Oil and Gas Wells

Now that we understand some of the basics of extraction and injection wells, we are going to shift our focus towards wells that service the oil and gas sector. These wells will be the main wells discussed in this course. Oftentimes both extraction and injection wells must be drilled in the area of interest (where oil and gas is present). For example, during the oil production phase of a project, petroleum engineers drill both extraction and injection wells. Extraction wells remove the natural resource: for example, oil. But these extraction wells only allow the resource to flow to the surface if the pressure differential between the rock layer containing the resource (higher P) and the ground surface (lower P) is maintained. As naturally induced flow continues, the pressure in the rock layer at depth eventually drops and the differential must be artificially maintained using an injection well. Injection wells help maintain pressure in the rock layer at depth and can push or ‘sweep’ oil out of the rock and into the extraction well. Engineers must make sure that both extraction and injection wells are drilled, operated, and retired safely. Let’s look into how engineers and scientists work to achieve these important goals. 

The Players

Now that we know a bit more about the agencies regulating these wells, let’s look into the players. Who undertakes exploration and production? Where do they conduct business? Who are the interested parties financially benefiting from exploration and production? 

Operators and Service Companies

An operator is the company involved in the drilling and production operations for extraction of oil and gas. Typically operators take part in the exploration phase before drilling has commenced. Some familiar international operators that you may recognize include ExxonMobil, British Petroleum (BP), Shell. These companies trade on the U.S. stock exchange. These large companies often lead the technological and environmental best practices in the industry. But there are also smaller, independent companies that explore for oil and gas. These companies may lead the way by developing very specialized technology, focusing on innovation, and demonstrating the ability to be financially nimble. Larger companies that operate in the U.S. are typically referred to as “majors,” whereas smaller companies are referred to as “non-majors.” 

Service Companies are involved in assisting the operator throughout the drilling process. Instead of being the major company overseeing operations, they are typically viewed as subsidiary companies that help in drilling and production of the field. Examples of well-known service companies you may be familiar with are Schlumberger and Halliburton. These companies are often first at the wellsite and perform very specific tasks for the operator, such as drilling, cementing, or hydraulic fracturing.

Where Do Companies Operate?

Oil and gas wells are categorized in two broad categories, 1) onshore and 2) offshore. 

Onshore Oil and Gas Wells

Onshore wells involve drilling into the Earth’s surface. Focusing on Texas, many of the state’s onshore drilling operations take place in West Texas such as the Permian Basin, one of the country’s biggest oil and gas fields. Well depths in the Permian Basin can exceed 18,000 feet in depth. The Permian Basin has been drilled for oil for quite some time now. During World War II, the Permian was extensively drilled to supply fuel for the U.S. war efforts. At one point during the war, the Permian Basin contributed one-fourth of the world’s oil and gas production. Renewed interest and increased exploration of the Permian Basin starting in 2011 has also opened up North and South Texas, bringing significant oil and gas investments to Texas. This renewed interest results from technological innovation. Historically, operators could only extract oil and gas from rocks such as sandstone and limestone, but development and adaptation of technology opened up extraction to an additional type of rock: shale. This innovation opened up many more areas of Texas, as well as other states and countries, to the production of oil and gas. You will sometimes hear people refer to the time period around 2011 as the Shale Revolution. Texas onshore oil and gas production has definitely been impacted by the Shale Revolution.¹https://www.blackmountainsand.com/blog/texas-oil-and-world-war-ii/

Offshore Oil and Gas Wells

Offshore wells involve drilling beneath the seafloor. Offshore drilling occurs in both federal (offshore) waters and state (offshore) waters. For example, offshore waters within ~10 miles of the Texas Coast fall under Texas state jurisdiction. With greater technology, such as seismic imaging that allows more certainty of what exists beneath the seafloor, operations have increasingly moved into deeper water and under federal jurisdiction. The Deepwater Horizon, notably known for the disastrous explosion and oil spill in 2010, was capable of operating in waters up to 8,000 ft deep, to a maximum drill depth of 30,000 feet beneath the seafloor. The federal government makes numerous deepwater regions in the Gulf of Mexico available for lease annually for oil and gas operations. Some of these larger offshore drilling platforms have a production timeline extending out 30 years into the future! 

