Understanding and Investing in Oil and Natural Gas

7/25/2019 Understanding and Investing in Oil and Natural Gas

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Understanding and Investin

Oil and Natural Gas Drillinand Production Projects

Lone Star Securities Inc.


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Understanding and Investing in Oil andNatural Gas Drilling and Production Projects

by Marvin ergusGeologist Riley James Development Corporation

Registered Representative Lone Star Securities, Inc.www.lonestarsecurities.com

1.866.859.7827

Table of Contents

Chapter 1: Introduction to Oil and Gas

Chapter 2: Geology

Chapter 3: History

Chapter 4: Drilling and Completion

Chapter 5: Ownership

Chapter 6: Investing in Oil and Gas

Chapter 7: Future Trends

Chapter 8: Conclusion

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Chapter 1:Introduction to Oil and Gas

The purpose of this book is to help potential investors understand the fundamentals of oil and gasdrilling and production. Its scope includes: the geology of oil and gas deposits, exploration

technology, drilling and completing wells, leasing rights, and evaluating the return beforeinvesting. In short, this book provides the necessary background information to help you make aninformed decision before investing in an oil and gas project.

Energy is not an option. Fossil fuels supply over 86% of the worlds energy. An abundant supplyof oil and natural gas remains vital in helping us and the industrialized countries of the worldmaintain and establish a way of life.

Source: Earth Science World and Exxon-Mobil

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Chapter 2:Geology

Oil and natural gas are products of plant and animal remains or organic material. For the mostpart, these plants, corals, and animals lived in seas. Over millions of years, the remains settled onthe ocean floor together with sediment which washed down from exposed earth and rock. In laterperiods, these layers of organic material and sediment were covered by more sediment which, asa result of time and pressure, converted these layers to sedimentary rock filled withhydrocarbons. To get a clearer picture of how this process occurred we need to understand somegeological history.

The earth is believed to have formed some 4.6 billion years ago from a cloud of cosmic dust andice. As the planet pulled itself together by gravity, compressing matter ever more densely, itbecame molten. The heaviest components, such as nickel and iron, sank to the center to form theplanet's core while the lighter materials, including silicon, aluminum, magnesium and other lightelements, solidified into a thin rocky crust. Water vapor moved to the surface to form oceans.

Over time the earth's crust has become thicker and more stable. Today, the planet can be viewed

as a system of plates that fit together like a puzzle which slowly move and change shape.

Pangaea

As recently as the Triassic Period 225 million years ago, the Earths continents were stillconnected together in a single super continent called Pangaea. Pangaea fragmented into severalpieces, each piece floating on a molten layer. These mobile plates of the Earths outer crust,lithosphere, have positioned themselves to form the Earth as we know it today.

During this 225 million year period, the continents and oceans experienced additional changes.As the earths plates moved against one another, the forward or leading edges either lifted up ontop of the next plate or moved below it causing edges to crumple and increase in height thus

producing the mountains we see today. As plates separated, magma rose from the mantle andsolidified in the rift forming mid-ocean ridges. The new crust, thinner than the continents, spreadbetween the plates. While the rate of plate movement is very slow (averaging perhaps the speedof a growing fingernail), over the time spans we are considering, the results are dramatic. Thetheory that explains these plate movements is called plate tectonics.

The two basic types of crust are oceanic and continental. While the oceanic crust is thin, about 5to 7 miles thick and composed of heavy igneous rock that formed from magma flows, thecontinental crust is 10 to 30 miles thick. Because of these differences, the continents tend to float,rising high above sea level as in the mountainous regions. These continental mountains weregradually worn down by rain and the action of ice, and the freed particles of rock were carried tothe sea where they were deposited in thick sedimentary beds, cemented together by mineralsand the pressure of more sediment deposited above.

At various times (some spanning tens of millions of years) much of North America was coveredby seas. This occurred in warmer periods when the polar ice caps were much smaller andconsequently held less water. This phenomenon of changing sea levels helps explain why oil andgas deposits are present far inland from any existing ocean.

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Source: U.S. Geological Survey

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The Right Conditions for Oil and Gas

Since sediment and deceased sea organisms are heavier than water, they naturally migratetoward lower areas or basins in the sea. These lower areas were caused by tectonic actionbetween the plates and eroded valleys that were created in colder periods before the rise inocean levels submerged them.

As these ocean basins gradually filled with layers of sediment, the weight of the newer layersincreased on the layers below. This weight or pressure created friction and heat and began theprocess of converting the organic material to oil and gas. The story becomes more complicatedbecause, along with organic material, salt water was invariably captured in the source rock.Under the weight and pressure of subsequent sediment layers, all three substances attempt tomigrate along a path. Since oil is lighter than water and gas is lighter than both, when a reservoirrock formation is found, it is stratified with gas on top, oil in between, and water on the bottom.


