Oil and Natural Gas- Economics of Exploration

Oil and Natural Gas: Economicsof Exploration

EMIL ATTANASI and PHILIP FREEMANUnited States Geological Survey

Reston, Virginia, United States

1. Introduction

2. Fundamental Concepts

3. Discovery Process of Conventional Oil and Gas

4. Exploration: Individual Firm Decisions

5. Industry: Exploration and Public Policy

6. U.S. Exploration: Market Failure and Regulation

7. International Oil and Gas Exploration Provisions

8. Trends in Exploration and Discovery

9. Conclusions

Glossary

barrel of oil equivalent Approximate energy equivalencerelations where one barrel of crude oil¼ 6 thousandcubic feet of gas or 1.5 barrels of natural gas liquids.

basin-centered accumulation A regionally extensive andtypically thick zone or unit of hydrocarbon saturatedlow-permeability rock in the deep, central part of asedimentary basin.

common property resources Resources not under thecontrol of a single authority and where access isunrestricted or cannot easily be restricted.

continuous-type accumulation A regionally pervasive hy-drocarbon accumulation that is not bounded (deli-neated) by a hydrocarbon-water contact that commonlyoccurs independent of structural and stratigraphic traps.

externality Situation where the welfare of an individualdepends not just on his own actions but directly onactions of another independent economic agent, such aswhen pollution upstream affects the welfare of down-stream water users.

inferred reserves Expected cumulative additions to provedreserves in oil and gas fields discovered as of a certaindate, where such additions come by extensions, addi-tions of new pools, or enhancing hydrocarbon flow tothe well.

known recovery The sum of a field’s past production andits current estimate of proved reserves. Known recoveryis an estimate of field size.

market failure Inability of traditional markets to efficientlyallocate the use of a resource.

proved reserves Estimated quantities of hydrocarbons thatgeologic and engineering data demonstrate with reason-able certainty to be recoverable from identified fieldsunder existing economic and operating conditions.

user costs The value of all future sacrifices (or the value ofopportunities foregone) associated with production anduse of a particular unit of in situ resource now ratherthan in some future period.

Exploration is the search for undiscovered oil andgas resources that have development and productioncosts no higher than the expected costs associatedwith adding and producing reserves from knowndeposits. This article explains from theoretical andempirical perspectives the economic forces thatgovern oil and gas exploration. It discuses publicpolicy issues associated with oil and gas exploration.The concluding section summarizes statistics relatingexploration efforts to discoveries in the United Statesand areas outside of the North America.

1. INTRODUCTION

In many areas of the world outside of North Americaand Europe, natural gas is still not an economiccommodity because there are no local natural gasmarkets. On a Btu basis, natural gas is almost fourtimes more costly to transport than oil, so transport-ing gas to international markets can be prohibitivelyexpensive. Most of the description of the explora-tion/discovery process applies to both oil and gas. Atthe heart of the discussion, however, is the assump-tion that gas is commercially valuable. In areasoutside of North America and Europe, it can beexpected that reporting of some gas discoveries and

Encyclopedia of Energy, Volume 4. Published by Elsevier Inc. 535

reserves is incomplete because the gas discovered isnot commercial.

The exploration decisions of firms in a competitiveindustry lead to a level of exploration where themarginal finding (discovery) costs are related to ‘‘usercost.’’ User cost is defined as the value of all futuresacrifices associated with production and use of aparticular unit of in situ resources now, rather than insome future period. Marginal finding costs andexploration productivity are important leading in-dicators of the long-term trend in the industry’s lifecycle and in the future availability of oil and gassupplies. The theme of this article is that informationgenerated by the exploration discovery process for oiland gas provides the basic data for both industry andsociety to assess future resource availability and forplanning and formulating a reasoned energy policy.

