Why oil companies won’t get out of bed for less than 50 to 1

We often hear, in general terms, about how the oil industry is driven by the risk-reward dynamic. It lies behind the vexed question of what is a fair government and oil company take: governments say oil companies are ripping them off because they make billions on big fields, companies reply that they need those margins for all the other times they drill dry wells or other stuff happens that prevents them bringing the black stuff to market.

But reading through some modeling of petroleum contracts this week, I came across actual numbers. They boggled my mind and I thought they might yours too. It turns out a company might need a potential market value of hydrocarbons some 50 times greater than the sums they sink into exploration in order to make the whole thing worthwhile. Here’s how that stacks up.

Let’s say a company needs to spend $15 million to sink an exploration well and shoot some seismic. And also, that they estimate there is about a 20 percent chance of striking lucky. That means the potential reward to the company needs to be at least $75 million to make the risk worthwhile, a ratio of five to one. But then – how much oil needs to be produced for the reward to the company to be worth that much? That depends on what the profit share is in the contract – what their take is. This is a highly variable figure of course, but 40% contractor take might not be unreasonable. That means the $75 million would need to be only 40% of the market value of the find, which now therefore needs to be $187 million, or a multiple of 12 to the original investment.

Big but. All the exploration will do is find the oil, not bring it to market. The immediate value to the company, or at least a company listed on any major stock market anyway, so an IOC rather than an NOC, is what value it can book on the reserves it has found. According to Daniel Johnston’s International Petroleum Fiscal Systems and Production Sharing Contracts – it’s more interesting than the title, I promise you – oil that is proven and developed can be booked for half to two thirds of the market value of the oil. That means, oil in fields where wells have been sunk, pipelines run and the entire physical and presumably regulatory and management infrastructure to get to market laid down and mapped out.

But we’re still a stage before that – the exploration would prove the reserves but all that development would still need to be done. The value of that oil is about half the value of developed reserves – so half of half is a quarter. So the market value of the oil now needs to be four times higher again than the contractor’s take of oil once brought to market to account for the risk of all the stuff that still needs to happen to get it there. Our $187 million now becomes $750 million – against the original investment of $15 million, or 50 to 1. Now we begin to see why the perspectives of the companies and governments can become so dramatically different once a big field is found, developed and producing, what economists call the “time inconsistency” problem. Everyone in government is saying, look, billions of dollars of oil out of $15 million investment and they’re walking away with 40% of it! And the companies are saying, look, we needed that 50 to 1 ratio to get out of bed!

It’s sobering to put the numbers on it.

Even more sobering when you think that I just kind of tricked you. Those are yesteryear’s numbers in terms of exploration costs, broadly speaking. Sure you can still sink a well in Oklahoma or Texas somewhere for under a million dollars and possibly have a viable business with production in the hundreds of barrels a day. But that’s not where the action is.

If we think of the surge in East African oil it’s offshore and deep offshore. Two hundred million dollars is a more reasonable sum for seismic and sinking one exploration well. At the 50 to 1 ratio that gives an estimate of a need to find ten billion dollars worth of oil. At (for simplicity’s sake) market price of about $100 a barrel, that means companies are looking for fields in the order of 100 million barrels in those conditions, worth sums of money that start to look like significant percentages of the host county’s GDP.

No wonder it’s a sensitive issue.

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