Investment dream or acquisition nightmare?

BUYING LOW and selling high in this market only works if you know the TRUE value of your acquisition.

Nobody, and I include myself, can predict oil prices for the immediate future. However, I do have another type of prediction: More new domestic oil and gas companies will be formed in the next five years than in any similar time frame in the history of the United States. This is for one simple reason: At these prices, oil is the safest investment simply because it is well below its replacement cost.

If you look at the true full cycle cost of development and production, today's price means that it is not possible for the United States to sustain exploration even at its present low level. No new exploration means no new reserves and less future production, which eventually leads to lower production and higher prices. So buy low and sell high.

I am not the only one who believes this, which may be why we see record amounts of capital gathering on the sidelines, waiting for the right investment opportunity. So the question is, what should you buy?

In working with our clients to help evaluate acquisitions, here is what we've discovered: A typical acquisition in the shale consists of a scattering of wells and leases across a broad area. Pooling agreements usually determine the working interest (expense) and net revenue interest (income) on each well based on tract acreage contribution to the "production unit." This means that one acre in this unit has a separate and distinct value that is different than one acre in another unit, in the same area, and even on the same lease. The value of each acre is dependent on where it is located, what depths/horizons are part of that acre, how much is developed, and how much undeveloped is remaining. When buying acreage, you need to know how many more wells can be drilled within that unit as per the pooling agreement, as it is now common to see multiple wells drilled within any unit.

Recently we came across a situation in which the oil and gas lease contained two adjacent tracts of land on the same lease. Each tract was in its own separate producing unit for the Haynesville shale formation. One of the units had six producing wells (fully developed) and the other tract had one producing well (five potential additional locations), all drilled during higher gas price years and within two years of each other. Production and depletion for all of the wells was similar, so the depletion type curve, EUR's for each well, cash flows, and remaining PV values would all be the same.

One might assume that based on today's commodity price and the fact that no new wells can be economically drilled, that the value of each tract would be based solely on the value of its current production. That assumption would be a mistake, and here's why.

The unit with six wells is "fully developed," meaning the reservoir has been fully developed and no more wells will be drilled in that unit, regardless of future commodity price. However, the tract in the unit with only one well drilled and producing can offer five new locations, when prices recover. So the value of the "underdeveloped" acreage has a greater income potential than the fully developed acreage.

Think of the undeveloped acreage as an open-ended call option. In other words, at some time in the future, as long as the lease/tract is HBP, the owner of that lease has the right, but not the obligation, to drill additional wells. So, if and when commodity prices rise, the "undeveloped" tract becomes more and more valuable.

Also, it's important to be aware of which leases have depth/horizon severance issues as well as horizontal and/or vertical Pugh Clause issues. With this awareness, you can determine what you can keep and what you will lose, as well as how much to budget for future payments and when to pay them.

The key to doing intelligent and effective due diligence and evaluation of an acquisition is to look at and value each tract of land, considering its present EUR and future EUR potential. As prices rise, the tracts with the least amount of developed producing wells will have a greater increase in value than those tracts that are more fully developed.

With today's database and GIS technology, this process can be simple, fast, and well worth the investment. Otherwise, I honestly do not know how anyone can truly be knowledgeable and competitive in acquisitions in today's environment.

Tim Supple is the president of iLandMan and has been in the oil and gas industry for nearly 40 years working as a landman, broker, and E&P operator, before entering the land software business in 2005.