2. FUNDAMENTAL CONCEPTS

‘‘Proved reserves’’ are estimated quantities of hydro-carbons that geologic and engineering data demon-strate with reasonable certainty to be recoverablefrom identified fields under existing economic andoperating conditions. Estimates of proved reservesare important because they are the leading indicatorsof short-term sustainability of oil and gas produc-tion. No more than 10 to 15% of proved reserves(and often much less) can be extracted annually toavoid reservoir damage. So proved reserve levelslimit annual production to amounts well short ofknown recoverable resources.

The objective of oil and gas exploration is toidentify resources that can be added to provedreserves. These resources should be of such a qualityand quantity that the resource can be commerciallydeveloped immediately. Industry exploration consistsof a variety of activities that include surveying ofsurface geology, processing and interpreting newlycollected geophysical data, reprocessing and inter-preting previously collected data, acquiring mineralrights and access, taking subsurface core samples,and finally drilling exploratory oil and gas wells.

Exploration wells drilled to find reserves areclassified by risk level. Categories for explorationwells are extension or outpost wells, new pool tests(shallower or deeper pool), and new field wildcatwells. Even the standard infill development well is notwithout risk; some development wells are drilled thatfail to make contact with the producing reservoir.Risk, or the probability of failure, on average tends toincrease from infill development wells to exploratory

wells represented by extensions and outposts, newpool tests, and then to new field wildcat wells.Historically, an exploratory well is classified as a newfield wildcat well when it is drilled at least two milesfrom the nearest productive accumulation. Otherexploratory wells that find reserves through new pooltests and extension drilling commonly add reserves tofields already discovered.

Figure 1 is a schematic showing the different typesof test wells (exclusive of new field wildcat wells). Inthe United States in the past two decades, theadditions to reserves that are derived strictly fromnew field wildcat wells represent a relatively smallproportion of annual additions to proved reserves.Most of the annual additions to proved reserves arethe result of the drilling of well types represented inFig. 1. The reserves found are credited to oil and gasfields that are already discovered and are recordedand published as extensions and revisions annuallyby the Energy Information Administration. Theapplication of fluid injection programs and wellstimulation also add reserves to discovered fields.These procedures facilitate flow of hydrocarbonsfluids through the production well bore.

Estimates of sizes of oil and gas fields arecommonly based on known recovery. A field’s knownrecovery is defined as the sum of its past productionand most recent estimate of proved reserves. Whenadditions to proved reserves are credited to a fieldalready discovered, its field size based on the estimateof known recovery is said to grow. Resource analystscall hydrocarbon resources that are expected to beadded to the proved reserves of discovered fields infer-red reserves. The movement of known hydrocarbon

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Known productive limits of proven pool

FIGURE 1 Schematic of wells leading to additions to reserves

in discovered fields; (1) shallower pool test, (2) deeper pool test, (3)infill well, (4) new pool test, (5) extension or outpost. In practice,

the operator or regulatory body may classify the accumulations

penetrated by wells 1 through 5 as a single field or as more thanone field. Recognition of the relationship among the accumulations

could also be further complicated by the order in which the wells

were actually drilled. Modified from Drew, 1997.

536 Oil and Natural Gas: Economics of Exploration

resources from the inferred to proved reserve categorycommonly requires exploratory drilling.

There may be some ambiguity whether newreserves are classified as either from new fields orfrom field growth (see Fig. 1). The U.S. Department ofEnergy defines a field as an area consisting of a singleor multiple reservoirs all related to the same individualgeologic structural feature and/or stratigraphic condi-tion. There may be two or more reservoirs in the fieldthat may be separated vertically or laterally byimpermeable strata. From a practical standpoint, thedefinition of an oil or gas field is not exact. Theassignment of pools to fields may be for conveniencein regulation, or it may be an artifact of the discoverysequence of the pools, rather than for well-definedgeologic reasons. Depending on the time sequence ofdiscovery, accumulations shown in Fig. 1 may beassigned to a single field or to more than one field.

