovery methods include injecting carbon dioxide,

ral gas, or both) are tightly enclosed, in order to fracture the rock and create small fissures that allow the hydrocarbons to escape into the well. It is performed in both vertical and horizontal wells, at any depth. Fracking fluid consists of large quantities of water mixed sand or fine ceramic grains (known as proppant), and small quantities of select chemicals.

Fracking adds a significant amount of technical difficulty and cost to the completion process, but when successful, it can unleash massive amounts of previously inaccessible hydrocarbons.

Though fracking has become very well known recently in the context of unconventional oil and gas recovery from shale formations – most of which are extremely deep and require extremely high quantities of pressure to fracture – fracking is also used in non-shale formations and at shallower depths as a common form of well stimulation.

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Global & U.S. Oil Outlook

T

he boom in developmental drilling of both conventional

For his report, Magueri did a field-by-field analysis of current

and unconventional reserves, and the technological revo-

oil projects worldwide, predicting that global oil production

lution that is making it possible, have increased current

will see a net increase of 17.6 mbd (million barrels per day)

and forecasted oil production on a massive scale, both

by 2020, the largest increase since the 1980’s, with total global

globally and in the U.S. Indeed, due to its massive shale plays and

production reaching 110.6 mbd in 2020. He likewise expects

its technical mastery of horizontal drilling and hydraulic fracturing,

the U.S. to be second only to Saudi Arabia in oil production by

U.S. production will grow more than production in most other parts

that year. He sees the greatest growth in 4 countries: the U.S.,

of the world in the next decade, and many predict that, by next dec-

Canada, Brazil, and Iraq. Three of those countries are in the

ade, it will be second only to Saudi Arabia in oil production, ahead

Western hemisphere, signaling an interesting change in the oil

of Russia.

production industry’s center of gravity.

Meanwhile, most price forecasts see the global price of oil remain-

Magueri says that his global numbers assume per-barrel crude

ing between $90 and $100 per barrel or higher over the next 3 to 5

price of at least $70, and that most of the projects he analyzed

years, due to steadily rising demand and geopolitical factors, par-

would not be profitable if prices were to drop below that mark;

ticularly in the Middle East.

though most U.S. shale plays, he says, are still profitable at prices as low as $50-$65 per barrel. Again, it is highly unlikely that

The most dependable numbers on oil production come from the

prices will drop close to that level, particularly in the next 3 to

U.S. Energy Information Administration (EIA), a global authority

5 years.

on energy-related information, as well as a recent report published by the Belfer Center for Technology and International Affairs at the Harvard Kennedy School, entitled “Oil: The Next Revolution,” by Leonardo Maugeri.

According to an EIA report published in January, 2012, U.S. oil production will increase by (CHECK SOURCE SHOULD BE ‘TO 6.4mbd’ not ‘by’) 6.4 Mbd (million barrels per day) by 2025, a million more than the country produced in 2010. The EIA had previously predicted that U.S. production would peak at 6 Mbd in 2022. Many analysts consider these figures an underestimation, primarily because they think the U.S.’s massive and still only partially understood shale plays will be much larger and more profitable than previously thought.

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Permian Basin Profile & Outlook

T

he Permian Basin in western Texas and eastern New Mexico is a key focal point in the

U.S. and global oil boom, and has been since its first commercial oil wells were drilled in the 1920s. The Basin is 250 miles by 300 miles, with over 1,500 operators working there. Its western section is home to some of the most important shale plays in the world, including the Wolfcamp Shale.

Other impor-

tant formations include the Avalon Shale, the Leonard Shale, the Spraberry Formation, the Yeso Oil Play, and the Bone Spring Formation.

The eastern portion of the Permian Basin, known as the Eastern Shelf, does not have the large shale plays of the West and is thus slightly off the current industry radar; but it has strong conventional plays and myriad legacy fields offering ripe opportunities for developmental drilling. Land lease prices are generally much lower in the Eastern Shelf than in the more crowded West.