In certain places, tectonic plate movement has caused the earth's crust to bunch up, creatingfolds or uplifts in rock strata. This movement also resulted in earthquakes that caused faults orfractures in the strata. These fractures and folds create the opportunity for oil and gas to moveout of their source rock toward the surface. If the oil and gas make it to the surface, the gas is lostin the atmosphere while the oil ultimately evaporates. However, if the conditions are right, thehydrocarbons remain trapped under a layer of impermeable rock in another sedimentary rockcalled a reservoir.

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Generally, oil and gas are found in a geologic structure called a trap that prevents the escape ofoil and gas. There are two general types of reservoir traps: structural and stratigraphic.Structural traps are formed by the deformation of the reservoir formation while stratigraphic trapsare those resulting from an up-dip seal of porosity and permeability.

The anticline trap is formed by the folding of rocks into a dome. These anticlinal traps containpetroleum that has migrated from a source below. Further upward, migration of hydrocarbonswas prevented by an impenetrable layer of rock above the reservoir. Fault traps are formed bythe shearing and offsetting of rock strata. The escape of petroleum from a fault trap is preventedby non-porous rocks that have moved into position opposite the porous petroleum bearing rockformation. Dome and plug traps are porous formations on or around great plugs of salt or

serpentine rock that has pierced or lifted the overlying rock layers. Stratigraphic traps are causedeither by a nonporous formation sealing off the top edge of a reservoir or by a change in theporosity and permeability of the bed itself.

6Source: Earth Science World and Exxon-Mobil



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Permeability and Porosity

Petroleum deposits reservoirs are trapped in layers of sandstone, limestone or dolomite.Exploration and production companies are most interested in reservoirs that have goodpermeability and porosity. Porosity is a measure of the spaces within the rock layer compared tothe total volume of rock. Though both are porous, a sponge is much more porous than a brick.

And though both can hold water in their pores, the sponge has a much higher capacity for holding

liquids. Permeability is a measure of how well liquids and gases can move through the rock and,thus, is a function of how well the pores within the rock are connected to each other.


Petroleum porosities are measured in percentages with the average reservoir ranging from sevento 40 percent. Permeability is measured in units named Darcies and the number of Darcies rangevariously throughout each reservoir from millidarcies to over 40 Darcies.

Knowledge of the trap and the reservoir rocks porosity and permeability are essential indetermining where to drill and, if found, how much oil and gas can be recovered.

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Chapter 3:History

Throughout human history, mankind has found petroleum seeping at the surface and initially

either put it to use as pitch for canoes or fuel for lamps. Modern methods of drilling for oil didntbegin until 1859 as a result of the determined efforts of Colonel Edwin Drake.

Cable-Tool Drilling

While petroleum oil was known prior to this, there was no appreciable market for it. Yet, studies ofcrude oil showed it to be a good source of kerosene if enough could be obtained. Drakesemployers were seeking enough crude oil to establish a new enterprise, providing kerosene forlamps.

With oil seeping at the surface and believing that this was an indicator of more below, Drakedecided to drill in and around Titusville, Pennsylvania. He initially used a steam engine to power

the drill, but his success was limited in finding a sustainable commercial yield. When attempts todig huge shafts in the ground failed due to water seepage, Drake decided to use a cable-toolsystem.

With cable-tool drilling, the drill bit is suspended in the hole by a rope or cable. By means of apowered walking beam operated by a steam engine, the cable and attached bit are raised andthen allowed to drop. This up and down motion is repeated again and again. Each time the bitdrops it hits the bottom of the hole and pierces the rock. However, two features of the cable-toolmethod are disadvantageous. First, the drilling had to be stopped often and the bit pulled up sothat cuttings of chipped rock could be removed. The other problem this system presents is that ithas a hard time drilling soft rock formations.

Drakes first cable-tool well was dug on an artificial island on the Oil Creek. It took some time for

the drillers to get through the layers of gravel and water. At 16 feet, the sides of the hole began tocollapse. Drake decided to drive iron pipe as he dug to keep the hole from collapsing and waterout of the excavated shaft. This continued until they reached bedrock at 32 feet. On August 27,1859 his drill bit reached a total depth of 69.5 feet. The next morning, Drakes driller, a blacksmithnamed William Smith, was surprised to see crude oil rising up the pipe. The oil was initiallybrought to the surface with a hand pump and collected in a bath tub. After Drakes breakthroughsuccess, many flocked to Pennsylvania to drill for oil and Drake became a fixture in history. Thecable-tool drilling method was in common use until the 1920s.

Rotary Drilling

The first rotary drilling rig was developed in France in the 1860's; however, it was seldom used

because it was erroneously believed that most petroleum was under hard-rock formations thatcould be easily drilled with cable-tool rigs.

