Monday, December 15, 2014

How do oil investors (principals) align the incentives of operators (agents) with their profitability goals?

With the so-called "1/3 for 1/4" contracts:  if an investor pays for 1/3 of the cost of the well, she receives 1/4 of the net revenue from the well (after the landowner receives a royalty payment, e.g., 15%).  If the operator sells three shares, then the costs of drilling are covered, and the operator gets a 1/4 share of the well.

Since the operator gets 1/4 of the upside but the investors bear most of the downside, the operator has a bigger incentive to drill a marginal hole than do the investors.  To mitigate the costs of adverse selection and moral hazard, the operator releases information to the investors:

As soon as the well is spudded, the investor will be entitled to receive daily drilling reports to keep him abreast of the well’s progress. Ordinarily, all sophisticated industry working interest partners are responsible for their proportionate part of the drilling costs, regardless of what the operator’s initial cost estimate was or how much money they have prepaid. If the well goes over budget, those partners may be called upon to contribute additional funds to keep the drilling rig going. A partner who fails to respond in a timely manner may forfeit all or part of his interest in the well.

In general, here are rules to screen out bad investments:

• Beware of overly simple deals in which you are approached by a broker or landman brandishing a small lease map with nothing more than a yellow outline on it. A legitimate prospect will almost always be presented by one or more industry professionals who have taken the time to prepare a comprehensive (and comprehensible) brochure that contains maps, several pages of text describing the geology of the immediate area, nearby (and presumably analogous) production data, cross sections, etc. 

• A slick brochure is no guarantee that the prospect has any geological merit. Your best bet is to hire a consulting geologist for half a day to take a look at the information the operator has furnished you and render an opinion. 

• Beware of “hot” deals that have a short fuse. If you have to put your money up by the end of the week in order to get in on a “can’t miss” prospect that is about to spud any day now, forget it. This is one of the oldest come-ons in the book.

• Don’t be in too big a hurry to spend your oil and gas investment money. Industry insiders ordinarily expect to participate in only about one out of every 10 to 20 unsolicited prospects that are submitted to them. You should be discriminating with your funds as well.

• Don’t put all your eggs in one basket. Take a small piece of several deals in several different areas. 

  1.  Most sophisticated investors within the industry would have to be very impressed with the geological features of the prospect before they would agree to a anything less than 1/4 for 1/3.


  1. Great Post ! In petro engineering school (at Texas A&M), Billy Pete Huddleston pounded into us "make damn sure you know a third or what for a quarter of what !".

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