Many oil and gas majors and juniors operate in the Permian Basin, having moved in or increased operations recently in light of its promising plays. These companies include Occidental Petro-

Resources, the largest producer in the Spraberry Field; Chesa-

leum, the Basin’s largest oil producer; Apache, which recently

peake Energy; Concho Resources; Anadarko Petroleum; Devon

purchased BP’s assets in the region; ExxonMobile, which has

Energy; and Eagle Production, an independent company with

performed both developmental and exploratory drilling; Pioneer

strong assets on the Eastern Shelf.

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Part II: Developmental Drilling

The Importance of Developmental Drilling Magueri’s report makes clear the role of reserve growth and devel-

provements in technologies that have made once-inaccessible oil

opmental drilling in both conventional and unconventional reserves

readily accessible and economical to produce. Magueri points to

in the context of the global oil boom, and the importance of the lat-

the famous example of the Kern River Basin in California, which,

est technologies. “U.S. shale/tight oil could be a paradigm shifter

in the century-plus since it was first discovered, has repeatedly out-

for the oil world” in the coming years, he writes, “because it could

produced expert estimates by a long shot, while showing no signs

alter its features by allowing not only for the development of the

of slowing up.

world’s still virgin shale/tight oil formations, but also for recovering more oil from conventional, established fields – whose average

The cause of this underestimation was, in part, faulty geological

recovery rate is currently no higher than 35%” (emphasis added).

analysis. But it also had to do with unforeseen technological advances and economic improvements. “Most of the world’s oilfields

Indeed, reserve growth and developmental drilling are about as

have revived over time,” Magueri says, drawing a general truth out

old as oil E&P itself: the history of the oil industry is full of cases

of the Kern River example. “Leaps in extraction technology have

where initial estimates of the size of a reservoir and/or the amount

led to tapping oil in once-inaccessible areas and in places where

that could be recovered profitably were vast underestimations even

drilling was once uneconomic. In a way, technology is the real cor-

without technological advances; and there have been continual im-

nucopia” (emphasis added).

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Why Developmental Drilling? Why Now?

F

rom an investor perspective, there are, no doubt,

easily and cheaply than exploratory drilling, at very low risk, gen-

serious returns to be had through high-risk invest-

erating significant cashflow in the near term.

ments involving wildcat drilling for unconventional and conventional hydrocarbons around the globe.

As developmental drilling depends heavily on technology, it is

On the unconventional side, there are the

most likely to occur and succeed in the most

still-unexplored shale plays in the U.S.; the

technologically advanced oil markets; and

tar sands of Canada; nascent shale plays in China and Eastern Europe; and the extremely nascent shale play in Argentina, among many others. On the conventional side, much of the world remains unexplored, and the recent rush of conventional oil exploration in Sub-Saharan Africa, for example, has yielded substantial reserves and massive profits. There will no doubt be more discoveries of both conventional and unconventional reserves in these relatively untrodden regions of the world in years to come by the companies willing and able to endure high risk.

Now, however, is developmental drilling’s moment. Many investors wary of the high risks and high upfront costs of exploratory drilling and unconventional hydrocarbon

The technologies necessary for risky, expensive unconventional production are getting better and cheaper, and they can be applied with enormous effect to developmental drilling and production of conventional and unconventional reserves.

as the U.S. has pioneered horizontal drilling and hydraulic fracturing and possesses most of the necessary equipment for it, it is leading the way not only in exploration for shale (unconventional) hydrocarbons, but in developmental drilling for conventional hydrocarbons.

In addition, the U.S. possesses another feature that is conducive to developmental drilling: market conditions that foster small, independent oil companies who are, in many cases, leading the way in performing developmental drilling in the many supposedly depleted or underperforming wells around the country; growing those reserves; and then selling their revived wells to larger companies looking to expand their reserve portfolios or other parties looking to purchase cashflow.

production are finding a perfect confluence of factors conducive to strong-return investment in developmen-

Thus, independent E&P companies with a developmental drill-

tal drilling. The technologies necessary for risky, expensive un-

ing focus in the U.S. are particularly well-positioned; and when

conventional production are getting better and cheaper, and they

it comes to horizontal drilling and hydraulic fracturing, the lion’s

can be applied with enormous effect to developmental drilling and

share of equipment and expertise is within U.S. boarders.

production of conventional and unconventional reserves. At the same time, the price of oil remains very high, holding at around

It seems, then, that independent oil companies that perform and

US85-95 per barrel, and many forecasters believe it will remain

specialize in developmental drilling will be extremely important

there, if not higher, for the near term, and that it is highly unlikely

within the context of a booming industry over the next 3 to 5

that it will drop substantially in the next few years. Developmen-

years at least, representing a low-risk, strong- and steady-return

tal drilling can thus bring growing reserves to production more

investment.