The rotary drilling system that circulates fluid to remove the rock cuttings was successfully usedin Corsicana, Texas where drillers searching for water discovered oil.

Rotary drilling operates by pressing the teeth of the drill bit firmly against the rock and turning, orrotating it. Simultaneously, a fluid, usually a liquid including clay and water called drilling mud, isforced out of special openings in the bit at high velocity. This forces the mud and rock cuttingsaway from the drill bit and back up to the surface.

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Well Logging

Some time in the early 1920's, logs began being kept by drillers. These driller logs recorded thedepth, kind of rocks, fluids, and anything else of interest that occurs while drilling the well. Thistype of information was useful when compared with nearby wells to interpret the subsurface

geology.

More useful are cores and mud logs.A core is a cylindrical cut of aformation while a mud log is a recordof the drilling mud which includes adescription of the drill cuttings thatare brought to the surface in thedrilling mud.

e sampled beds.

A core sample contains the mostinformation since it is a directmeasurement of a large piece of therock. Either a core barrel attached tothe drill pipe is used or a deviceattached to a wireline takes asidewall core. Once the sample is

brought to the surface, it is packagedand sent to a laboratory for analysis. Core samples can provide a clear understanding of thestratas lithology, porosity, permeability and, most importantly, hydrocarbon content. Thisinformation helps determine the oil-bearing potential of th

As technology advanced, electric logging came into widespread use. An instrument called asonde is lowered into the bore on a conductor line or electric wireline. The sonde measures andrecords electrical, radioactive or acoustic properties of the various drilled formations andtransmits its information up the wire to a recorder. Porosity, permeability and fluid content are theprimary objectives of well logging, especially for target reservoir rocks.

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A Spontaneous Potential (SP) log records the electrical currents that flow in rock formations. Mostminerals are non-conductors of electricity when dry. However, some, like salt, are excellentconductors when dissolved in water. As drilling fluids invade a permeable formation, spontaneouspotential causes weak current to flow from the un-invaded saltier rock into the invaded rock. TheSP log can be used to visually identify bed boundaries and calculate formation water salinity.

Resistivity logging devices measure and record the resistance of a formation to the flow ofelectricity. High saltwater saturation lowers resistivity, while oil and gas raise resistivity, since

hydrocarbons are poor conductors. Common resistivity logs include the lateral focus log, theinduction log, and the micro resistivity log.

Radioactivity logging devices, including gamma ray and neutron logs, measure natural andinduced radioactivity. Gamma ray logs record the emissions of naturally radioactive elements information sediments. Since these elements leach out of porous and permeable rock, a gammaray logging device can identify impermeable formations such as shale and clay-filled sands. Theneutron log emits radiation from the sonde, bombarding the rock around the wellbore to primarilydetermine porosity.

Acoustic logging devices are also called sonic logs and operate on the understanding that soundtravels better through dense rock than through more porous rock.

Correlating data provided by several different logging methods can provide a clear picture of thetarget reservoir rocks. It is important to note that, due to the expense of logging a well and theoverlapping information provided, not all types of logs are run on each well being drilled.

Formation Pressure Data

As more wells are drilled and logged in a given field, it becomes easier to predict and determinewhere the productive petroleum reservoir will extend and end. However, with a new discovery, itis imperative to take some pressure readings to help estimate the lateral extent of the reservoir.Pressure can be taken through a DST or drill-stem test or wireline. Both involve isolating thepotential reservoir to recover a sample of fluids and take pressure readings. What is recoveredand the pressure data gained helps determine if a commercial reservoir has been found.

Offshore Drilling

By the 1930's petroleum exploration companies realized that oil and gas reservoirs existed inshallow waters offshore. However, the problem remained how to drill when your drilling rig mustbe above water and at the same time stand steady against any heavy wave action. The solutionwas a type of rig known as a submersible.

The earliest form of submersible rigwas a posted barge. It consisted of abarge with several steel postsattached and anchored. A deck waslaid across the top of the posts, andthe drilling equipment was installedon the deck. Posted barges cannotbe used in waters exceeding 30 feet.Later improvements on this conceptresulted in ship-shaped barges anddrill ships. While the ship-shapedbarge must be towed into place, thedrill ship travels under its ownpower. In deep waters, drill shipsand ship-shaped barges are

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anchored much like an ocean-going boat may be anchored or may be held into position bydynamic positioning. Here computer-controlled thrusters are used to maintain the ships position.

Another early drilling platform was the bottle-type submersible rig, which has several steelcylinders or bottles that when flooded with water come to rest on the ocean floor. When it comestime to move the rig, the water is pumped out, and the rig is moved by tugboats to the newlocation. Bottle-type rigs are usually designed to operate in maximum water depths of 100 feet,although some have been built that can work in up to 175 feet of water.

