Members SPE-AIME

Abstract

In the last decade, the petroleum industry has experienced the most strenuous growth cycle in recent memory. Beginning in 1973, it enjoyed a period of unprecedented growth until late 1981 when a precipitous decline was initiated. This downturn, which was unforeseen by most organizations and individuals, has adversely affected many including investors, operators, equipment suppliers, and the financial community.

This paper will put this rapidly changing environment into perspective by illustrating the historical relationships between price changes in actual and real terms, activity levels, energy supply/demand and petroleum reserves in U.S.A., all of which have had significant impact on the investment outlook of the petroleum industry. It will demonstrate that rapidly rising prices in last decade elevated expectations of return on investments in the oil and gas industry. For the investor, this became a seller's market where the investor generally took what the operator offered with marginal room for negotiations. High activity levels often resulted in higher than anticipated costs and when complemented with sudden downturn in prices, caused many programs to generate less than desired results. By relating programs to generate less than desired results. By relating average 1980-81 industry finding and acquisition costs to after-tax rate of return on investment based on actual exploration and acquisition programs, this paper will illustrate why many investors became disappointed with these programs. This explanation will take into account economic factors such as federal income tax changes, excise tax (windfall profits tax), price and market changes as well as exploration and development costs.

Based on this actual data and information, the relationships between after-tax return on investment and both finding and development costs and acquisition costs will be graphically illustrated for several future oil and gas pricing scenarios. Comparisons are provided to illustrate the tax benefits associated with exploration and development vis-a-vis acquisition. In addition, examples will be given to demonstrate the various factors which result in different rates of return for similar acquisition costs. In effect, using this information, analysts will be able to do a better job of screening future programs without doing a tedious, detailed analysis. This information should be useful to anyone involved in economic decisions within the petroleum business, especially management, consultants, bankers and investors.

Introduction

Ten years ago the "official price" of crude oil produced in the Persian Gulf was $2 per barrel. Currently it is $29, somewhat less than the $34 charged last year. During the previous decade, the petroleum industry has experienced previous decade, the petroleum industry has experienced dramatic cycles in economic growth as a result of these often unexpected price changes. Based on an analysis of these historical growth cycles, qualitative relationships between oil and gas pricing, investments, activity levels, reserve changes and energy consumption levels can be developed which are useful in managing and predicting future trends in the industry. In addition, these relationships are further explained by the observation and analysis of actual oil and gas programs, which are a representative sampling of the entire programs, which are a representative sampling of the entire industry. Consequently, the conclusions and relationships developed as a result of this effort are useful for explaining those events affecting the entire U.S.A. petroleum industry. In order to present this information, it is important to understand the historical context from which these concepts and relationships are observed. The key to understanding the industry cycles is to understand the forces which affect pricing. The major force affecting oil and gas pricing in the pricing. The major force affecting oil and gas pricing in the world continues to be the political events of foreign oil suppliers, especially in the Middle East.

Historical Context

This year marks the 10th anniversary of the first "oil shock." It was in September of 1973 that the "spot" price of oil in European markets (i.e., crude oil traded there for immediate delivery) for the first time exceeded the Persian Gulf producers "posted price" (i.e., the price that they charged for crude oil sold under long-term contract, then about $2 per barrel) plus shipping costs.

A month later during the so called Yom Kippur War, the ministers of the Organization of Petroleum Exporting Countries met in Kuwait. Their hitherto obscure acronym (i.e., OPEC) suddenly became a household word when the ministers announced cuts in production of at least 5 percent across the board, and a posted price for Persian Gulf oil of about $5 per barrel.

This content is only available via PDF.
You can access this article if you purchase or spend a download.