CHAPTER 1 OVERVIEW OF EXPLORATION, EXPLOITATION, AND ACQUISITION OF OIL AND GAS PROPERTIES

• Jurisdiction: United States

Oil and Gas Agreements: The Exploration Phase
(May 2004)
CHAPTER 1
OVERVIEW OF EXPLORATION, EXPLOITATION, AND ACQUISITION OF OIL AND GAS PROPERTIES
B. P. Huddleston, P.E.
Huddleston & Co., Inc.
Petroleum and Geological Engineers
Houston, Texas

B. P. (Pete) Huddleston is Chairman of Huddleston & Co., Inc. consulting petroleum and geological engineers. Huddleston & Co., Inc., founded in 1967, has represented more than 500 exploration and production companies including many of the large majors, large independents, financial institutions and government agencies. Huddleston services include virtually all phases of upstream activities from leasing to public financing of oil and gas properties.

B. P. Huddleston is Chairman of Peter Paul Petroleum Co. (PPPCo), a privately held E&P Company. PPPCo has continually managed oil and gas partnerships since 1973 and currently operates over 600 wells and manages over 600,000 mineral acres.

He has served on the U. S. Securities and Exchange Advisory Committee, the Financial Accounting Standards Advisory Committee and was a visiting professor of petroleum engineering at Texas A&M from 1981 to 1998. He is a registered engineer, and was elected as a Distinguished Graduate of Engineering at Texas A&M University. He received the Society of Petroleum Engineers Economic Award in 2001 and the AIME Economics Award in 2002. He has written over 100 papers on various topics related to the oil and gas industry.

CONTRIBUTING AUTHORS

Adrienne Randle Bond, Attorney at Law

Law Offices of Adrienne Randle Bond

V. Investment Structures (or Investment Vehicles)

VI. Offering Document - Private Placement Memorandum

X. Purchase and Sale Agreements

Robert A. Brook, President

Output Exploration, LLC

VIII. Seismic Options and Seismic Surveys

Thomas K. Edwards, President

John L. Kennedy, Vice President

CIMA ENERGY, LLC

XIII. Marketing

Peter D. Huddleston, P.E., President

Huddleston & Co., Inc.

XI. Bank Loan Agreements

TABLE OF CONTENTS

I. Geographical/Geological

II. Budget

III. Target Mix: Acquisitions and Drilling

IV. Risk Profile

V. Investment Structures (or Investment Vehicles)

VI. Offering Document - Private Placement Memorandum

VII. Oil and Gas Leases

VIII. Seismic Options and Seismic Surveys

IX. Farmout Agreements

X. Purchase and Sale Agreements

XI. Bank Loan Agreements

XII. Drilling Contracts

XIII. Marketing

XIV. Joint Operating Agreements

XV. Areas of Mutual Interest

XVI. Initial Public Offering of Stock

XVII. Guidelines for Successful Performance

XVIII. Exit Strategy

Appendix: Petroleum Property Management - Check List of Key Words and Concepts

Preamble

This paper is an ambitious undertaking that probably requires the talents of a multi-disciplined team. We will touch on geology, geophysics, reservoir and operations engineering, land, legal, accounting, and financing, and numerous legal agreements required for oil and gas operations. This includes almost everything, except vacation schedules and hospitalization.

The primary focus of the paper will be a technical manager's views of the various agreements and contracts that sequentially evolve in the development of oil and gas properties. The author's perspective is from an independent's view as distinguished from a major integrated oil company's or a very large independent (such as Anadarko, Apache, or Devon). ¹

I. Geographical/Geological

An oil and gas company must first select the target geographical/geological areas, e.g., East Texas, South Texas, Permian Basin, South or North Louisiana (totally different geology), Mid-continent (Oklahoma), Appalachia, California, and the Rocky Mountains. Few smaller companies ($100 million to $500 million) will have expertise in more than two, or at most, three areas.

Nine states will provide at least 85% of all drilling activity.

Generalized trend economics for a given area can now be calculated rapidly by sorting wells drilled by year and geological formation. A typical production profile can be developed from time-zero plots (an averaging technique that permits wells coming on production at different times to be adjusted to a common starting time).

Trend economics are not accurate enough to assess a particular prospect, but it is a helpful tool in selecting an area of interest or condemning an area.