Continuing exploration to further offshore drilling in deeper waters resulted in new submersibledesigns. The Jackup rig made it possible to drill in waters up to 350 feet with a few operable in upto 600 feet. Jackups are bottom-supported rigs that can be either column- or truss-supported.Columnar legs are steel cylinders while open truss legs resemble a derrick. Both types havewater-tight hulls that can float on the surface of the water while being moved into position.

Today the most common type of offshore rig is the steel-jacket platform. This consists of thejacket, which is a tall vertical section manufactured from tubular steel. The steel jacket is pinnedto the ocean floor using driven piles. Additional sections of tubular steel are placed on top of eachother. Above the water level are quarters for the drilling crew and the drilling rig. This system hasbeen used to drill wells in up to 1,000 feet of water.

There are other ocean drilling rig designs that are used in special situations, including theconcrete gravity platforms used in the North Sea and the steel-caisson platform used in the CookInlet of Alaska.

Directional Drilling

Directional drilling techniques were employed in the 1970's. Normally wells are drilled vertically;however, there are many occasions when it is helpful to be able to drill at an angle. Directionalwells are drilled straight to a predetermined level and then gradually curved. By changing thedirection of the drill bit in small increments of no more than 2 to 3 degrees at a time, it is possibleto drill many wells into a reservoir from a single offshore platform. Directional wells may also bedeflected from a shoreline to reach a reservoir under nearby water. In addition, directional wells

are very useful in avoiding fault lines, which can cause hole problems, as well as in instanceswhere it is undesirable to set a rig in a givenspot because of an obstruction or forenvironmental reasons.

Directional well bits can be used to straighten ahole, deflect the hole from the original dry wellto intersect a reservoir, kill a wild well that isburning, or sidetrack around a fish (an objectthat has become lodged in the hole and cannotbe removed).

Several special tools are available to assist indirectional drilling. The most common involvesthe use of a bent sub and a downhill motor. Abent sub is a short piece of pipe that isthreaded on both ends and bent slightly in themiddle. It is installed in the drill stem betweenthe bottommost drill collar and the downholemotor. A downhole motor is driven by drillingmud, thus eliminating the need to rotate thedrill stem.

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Chapter 4:Drilling and Completion

While the equipment used to drill and complete an oil well is usually quite simple, the engineeringrequired to drill one properly can be highly complex. Whether the drilling rig is offshore oronshore, they all have the same basic structure and use the same equipment.

Anatomy of an Oil Rig

The purpose of a rotary oil rig is to drill a hole to a predetermined depth. Hopefully, in the drillingprocess, one or more oil and gas bearing reservoirs will be encountered. While drilling, cuttingscreated by the drill bit must be removed. This is done by pumping mud through the drill pipe tothe bit and backing up the annulus or space between the drill pipe and the outer casing that isadded as drilling proceeds. The mud is mixed with chemicals and pumped down the drill pipe.The returning mud and rock cuttings that reach the surface move by gravity down a return line toa shale shaker designed to separate the returning mud from the rock cuttings for re-use. Theremaining cuttings travel down a shale slide to a reserve pit.


The Kelly is a special section of pipe that has flattened sides that are either square or hexagonalin shape. The Kelly fits inside an opening called a Kelly-bushing. The Kelly-bushing, in turn, fits

into a part of the rotary table called the master bushing. As the master bushing rotates, the Kelly-bushing rotates. The turning Kelly rotates the drill stem and thus the bit. Since the Kelly slidesthrough the opening in the Kelly-bushing, the Kelly can move down as the drilling progresses.

Power to rotate the drill stem comes from the rotary table. This is equipped with its masterbushing and Kelly-bushing. When the Kelly and Kelly-bushing are removed, the hole left in themaster bushing accommodates slips that have teeth-like gripping elements called dies. These areplaced around the drill pipe to keep it suspended in the hole when the Kelly is disconnected andan additional section of drill pipe and/or casing is attached.

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Both the mud transfer pumps and drilling pipe require power to operate. Usually both are handledby large diesel engines with as muchas 3,000 horsepower. Additionalpower and engines are required tosupply electricity to the rig since therig typically drills 24 hours a day.

DrillingThe engineering becomes morecomplex as the well is being drilledto its total depth. The deeper onedrills, the more pressure that isexerted on the lower strata. Drillingengineers maintain a density(weight) of mud in the hole in orderto counter the natural pressures of fluids and gases that might otherwise release into the wellhole. But at certain depths and conditions, it becomes impossible to either keep the mud frompenetrating a formation or for fluids to release into the well hole. At some point, it becomesnecessary to pull the drill stem and bit from the hole, insert casing in the hole, and fill the annulus

(space) between the casing and the wall of the hole with concrete.

