VOLUME RISK AND PRICE RISK
Owning oil and gas interests has two main types of risk that an owner needs to be aware of. Factors outside of your control may result in large and unexpected gains, or may lead to sudden loss of income. In this blog post, I’ll explain how I view these factors.
Volume Risk
The first risk is what we refer to as volume risk. There are a lot of good and bad things that can happen on any one lease. The possible good things include anything that increases output, such as: new horizontal or vertical wells may be drilled, new technology can be implemented, shallower zones can be opened up, etc.
As much as we hope for these positive developments, negative events do occur very frequently. The production casing can collapse, wells can "water out", the operator can take off with everyone's money, and so forth.
The most common negative event is that wells get plugged out as non-commercial. Remember, with the exception of taxes, you own a non-cost-bearing interest. Let's say for example way back you or your predecessor in interest signed an oil and gas lease with an exploration company. That lease granted the company and its partners (the Working Interest Owners) the right to drill a well. The mineral owner(s) received a royalty interest under the lease or leases, thus creating the Royalty Owners. The company and/or the Working Interest Owners paid 100% of the cost of drilling, completing, and producing the well or wells and you paid and pay nothing to keep the well producing. They get 100% of the revenue LESS THE ROYALTY INTEREST, which means they are receiving something like 75% to 87.5% of the income, but paying all of the bills.
When the Working Interest Owners make less money from the production than the lease is costing them to produce it, and all or most of the possible opportunities have been tried or studied, they will plug the wells and walk away. This means you could be getting $1000 a month on a well that is very important to you but that is uneconomic or non commercial for the operator. These companies will not produce a money losing well for very long. So you go from a big check to nothing when non commercial well gets plugged and it can be a nasty surprise. Leases all have an economic life; some are shorter and some are longer; but eventually the costs are going to exceed the revenues.
The way we mitigate against this type risk is by buying thousands of interests in thousands of properties. We make estimates about the projected future output of a property in the process of making an offer or buying a deal, but those are guesses based on historical production; and they’re always wrong. Oil and gas do not grow under the ground; these fluids are trapped there. As you remove volume, there is less fluid in the reservoir and thus less pressure to push the fluids to the "low pressure sink" that is created around the well bore. Thus, in the absence of any other risk factors, the production volume normally goes down over time. This is what we mean by the term decline. So to make a guess as to what future volumes are going to be, we plot the recent historic production against time and simply project the "decline curve" forward into future periods to see what those volumes might be if the current decline holds. Usually, the assumption is that whatever the decline is now will be the decline for the life of the property under our "guesstimates."
Sometimes these guesses are off only a little bit and sometimes by a lot, but they are always off. But what happens is that the ones that do better than we guessed and the ones that do worse tend to offset each other. So our guess on any one property is always wrong, but as a group, we are usually pretty close. So our "volume" risk goes way down by owning a lot of properties relative to someone who owns one or a few. Out of a thousand leases, if one goes down, hopefully another increases and unless one or two leases make up the majority of the income, they tend to balance out.
Price Risk
The second type of risk is simple price risk. The price of oil goes up and down and whoever holds a property is subject to the variances of the markets that set prices. One thing that happens though to me as a buyer is that if I use the same source of price guesses for future periods every day, then the valuations I used over, say the last five years, should be the same as the average price over the previous five years. Which is probably not a bad price to use today. Going forward with the portfolio we have, same thing though. Who knows? None of us can get away from price risk.