II. Budget

An oil and gas company in today's volatile price environment should not commit more than 60% of its cash flow for new drilling. Rapid swings in prices can cause a company with a 90% - 100% commitment to drill on borrowed money. This is not a healthy practice.

Overall, the industry's typical target return for drilling activity is $2 of net cash flow per $1 invested. Generally this will net about a 12% to 16% rate of return and a payout of 3 to 5 years.

A good balance is for a company to commit no more than 10% of its budget to high-risk, high-return prospects with an overall target in the 40% to 60% probability of success ("POS") range. Selection of only high POS prospects will likely preserve capital but will provide marginal returns.

III. Target Mix: Acquisitions and Drilling

Oil and gas companies have a broad spectrum of philosophies, ranging from pure drilling to solely acquisitions. Drilling should provide higher returns than acquisitions. Many companies that participated only in acquisitions have not survived, so this activity is more difficult than is often perceived.

The best is a targeted mix of drilling and acquisitions, but the two activities are vastly different and require different technical skills. Good exploration managers are not likely to be good at acquisitions, and acquisition managers are likely not good at exploration.

This translates to a simple budgeting exercise. Assuming an oil company can obtain a 2-to-1 return, at least 50% of net cash flow at the property level must be reinvested for the reserves to stay even. If debt service requires more than 50% of the cash flow, the company will likely shrink in size and value.

IV. Risk Profile

The risk profile or POS of drilling wells in the U.S. ranges from only 10% up to 90%. Generally the higher risk prospects are expected to provide higher returns and the lower risk prospects are expected to provide more conservative returns.

Three dimensional (3-D) seismic, which became a predominate seismic tool beginning in about 1990, greatly enhanced exploration and likely moved the typical drilling program from 25% POS to 50% or 60% POS. However, new problems developed with 3-D--the surveys are very expensive and explorationists frequently attempt to use 3-D past the tool's resolution ability.

V. Investment Structures (or Investment Vehicles)

All oil and gas investments must be made in some form or "vehicle." The most common and familiar form of ownership (particularly of minerals/royalty) is individual or sole proprietor, followed by publicly held corporations. All transactions must be recorded for federal income tax purposes and identified by a tax number assigned by the Internal Revenue Service. The Social Security number is used as the tax I.D. number for individual ownership. An attorney experienced with forming any particular business vehicle should be consulted in all situations.

Every form or vehicle has a purpose, and generally one form has advantages or disadvantages for certain types of transactions. The more common considerations for selecting a vehicle are:

1. Liquidity

2. Federal taxes

3. Liability

4. Ability to raise capital

5. Continuity of managed assets

Necessity for Understanding Vehicle - Most entry-level graduates into the business world are hired by publicly held corporations and have few apparent requirements to understand the various forms. However, the petroleum industry has substantial fractionization of ownership in oil and gas properties and it is very helpful to understand the basics of the various forms that make up the ownership of a single property.

Individual (or Sole Proprietors) - Individual ownership of such investments as real estate, common stocks of corporations, and bonds is the most simple of all investment forms. No agreements are required, no reports must be filed (except for government forms) and decisions can be made quickly. The major disadvantage of individual ownership can be personal liability. For example, owning an oil well or any type of investment subject to personal or property damage can be risky (even with insurance) if there are substantial holdings. This liability disadvantage is followed by estate taxes for substantial holdings, which is effectively double taxation.

Joint Venture - A joint venture can be formed by a combination of any of the investment forms, such as two individuals, a trust and a corporation, or a partnership and an individual. Joint ventures have the advantage of pooling capital and, often, talents. Ownership is vested directly into each joint venturer and each owner is taxed directly to their particular vehicle.

Partnerships - There are two basic types of partnerships: General and Limited. The primary differences are that the General Partner(s) ("GP") will have greater liability, whereas usually the Limited Partner(s) ("LP") will have limited or less liability exposure than the GP. In some situations, there is also different treatment of the GP and the LP with regard to federal income tax. Individuals, corporations, and trusts can own partnership interests, even within the same partnership.

It is essential to remember that partnerships own the investment and the individuals or participants do not directly own the property. This is a subtle difference to the novice investor but the legal distinction is important. For example, an LP may not be able to pledge its interest for collateral for a loan, or at least a bank may attribute little collateral value to an LP or GP interest. The legal form of ownership in a partnership is the significant distinction from a joint...