Anytime the drill stem and bit are removed, whether to case the well or retrieve a broken tool, theprocess is call "tripping out." Cement is used to cement casing or steal pipe in a wellbore. Thecement is pumped into a special valve called a cementing head. As the cement arrives at thehead, a plug called a bottom plug, is released from the cementing head and precedes theconcrete slurry down the inside of the casing. This plug keeps the cement and the mud ahead ofit from mixing. The plug travels downward until it reaches the float collar. At the collar, the plugstops, but continuing pump pressure breaks the seal in the top of the plug and allows the slurry topass on. The slurry flows through the plug and starts up the annulus. When the estimated amountof cement required has been pumped into the casing, a top plug is inserted and fluid is pumped inbehind the top plug. The top plug keeps the cement from being contaminated by the followingdisplacement fluid. When the top plug reaches the bottom, the pumps are stopped, and thecement is allowed to harden. Once the cement hardens, to resume drilling, the drill stem and anew, smaller bit that fits inside the casing must be tripped back into the hole. This process iscalled "tripping in.

Completion

Once a well has been drilled and tested (logged, cored and pressure data), a decision must bemade whether to complete the well or plug it. Examination of the target reservoir rock porosityand permeability may indicate that the potential flow of oil and gas from the well will not justify thecost to complete the well. In these cases, the well is plugged with concrete in several places, andthe well is abandoned.

If, however, the wells test information indicates that the well will be commercially productive, thewell is completed. If the well is to be completed, production casing is run down the hole andcemented. Once the casing is in place, a tool called a "perforating gun" is lowered into the well-bore to blast holes through the casing, cement and into the reservoir. These holes are made inorder for there to be communication between the reservoir and the production casing. Tubingmay then be lowered into the casing. A plug may then be set above the perforations as a barrierbetween the production casing and the tubing. This allows the earths natural pressure to pushhydrocarbons to the well-bore and to the surface through the tubing unless a pumpjack isnecessary to raise the fluids to the surface.

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Several steps are taken at this time to cut out excessive costs from the production process. Alarge drilling rig will be replaced by a smaller, moveable completion rig. Also, a completion teamwill use a swabbing method to force the reservoir to give up fluids naturally. This natural flow ratewill be measured and compared to other wells in the area. If it is not up to par, then furthermeasures will be taken to increase the volume of production. These measures include chemicallyor physically treating the reservoir to stimulate the flow. Acid treatment can be used in a reservoircontaining limestone. A physical method would be to pump fluid containing small beads into areservoir under great pressure to fracture the

reservoir. The beads are then used to keep thefractures open to allow the flow to increase.

When a satisfactory rate of production has beenestablished, the well will be tested to calculate themaximum production for the well over a period of 24hours. This is termed as a wells potential. This andother completion information may be required by thestate and will aid other geologists and analystsscouting for oil and/or natural gas in the same area.

If a well contains more than one zone of interest, theoperator will usually begin by producing the lowest

zone in the well-bore first and then work their way upthe well-bore as each zone becomes depleted. Whena zone is completed, a multi-valve device will beconnected to the surface called a "Christmas tree."This device is placed at the top of the productioncasing and will allow connections to flow the oil andgas. Equipment to process the recovered oil and gasis placed near the well to make sure the oil or gas isready for transportation.

Production

Production is the process of extracting petroleumfrom the underground reservoir and bringing it to thesurface to be separated into gases and fluids that canbe sold to refineries. Production begins with a highlevel of production and decreases through time untilthe well is ultimately plugged and abandoned. Thisdecrease in production is a natural result of theinevitable decline in original pressure within thereservoir. The time period for commercial productionand the rate of production depends on the reservoir.

Either gas expansion and/or water encroachmentprovides the principal natural energy for most

petroleum reservoirs to produce. Both can operate asreserves are taken from the reservoir. The reductionin pressure around the well-bore as hydrocarbons areextracted causes other hydrocarbons to move intotheir space. This process continues until the energyis depleted and/or the well makes too much water to be commercially productive.

Engineers take the past performance of a well and use it to project the future reserves of a well.One way of predicting future production is to measure the percentage of decline in productionover a given period of time and use this rate of decline to estimate future reserves.

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Reservoir Engineering

Reservoir engineering is the application of scientific principles to develop and maintain petroleumreservoirs to maximize economic benefit. For example, carefully spacing out wells over areservoir and restricting production rates can make a difference in the overall productivity of thereservoir. In 1904, Anthony Lucas, who had discovered Spindletop, spoke about the decline inproduction. He claimed that "the field had been poked with too many holes and that the cow was

milked too hard." Oil operators in that day gave little thought to reservoir depletion as theycompleted wells. They produced a well at the highest rate they could without regard for wellspacing. As a result, in the 1920's the federal government questioned the wasteful treatment ofreservoirs and decided to initiate studies. These studies consisted of applied mathematics,geology, chemistry, fluid dynamics, and physics to aid in the analysis of hydrocarbons within areservoir. Reservoir engineering began as engineers implemented what the government learned.