Other Stakeholders in Resource Discovery

Individual Landowners – Surface and Mineral Rights

Something that is unique in the U.S. is that private landowners own mineral rights. In most other countries, the mineral rights are owned by the government. In Texas, and most other states, the ownership of the mineral rights can be separated (severed) from the surface rights. Surface rights apply to the surface area of a piece of land and include any structures on the property, as well as the rights to farm the land or exploit aboveground resources such as trees, plants, or water according to local laws and ordinances. With surface rights, you are allowed to sell or transfer title to the land surface, but you may not sell or lease your property to an oil, gas, or mining company for exploration or extraction… unless you own the mineral rights as well. Mineral rights are the rights to underground resources such as oil, natural gas, gold, silver, coal, uranium, and other minerals. Sand, gravel, limestone, and subsurface water are not considered mineral rights and typically belong to the surface rights holder. A landowner may choose to sell their mineral rights, but keep their surface rights. Often operators will try and buy the mineral rights from the landowner in order to drill within the desired location.²https://www.land.com/owning/minerals/guide-to-mineral-and-surface-rights/

Resource Rent – The Government Receives Money for its Oil and Gas Natural Resources 

When operators want to explore for oil and gas on government property, operators must often provide a bid in an effort to secure an area of land (sometimes referred to as the prospect area) where they will drill their oil and gas wells. These bids differ depending on state or country, well location (onshore vs. offshore), risk involved and other parameters. Many bidding contracts include multiple ways for governments to make money, such as royalties, taxes, and production sharing agreements. We will discuss these examples when we look at benefit structures below. Many times, bids are closed; in other words, those bidding do not know the bids of their competitors. Companies try their best to win the bid, but also make sure they do not overbid (this is called ‘leaving money on the table’). A good comparison to make for the oil and gas bidding process is like an online auction, where you do not always know what other people are bidding. 

Benefit Structures

Government’s use various ways to benefit from oil and gas projects, as they hold the mineral rights under federal territory. Therefore, companies that secure bids and perform hydrocarbon production must provide the government with monetary compensation. Let’s take a look at examples of benefit structures that governments have employed in the oil and gas industry before we encounter a short problem set on the topic. 

• Example 1: Oil and gas royalties: Royalties are payments to the host government for operating within their territory. These payments can be fixed or variable and are typically expressed as a percentage and represent a portion of the resource or revenue that is produced.

• Example 2: Oil and gas taxes: Operators also pay a variety of other taxes, such as income taxes, special taxes during operation, etc. Government’s then use these taxes to provide funds to a variety of purposes, such as improving the area’s infrastructure or schools. 

• Example 3: Oil and gas production sharing contracts: Profits and work can be shared with companies that are housed out of the host country. Production sharing comes into play when operator companies are working in foreign territory. If a foreign-based company(for example: Chinese National Petroleum Corporation with headquarters in Beijing) is operating in the United States, the U.S. is termed the host country and they can ask for a percentage participation for American companies (for example, ExxonMobil with headquarters in Irving, TX) to operate in the prospect as well, but not incurring any of the costs as those are placed on the foreign operating company. 

• Example 4: Oil and gas signature bonuses: In some cases a bonus must be paid to the host government that consists of a single, non-recoverable lump sum payment. This one-time fee for the assignment and securing of a license for oil and gas exploration is paid whether or not the wells are economically successful.

These governments can then use the monies from any benefit structures to fund programs of importance to its citizens. For example, Texas has a fund called the Permanent School Fund. What’s the Texas Permanent School Fund? The Texas Permanent School Fund is a sovereign wealth fund. The fund was created with a $2,000,000 appropriation by the Texas Legislature in 1854 expressly for the benefit of public primary and secondary education of Texans. The governing constitution of Texas later stipulated that certain lands and all proceeds from the sale or lease of those lands should go into the Texas Permanent School Fund. Currently, oil and gas leases on Permanent School Fund lands (both onshore and in the near offshore) generate more revenue than any other source of income for the public education endowment.

Problem Set: Bidding with a Signature Bonus 

Let’s walk through the following problem to grasp how signature bonuses work. Signature bonuses are a percentage of the project profit paid out to the government of the country (or other sovereign) in which your company is operating. To secure the prospect area where you will be drilling, your bid must yield a substantial signature bonus and one beyond your competitors. For example, if Company A includes a signature bonus that is 40% of their expected value, and Company B includes a signature bonus that is 20% of their expected value, Company A will win the bid. But what exactly is expected value? Let’s explore that financial concept with a simple math problem.

Problem: Your company is currently trying to secure a block that you believe to be highly successful. In order to secure the block, you must present the winning bid, therefore your company decides to include a signature bonus that is 45% of your expected value. Using the equation for Expected Present Value (EPV) and given parameters, calculate the amount of money allotted as a signature bonus that will then be paid to the host government to secure the block of interest for your company. 

Expected Value = geologic chance of success * PV of success – geologic chance of failure * Pv of failure 

Necessary parameters and corresponding definitions: 

Geologic chance of success: % chance that the prospect will be drilled successfully: 47% 

Geologic chance of failure: % chance that the prospect will not be fully successful: 53%

PV of success: Present Value (cash amount discounted to today) of a successful prospect: $2,250,000,000.00 

PV of failure: Present Value (cash amount discounted to today) of a prospect that is not fully successful: $236,000,000.00