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How Developmental Drilling Works

W

hen investing in the developmental drilling in-

these geologists have advanced methods for analyzing such data

dustry, it is important to have at least a basic

(some of which methods have been codified in new software pro-

understanding of the complex processes it in-

grams) and locating areas where developmental drilling is likely to

volves. It is especially important when invest-

be successful. Many geologists complement their research and data

ing directly in an independent developmental drilling company via

analysis with hands-on drilling in the fields, examining rocks and

a limited partnership, as we discuss in Part III.

hydrocarbon shows as they occur.

Developmental drilling begins with geology and what is called pros-

Once an petroleum geologist has located a high-potential area for

pect generation. Petroleum geologists – who may be independent

developmental drilling, a prospect is generated. Then by determin-

contractors or on the staff of companies – have a host of constantly

ing which units of land in that location must be leased. In most

improving technologies at their disposal to evaluate rock formations

cases, a landman is hired to help a company obtain a lease and ne-

for possible oil resources and re-evaluate reserves; indeed, reserve

gotiate with the land/mineral owner how mineral royalties will be

growth may come simply from new estimates of recoverable oil due

split. In the U.S., it is quite common for royalty revenue – referred

to more accurate geological studies. Geologists also utilize dec-

to as net revenue interest (NRI) – to be divided (for example) 25%

ades’ worth of data from past drilling in a given region, much of

to the land/mineral owner, 75% to the oil company and investors

which is stored inside invaluable libraries, both physical and online;

leasing the land; though other arrangements are possible.

Steps to an Oil Production Company 4: Drilling, Well Completion, and

1: Prospect Generation

Start of Production

By drilling in the oil fields and consulting local land, drilling, completion, and production data from numerous libraries, EPI geologists map out high-potential, low-risk areas for developmental drilling.

Upon transfer of land rights, EPI begins drilling within the year.

Well completion will follow drilling operations within a month, after designing optimal completion strategy with engineers. We may drill new wells and/or re-enter old well. We may drill multiple wells simultaneously while employing latest technology.

2: Economic Modeling and Funding

5: Growth

With an inventory of high-potential prospects, EPI performs all economic modeling and due diligence and obtains funding.

Funding can come from larger oil companies, outside investors, or EPI’s own cash flow. EPI commonly uses a “third for a quarter” arrangement with outside investors.

Cashflow from initial wells is invested in subsequent wells. We have a minimum of 10 producing wells at the end of year 1, 20 by the end of year 2, and 40 by the end of year 3. Each well produces a minimum of 25 BOPD, for a total of at least 1000 BOPD (these estimates used modeling purposes only).

3: Leasing Land

6: Divestiture

Years of experience in the oil field has provided insider knowledge of Permian Basin land law and practices. EPI negotiates leases and mineral royalty terms with land and mineral owners. Net revenue interest (NRI) for the land owner is commonly 20-25%. This process takes between 60 to 90 days.

Upon reaching production goals at the end of year 3, EPI arranges for an orderly divestiture. Often the new oil-producing company is sold to a larger company, and the lease by this time has increased significantly in value. In worldwide markets, divestiture price for oil wells in production normally ranges between 36 and 60 months of gross cash flow.