Recovery

Initially an oil reservoir is in primary recovery. Gaseous fuels, natural gas or water are usuallypresent, and supply the needed pressure. Depending on the reservoir, once the natural flowceases, the reservoir will have yielded only 15 to 70 percent of the total volume of the oil it

contains. The rest is trapped in unconnected rock pockets or is bound to the rock and refuses tomigrate toward the wellbore.

Petroleum engineers have developed a number of ways to help the reluctant oil migrate to thewellbore. The most common approach is to drill adjacent wells and use them to inject water intothe reservoir to force the oil to move toward the production wells. Another is to inject gas intoadjacent wells to maintain reservoir pressure or to enhance gravity drainage. Both approachesare referred to as secondary recovery processes. Even after secondary recovery steps havebeen taken, as much as 50 percent of the oil in the reservoir will remain. Tertiary oil recoveryreduces the oil's viscosity to increase oil production.


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Chapter 5:Ownership

Once an area has been determined to be viable for drilling, it is necessary to get a lease to drillon the property. The rights to the surface and the hydrocarbons beneath can be separate. An oil

and gas lease is a contract between the person or corporation that owns the oil and gas rights toa property and a party who wants to drill a well on that property. If a lease is signed by bothparties, the owner of the oil and gas rights is the "lessor" and the recipient of the rights is referredto as the "lessee."

The bonus, royalty, and the primary term of the lease are the three most important itemsconsidered during lease negotiations. The bonus is the amount of money required up front by thelessor and is paid whether or not a well is drilled or produces. The royalty is the interest the lessoris to receive if any oil and gas is pumped or taken from the well. The primary term is the timeperiod that a company will be allowed to explore or drill. Most leases are taken on a standardform with additional negotiated terms added at the end.

It is important to note that there are costs associated with preparing oil and gas leases

expenses to evaluate the property before considering a lease, legal fees to establish ownershipof a property to make the leases legally valid, and payments of bonuses to the owners of the oiland gas rights to secure the leases.

Landmen

Landmen work for oil companies to research ownership of the surface and oil and gas rights andnegotiate leases. The landmen also understand laws and rules concerning leasing in a certainarea and how to file the proper paperwork with the local government. In addition, the landmanworks to resolve problems that may occur in disputed ownership rights, and they are generallyknowledgeable about drilling that has taken place in a certain area.

Types of Legal Instruments Used for Oil and Gas

There are five main agreements an averagesurface or oil and gas rights owner could enterinto with an oil and gas company. The first is theoil and gas lease described above. The second isa surface easement, which would be used tocreate a pipeline or road. Next is a seismicagreement which permits necessary seismictesting over a property. Fourth is a generaldamage agreement for use of roads and clearinga location to drill a well. On land, rigs need a

minimum of one acre to work. The final type ofagreement is a water rights agreement whichallows access to surface or underground water todrill and complete a well.

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Working Interest

Small exploration companies are known as independents. Independents may not be able totake on the full financial risk of drilling a well. Instead, working interest in the well will be sold toindividual investors or other independents. This allows everyone involved to spread their risk overmore wells.

A working interest owner pays a percentage of the costs associated with a well. After royaltiesare paid, the working interest owner is entitled to his share in production revenues with otherworking interest owners based on the percentage of working interest owned.

Taxes

Because of the high risk associated with drilling for oil and gas, the government provides taxincentives that allow individual investors to write off the entire cost of their investment regardlessof the outcome of the well. Generally, only high income or high net worth investors can takeadvantage of these incentives. In fact, the government discourages those with limited financialresources from making direct investments in oil and gas drilling projects.

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Chapter 6:Investing in Oil and Gas

There are three main forms of investing for the typical oil and gas investor, which are listed below.

Publicly Traded Exploration/Production Company

The easiest way to invest in oil and gas is through a publicly traded company. Here you arebetting that the company will be able to effectively find, develop and maintain oil and gas fields.

Production Projects

Purchasing producing oil and/or gas properties allows immediate income from your investment.However, it takes a trained petroleum geologist or engineer to give a reasonable expectation ofhow long the oil and/or gas will continue to be produced in order to make a sound investment.

Drilling Projects

Many investors are looking for opportunities to invest in drilling projects as a means to diversifytheir portfolio. Drilling projects offer high net-worth / high-income investors tax deductions and

income potential. But drilling for oil and gas is arisky business as a substantial portion of the wellsthat are drilled either do not hit commercialreserves or the well experiences unexpectedproblems.

