Sharpe: The worth of a well

George Sharpe
Investment Manager – Merrion Oil & Gas
George Sharpe, Merrion Oil and Gas investment manager

A company called Western used to have a television ad that said, “If you don’t have an oil well, you should get one!”  Hmm, maybe Walmart has some out back?

But it brings up the question that haunts me in my dreams — “What’s a well worth?”  That’s kind of like asking, “How long is a string?”  It depends on a lot of variables.  It does take a little bit of math to figure out, but it’s only fifth grade math, so stick with me!

Estimated Ultimate Reserves

The first variable is how much oil we think a well will make (Estimated Ultimate Recovery, or EUR).  Let’s take the Mancos oil play as an example.  There have been 203 horizontal Mancos wells drilled in the sweet spot along the Highway 550 corridor.  Connie Dinning, our evaluations engineer, fit the production decline curve on these wells to predict the EUR of each.  The results are graphed below from lowest to highest.  The median well in the middle of the pack is predicted to make 200,000 barrels of oil equivalent (BOE, which converts the gas production to an equivalent barrel of oil).

Estimated ultimate reserves

Net Revenue

The ultimate profit for a well (or anything else for that matter) is all the revenue minus all the costs.  Starting with revenue, the net oil price (after trucking) in the basin is approximately $40 per barrel. Therefore, the gross 100 percent revenue is calculated by multiplying 200,000 barrels times $40 per barrel, which equals $8 million. However, the operator doesn’t get to keep all that because they have to pay the landowner a royalty, and they may have other overrides burdening the revenue.  Assuming a 12.5 percent royalty and a 2.5 percent override, 15 percent of the revenue goes to those entities ($1.2 million), leaving the operator $6.8 million in “net” revenue.

Less Taxes and Operating Expenses

Next, we have to pay the “Man”.  Production taxes are approximately 8.2 percent, so $560,000 goes to local counties and the state of New Mexico. Please also note that half of all federal royalty and 100 percent of royalty from any state lease goes to the state of New Mexico, primarily in support of schools and education. That’s a lot of money for each well drilled in the state.  And a lot of jobs to go with.

Operating costs can vary widely depending on specific well conditions.  A Mancos well can cost between $5,000 and $10,000 per month to operate (which pays for a lot more jobs, by the way).  Let’s be optimistic and use $5,000 per month.  Over a 20 year life, that adds up to $1.2 million.

Operating Profit and Present Value

The math to calculate operating profit is intuitive…it is the $8 million in gross revenue, less $1.2 million to the royalty owners, less $0.56 million in taxes, less $1.2 million in operating expenses, leaving $5.04 million to the operator.  That sounds like a lot.  However, keep in mind that money comes in over a 20-plus year life.  If I’m going to give you $1 million, would you rather have it now or an “average” of 10 years from now?  Now of course, because if you invested in the stock market at an 8 percent return, it would be worth $2.16 million in 10 years.  If you invert that same ratio, $1 million 10 years from now is only worth $460,000 thousand today.  Using a 0.46 multiplier, the Present Value (discounted at 8 percent) of the $5 million in the future is only $2.3 million today.

Total Profit after Drilling Costs

The question is, can you drill a Mancos horizontal for that less than $2.3 million?  The answer, unfortunately is “No”.  It costs around $5 million to drill and complete a one-mile Mancos horizontal.  So the middle of the pack well will make its money back over 20 years, but it doesn’t even come close to generating a competitive rate of return.  You are far better off putting your money in the stock market.  Given that, it should come as no surprise that there is only one rig running in the San Juan Basin.

Hope for the Future

Connie’s predictions aside, there is some good news for the future.  First, many companies are more aggressive predicting reserves than Connie (she is SO conservative).  Second, if you dig deeper into the statistics, you would find that the operators have been learning over time (drilling longer laterals, more efficient fracks), and the more recent wells have been doing better and better.  As a result, WPX is predicting as much as 650,000 BOE vs Negative Nancy’s 200,000 BOE median well. (  Consequently, WPX is planning to run one rig in the basin through 2017, spending up to $200 million to drill 40 wells.  In addition, Encana plans to be active, and there are several newer private equity companies in town (Logos, DJ Resources, Juniper Resources, among others) who are putting together a land position with plans to drill.  Let’s keep our fingers crossed that WPX is right.

So how much is a well worth?  How long is a string?  It depends.  But now, if you see one at Walmart, you can figure it out!