Deriving Revenue from Oil Well Ownership or Investment
When considering the financial aspects of owning an oil well or investing in an oil company, the complexity can be overwhelming. From landowner rights and leasing agreements to the volatile oil market and varied stakeholders, understanding how one derives revenue is crucial.
Overview of Oil Well Ownership and Leasing
An individual or group of individuals can own an oil well or have an interest in an oil company. However, the process begins with a landowner granting the right to drill on their property. Typically, an oil drilling company initiates this process by completing geologic studies, after which they secure the rights to drill. The landowner is then compensated, often with a large payment that secures their rights.
Leasing Process and Landowner Payments
A typical fracking pad covers approximately 2 acres of land and can exploit a leasehold spread over 1 to 3 miles. Horizontal drilling techniques allow the drilling of multiple wells from a single two-acre pad. If the landowner owns the entire lease area, they receive a one-time payment that can be substantial, often in the range of hundreds of thousands of dollars.
Lease Expiration and Renewal
If the party acquiring the lease does not exploit it within the specified timeframe, the lease expires, and the landowner retains the payment. This presents an opportunity for the landowner to lease the property to another party in the future. Alternatively, if drilling proceeds and results in the extraction of oil and gas, the landowner shares in the proceeds proportionally as long as the well is producing.
Revenue Generation from Oil Wells
When oil, gas, or natural gas liquids (NGLs) are extracted, the landowner receives a share of the revenue. According to current market prices, the landowner might receive several dollars per barrel. Forecasting revenue is complex because the returns depend on the mix of oil, gas, and NGLs produced by the well. A typical horizontal well might produce 500 to 1000 barrels per day during its initial months of operation, but this declines to 10 to 20 percent of the initial production after 2 to 3 years of operation.
Joint Venture Limited Partnerships
To fund the drilling operations, investors often form joint venture (JV) limited partnerships. The drilling is carried out by an operator with a budget ranging from millions to tens of millions of dollars. Investors in these JVs receive their returns based on a percentage of the proceeds from oil, gas, and NGLs. The actual well, however, is just a perforated pipe in the ground, and various stakeholders share in the revenue generated.
Revenue Distribution and Stakeholders
The revenue generated by an oil well is distributed among several parties. Landowners, states where the well is located, JV investors, and operators all receive a portion of the revenue. Notably, no one works for free: contractors, equipment haulers, and numerous other service providers are compensated from the revenues generated by the well. Auditors ensure that all parties receive their rightful shares, adding another layer of complexity to the process.
Volatile Oil Market and Tax Implications
The price of oil is highly volatile, even with international cartels like OPEC attempting to regulate output to keep prices stable. Prices fluctuate daily, making it difficult to predict revenue accurately. Additionally, the tax treatment of investments in oil-gas JVs involves deductions from ordinary income, with intangible drilling costs often being the focus. These costs can significantly offset the initial investment, affecting net returns.
Understanding oil well ownership and investment requires an awareness of complicated legal and financial processes. It is essential to consider all stakeholders and the volatile nature of the oil market to fully comprehend the financial aspects of deriving revenue from these investments.