Sophisticated oil and gas investors realize thatthey may have to participate in several projects in

order to obtain a paying interest in a well. So, therewards of a producing well will essentially have tomake up for losses on past projects as well asfuture projects that may prove to be dry. Thisbeing the case, it is important to invest in dealsthat offer a promising chance for success and anexcellent return on your investment. There arethree key areas to evaluate when considering anoil and gas drilling project: the People, the DealStructure, and Projections.

Who Am I Doing Business With?

As a petroleum geologist, when I evaluate an oiland gas drilling project, I look first at the peoplewho originated the deal. When oil prices are high,

more and more people enter the oil business and start assembling and marketing oil and gasdeals. Therefore, look first at the company offering the project to determine how long they havebeen in the oil business and in what capacities. Here, I would look for experience in managingprojects. This criterion will help keep you out of deals with people who are inexperienced and lesslikely to manage the project properly.

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Next, I would make sure there is a petroleum geologist on the project managers staff. This is theperson who will look at the geology and related data on a project and give their evaluation of itslikeliness for success. While prospect-generating geologists are almost always reputable, theywill have a certain natural bias toward their project. But, while they may be focusing on a goodprospect, there may be even better prospects elsewhere. A full-time, in-house petroleumgeologist has the latitude to select from many projects.

When looking at the project management company, also ask to speak with prior / existing

investors. Its important that investors be kept well informed as to the drilling status, whichincludes receiving timely progress reports as well as monthly well production and year-endreports. Sadly, not all companies are prompt in providing monthly progress reports or supplyingessential year-end information that's needed for filing timely tax returns. With that in mind, Isuggest talking with the project managers investors who have participated in prior drilling andproduction projects.

How Is The Project Structured?

There are nearly as many ways to put together an oil and gas investment in a drilling orproduction project as there are oil companies in the industry. However, regardless of the project'sstructure or complexity, each can be boiled down to answering two simple questions: Who gets

what percent of the revenue over the life of the project? And, are the anticipated costs within areasonable range?

Most oil and gas projects have the following parties involved when it comes time to sharerevenues from a producing well the mineral owner (owner of the oil and gas rights), the projectmanager, and the investor group which is financing the cost of drilling, completing, and producingthe well.

Traditionally, the mineral owner receives a royalty interest of 12.5% to 25% of the total productionrevenue of a producing well without paying any costs. The remainder of the revenue interest isdivided up between the project manager and the investor group. When the deal is structured witha royalty interest greater than 30%, someone has carved out an overriding royalty interest that isexorbitant. This cuts into the investors rightful revenue interest. Therefore, it usually doesnt

make good investment sense to get involved in an deal where the royalty interest is greater than30%.

On the cost side, we are looking at the cost of generating the prospect, buying the lease, anddrilling and completing the well. Some deals are structured in a manner that the project managercan come back to the investors with additional investment demands in the event of unexpectedadditional drilling and/or well completion costs. For the investor, I am wary of this type of dealbecause the investor's risk is not certain or capped. When a deal is capped or turnkeyed, theprudent project manager should add a reasonable allowance to the drilling and completion budgetto cover unexpected expenses. If costs overrun this additional padding, the project manager isresponsible for any overruns. If the well drilling and completion costs come in below budget, theproject manager will keep the difference. At first, this may seem unfair, but in this way thepadding acts like an insurance policy paid for by the investor group. The investor has a cap on his

liability and the project manager assumes the added risk. The project manager should provide thedrilling and completion costs estimate, called an AFE (Authorization for Expenditure), to theinvestor. A few calls to service companies and the drilling contractor used by the project managercan reveal the extent of the markup.

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Does the Projected Monthly Production Justify the Money YouAre Investing?

In an established oil and gas area,the petroleum geologist makes theproduction projections on a payoutbased on the production histories ofnearby wells. My simple rule ofthumb is that you want to seeprojections that (at current oil andgas prices) will return your entireinvestment in 24 months or less. Ifthe projected production doesn'tsupport a 24-month return or betteron the investment, the investmentrisk is too high given the expectedreturn. Allowing for the fact that agood portion of all wells drilled will benon-producing, you want to makecertain that the ones that do produce

make up for the ones that do not.

Additional Considerations

Be wary of the project manager that claims to have hit nine of the last ten wells or anythingsimilar. If that were true, they would not need your money to help spread the risk since therewouldn't be any risk. In addition, be careful of multiple well projects on the same acreage. Only bycompleting a well and establishing production do you gain the necessary information you need todetermine if a second well should be drilled on the same acreage.