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Some prospects may be in areas where no drilling has ever occurred,

may suggest that the reserve below the field extends beyond the

either because it was not known that a known reserve extended that

established field, and they may thus expand the field beyond its

far, or because it was not thought possible to access a known re-

previously established boundaries.

source profitably from that location. In other cases, drilling may have occurred there but been abandoned, either because it was be-

The methods and technologies employed in the drilling and well

lieved that the reserve was entirely depleted or that the oil could no

completion stages will depend on the specific geology of the land.

longer be recovered profitably. Thus, the company may drill new

E&P companies with a developmental drilling focus employ vertical

wells and/or re-enter wells with improved technology and methods

drilling and horizontal drilling, complementing both kinds with hy-

and/or a more precise sense of the nature and location of the forma-

draulic fracturing when necessary. There are also other, less costly

tion with the reserves.

well stimulation methods, such as acidizing (normally to clean up near well bore damage from drilling fluids), whereby acid is pumped

In most cases, developmental drilling is a combination of in-field

into the well to increase performance; when acid is pumped in at

drilling and/or extending a pre-established field. For example,

high pressure, enough to fracture the surrounding formation, it is

a developmental drilling program may entail leasing land where

referred to as acid fracturing. We are constantly seeing advances

wells had been drilled decades earlier, but where production was

in well stimulation technology; currently there is increased interest

abandoned for technical and/or economic reasons. In this field,

in carbon dioxide injection as well as the use of microbes to free

the previous drillers may have drilled 1 well per 40 or 80 acres.

trapped oil from tight formations. E&P companies with a develop-

The E&P companies with a developmental drilling focus would

mental drilling focus are interested in all such technologies and tech-

do what is called downspacing by doubling the amount of wells

niques. Acidizing and fracking, however, remain the most common.

in that field, to every 20 or 40 acres. Additionally, their geology 12

A Note on Environmental Impact

U

nlike exploratory drilling companies, who venture

many of the allegations are misguided, overstated, or simply false,

into areas where drilling has never been performed

and that given the immense quantity of fracking that has been per-

before, many of which are environmentally deli-

formed in recent decades (the technology is much older than many

cate, developmental drilling companies have the

people realize), there have been remarkably few mistakes. But most

benefit of generally operating in areas where drilling has occurred

experts, even in the industry, concede that poorly executed drilling

for decades and the appropriate protocol, regulations, and public

and fracking – and especially poorly executed cement casing and

attitude have been established. Developmental drilling companies

sealing – can lead, and have lead, to environmental damage.

are therefore far less likely to infringe on environmentally protected or otherwise precious resources and to face complicated legal and public relations issues.

All E&P companies must comply with state and federal regulatory agencies regarding the protection of ground water and the environment. Diligence in compliance to environmental regulations has become and industry standard.

Nevertheless, as developmental drilling

There are relatively few developmental drilling funds currently. Eagle Production, Inc. (EPI), based out of Abilene, Texas, in the Permian Basin, is set to launch one in the second half of 2012.

In a comprehensive report on the shale gas revolution, “The Shale Gas Shock,” the science writer Matt Ridley discusses fracking in depth, rebutting all of the environmental arguments against it.

Though his report is focused specifically on gas production, it applies to fracking within the context of oil production, too. (Oil and gas often exist together within reservoirs, and oil production may lead to significant gas recovery.)

companies are increasingly utilizing hyRidley concedes that fracking fluid can

draulic fracturing as a well stimulation method, it is important to address the notoriety fracking has gar-

contaminate ground water if cement casing is not properly installed

nered in certain parts of the public discourse.

and/or if abandoned wells are not properly sealed, but maintains that contamination is “unlikely if proper procedures are followed.” He

This notoriety is due primarily to the environmental damage frack-

also notes that the supposedly toxic chemicals in fracking fluids oc-

ing allegedly causes. The allegations have come mostly from en-

cur in traces that are smaller than those in many household and ag-

vironmentalists worried that fracking contaminates underground

ricultural products, and that it is far more common for aquifers to be

aquifers (the sources of drinking water reservoirs) with toxic chemi-

contaminated naturally with traces of gas than because of fracking.

cals and dangerous quantities of methane; that the waste water from

Finally, he makes it clear that allowing significant traces of gas to

fracking is toxic and liable to seep or spill into groundwater, rivers,

escape from wells is not at all in the industry’s interest in terms of pro-

and lakes; and that the water-intensive process is wasteful of an

duction quality, let alone the industry’s own environmental concerns.

increasingly precious resource. All of these are legitimate (if yet unproven) concerns, and for that reason, the EPA, the Massachusetts

Nevertheless, Ridley’s concession that mistakes have been made – a

Institute of Technology, and numerous other bodies have studied the

view shared by nearly everyone in the industry – points to the con-

topic in depth; and it is essential that more studies be done to en-

sensus opinion that fracking is essentially harmless if done correctly

sure that the environment is protected optimally while still allowing

and responsibly, but that regulations and best practice guidelines are

the economy to benefit from the growth that fracking has provided.

necessary to ensure that ongoing developments in the industry are

Based on existing studies, however, the current consensus is that

aligned with environmental protection.