The Acid Test: Evaluating Oil and Gas Projects

Potential investors are cautioned to look at oil and gas projects carefully. Investors need areasonable opportunity for reward versus their investment. My advice is to look at the potentialpayout of a proposed project versus your investment. Youll need to do a little math to comparethe risk/rewards associated with various project offerings: Say you are being offered a .7% netrevenue interest in a project for $100,000. For your investment to break even, the well will need toproduce a total of $14,285,714 in revenue ($100,000/.007 = $14,285,714). If oil averages $50 abarrel, your well will have to produce at least 285,714 barrels of oil over its productive life($14,285,714/$50 = 285,714 barrels) for you to break even. You can do the same math for gas ora combination of oil and gas projects using the anticipated price per thousand cubic feet of gas.Now heres the acid test: look at the wells in the area and see if any have yielded theamount of gas and/or oil your project will need for you to get a substantial return on yourinvestment.You always want to use a conservative price for oil and gas when doing the acid

test. If you buy into a project as a speculative bubble is growing for oil and gas, you dont want toget caught when the speculative bubble pops. Of course, if the project does pass the acid test,you still need to examine the geology to evaluate the risk.

Investing in a single oil and gas drilling project should not be looked at as a one-shot proposition.Most investors will have to experience a certain number of non-producing projects before they hita producing project. When you do hit that producing well you want to be in a project with peopleyou trust, and you want to be in a project that's fair, and one that has is likely to pay back yourinvestment in short order. I believe the above guidelines will go a long way toward helping youachieve those objectives.

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Chapter 7:Future Trends

Oil supplies may not last forever, but oil will be available long after our children's lifetimes. Whileno one can accurately predict oil's relative supply and demand, even in the near future, severaltheorists have attempted to predict when the world will deplete its oil supply. The most notabletheorist on this subject is M. King Hubbert.


Hubbert's Peak

In the 1950s, Hubbert claimed that oil was a resource which would not last forever and thatproduction will rise to a point which cannot be sustained and then die down to a point of totaldepletion. Understanding his model, one can conclude that once Hubbert's Peak has beenreached, half of the world's oil reserves will have been depleted. This can also be used for an oiland gas field with many wells. When one takes what has already been produced from the field

and what can potentially be produced for the field and combine these two numbers, they get theultimate potential of the field. Its peak in production would be placed at the ultimate divided bytwo.

The problem with determining the peak in world production is one must use estimates todetermine ultimate world production. There are three main numbers or concepts used to do this:1) cumulative production or what is known as reserved production; 2) knowable, undiscoveredproduction; or 3) what is predictable from past trends. From these numbers, we can estimate thatultimate equals cumulative production plus reserved production plus undiscovered production.However, due to each country's different analysis for total production of oil and gas, determiningthe ultimate world oil production is very difficult and highly debatable.

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Each country will have its peak. Hubbert predicted that the United States would reach its peak inthe 1970's and it appeared to do so. The country was depending on Texas for the bulk of its oil,and when the Texas Railroad Commission announced in 1971 that Texas was at 100 percentcapacity, the Organization of Petroleum Exporting Countries (OPEC) was created to control thesupply of oil and gas for the world market.

Hubbert suggested that it will take many years to completely deplete the world's oil supply.

However, he also suggested that each country will have its peak and then experience decreasingproduction from there. We are already seeing that some Middle Eastern countries may havepeaked due to a decline in production. So, what does this mean for the oil industry? Cheap oil willlikely be a thing of the past in the next 10-20 years.

While there is no denying that there is a finite amount of oil and gas on this planet, newtechnologies and recovery methods continue to increase the percentage of an existing field'srecoverable oil and gas. At the same time, while the rate of discovery of new fields declines, weare getting better at finding them by digging deeper and in more isolated areas. Who's to saythere will not be advances that once again tip the scales in favor of more supply than demand?

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Chapter 8:Conclusion

Often, investors focus primarily on the potential rewards of an investment; however, you must be

equally aware of the risk that accompanies it. When investing in an oil and gas drilling project,you must be aware that it is possible you may lose your entire investment due to the inherent riskand complex process associated with locating thesenatural resources. For that reason and to encouragedomestic drilling programs, the U.S. governmenteffectively underwrites a portion of the risk byproviding substantial tax benefits to investors taxbenefits which exist whether the well is successfulor not.

Due to the risk and complexity of drilling projects, itis unlikely an investor will have success with everyproject. Therefore, it is important to ask yourself if

youre willing and able to invest in multiple projectsrather than approaching it as a one-time deal.

You should also understand that this is a businessthat has its fair share of unscrupulous players. Askfor references so you can hear what the companysexisting investors experience has been. Look for acompany that utilizes a registered broker-dealer asits agent. Registered broker-dealers are membersof the Financial Industry Regulatory Authority(FINRA, formerly the NASD) and are held to thehighest standards of disclosure. And, instead of justevaluating the prospect for hitting oil, break the deal

down to make sure there is going to be a fairdistribution of the rewards. Finally, I suggest thatyou find a consultant to give you an unbiasedopinion as to the oil and gas project you are considering.

Copyright 2009 | Lone Star Securities, Inc. | All rights reserved.

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Understanding and Investing in Oil and Natural Gas