13

Part III: Investing in Developmental Drilling

Gaining Exposure If investors are looking for exposure to oil or the oil industry gener-

developmental drilling through a limited partnership with a drilling

ally, as opposed to developmental drilling specifically, the best and

company; and investing in a developmental drilling-specific fund.

safest ways are through oil-focused exchange traded funds (ETFs), which are publicly traded index-tracking funds, or buying commod-

There are relatively few developmental drilling funds currently.

ity shares of oil.

Eagle Production, Inc. (EPI), based out of Abilene, Texas, in the Permian Basin, is set to launch one in the second half of 2012. EPI’s

Investors who want exposure specifically to developmental drill-

fund will invest according to a limited partnership model that the

ing projects have a handful of options: buying private equity in

company, as well as many other small to mid cap independents, fre-

developmental drilling-focused companies; buying listed equities

quently use. It will raise about $5-50 million to be invested in 5-10

of public developmental-drilling focused companies; investing in

prospects over 3 years, all in the Permian Basin.

Costs & Risk Economic modeling and due diligence are performed before opera-

The cost of actually leasing land varies widely, even within a sin-

tions begin, usually by the E&P company, and an authorized for fi-

gle basin. For example, on the Western side of the Permian Basin,

nancial expenditure (AFE) is agreed on.

where there are several popular and lucrative shale plays, land is leased at $2,000 to $6000 per acre, not including landman and le-

Costs will vary according to many factors, but there are certain

gal fees. In the Eastern Shelf, on the other hand, there are high-

rules of thumb that can be applied in many areas of the U.S. and

potential prospects that can be leased for $200 to $300 per acre

in the Permian Basin specifically. For vertical drilling, total costs

– offering high-return opportunities even as real estate investments

for drilling and well completion will be between $100 and $120 per

merely.

foot of well depth, with about half the costs applied to drilling and the other half to well completion. These costs include equipment.

Returns will depend on numerous factors, including total costs,

Thus, for a 4,500 foot well, at $100 per foot, the total cost will be

total cashflow generated, the appreciation of the lease value, and

about $450,000. The $120 end of the spectrum represents the costs

the divestiture sale price. If a 4,500 foot vertical well costs about

when more expensive stimulation technologies are needed, includ-

$450,000 to bring on production, and produces 25 BOPD at $100

ing fracking.

per barrel, with a 75% NRI a full return on investment can be achieved in approximately eight months, depending on the initial

For horizontal drilling, the rule-of-thumb costs are between $250 and

potential (IP) the decline rate and operating expenses. The aver-

$325 per foot of well length (vertical + lateral), with the higher figure

age divestiture price for selling production, as a rule of thumb,

again reflecting the costs when multi-stage fracking is utilized.

is between 24 and 48 months of cash flow; or between $50,000 and $100,000 per daily barrel. Thus, a single well producing 25

In addition to these drilling and completion costs, there are admin-

BOPD will sell for between $1.25 million and $2.5 million using

istrative costs which are approximately $1000 per month per well.

this model.

14

First Closing: Vertical Drilling US $6 Million Low End

High End

# Months Gross Cash Flow

24

48

Barrels Oil per Day

1000

1000

Divestiture Price

US $48,600,000

US $97,200,000

Second Closing: Horizontal Drilling US $15 Million Low End

High End

# Months Gross Cash Flow

24

48

Barrels Oil per Day

2160

2160

Divestiture Price

US $104,976,000

US $209,952,000

Third Closing: Horizontal Drilling US $30 Million Low End

High End

# Months Gross Cash Flow

24

48

Barrels Oil per Day

3360

3360

Divestiture Price

US $163,296,000

US $326,592,000

15