Figure 1 shows discrete oil or gas accumulationsthat are considered to be conventional and produci-ble with conventional methods. Continuous-type oilor gas deposits are identified regional accumulationsand are analogous to low-grade mineral deposits. Anexample is the Wattenberg continuous-type nonasso-ciated gas accumulation that extends over an area ofmore than 1000 square miles in the Denver basin.The boundary of a discrete accumulation is usuallydefined by a hydrocarbon/water contact, but there isno such clear-cut boundary for a continuous-typeaccumulation (see Fig. 2). The geographic locationsof continuous-type accumulations are generallyknown although their extent may be uncertain.

Continuous-type hydrocarbon accumulationscommonly have reservoir properties that impedethe flow of hydrocarbon fluids. Most of theseaccumulations require that extra measures be taken

to induce additional flow to the well bore in order toattain commercial production rates. These measuresmay include drilling wells with horizontal sections orfracturing the formation to create passageways forthe resource to migrate to the well bore. Unconven-tional or continuous-type gas accumulations havereceived increasing attention by the U.S. domesticpetroleum industry during the past decade. Basin-centered gas accumulations (Fig. 2) may be partiallydeveloped by the recompletion and stimulation ofwells that have depleted shallower conventionalpools. If new wells target the continuous-typeaccumulation, the drilling risk is dominated byfailure to stimulate or complete the well so thatcommercial flow-rates are attained, rather than bymissing hydrocarbon-charged sedimentary rocks.Most of the wells drilled in continuous-type accu-mulations are classified as development wells. In thisarticle, only exploration for conventional discreteaccumulations is discussed.

Outside of the United States and Canada, oil andgas exploration is still directed to discrete conventionalaccumulations. Nonetheless the in situ hydrocarbonresources in the continuous-type accumulations aresubstantial, and the costs incurred in drilling andproducing such resources provide a backstop or upperbound to the costs that should be incurred in findingand developing discrete conventional accumulations.

3. DISCOVERY PROCESS OFCONVENTIONAL OIL AND GAS

Physical properties of the occurrence of oil and gasfields tend to cause regularity in the process of oil andgas discovery. The regularity provides the basis ofpredicting yields of future exploration from esti-mated undiscovered resources. Oil and gas depositsoccur in sedimentary basins. Within a basin, dis-coveries are typically classified into sets of geologi-cally similar deposits that are called petroleum plays.The petroleum industry uses the concept of thepetroleum play, commonly identified in terms of ageologic formation or strata, as a basis to classifytargets in a basin geologically.

The observed size-frequency distributions of dis-coveries in most petroleum plays and provinces arehighly skewed. A very small proportion of theaccumulations contain most of the discoveredresource. Figure 3 shows the frequency-discoverysize distribution of oil and gas fields discoveredin the Permian basin of the United States through1996, and Table I shows volumes of hydrocarbons

Tens of miles (kilometers)

Discrete-types

Land surface

Continuousbasin-centeredaccumulation

Stratigraphicaccumulation

Structuralaccumulation

FIGURE 2 A schematic diagram that shows the geologic setting

of a continuous-type accumulation in relation to discrete conven-tional accumulations in a structural trap and in a stratigraphic

trap. Data from U. S. Geological Survey National Oil and Gas

Resource Assessment Team, 1995.

Oil and Natural Gas: Economics of Exploration 537

associated with each discovery size class. ThePermian basin, located in Southwest Texas andEastern New Mexico, is the most prolific oil-producing basin in the conterminous United States.

The largest 27 fields (or 0.55% of the fields) containmore than half of the hydrocarbons discovered todate, whereas the 1414 fields in the smallest size class(less than 60 thousand barrels of oil equivalent,

TABLE I

Proportion of Total Petroleum in the Permian Basin Contained in Various Size Classes of Fields

Fields Petroleum

Size classa (BOE) Number Cumulative percentage Percentage in size class Cumulative percentage

2048–4096 1 0.02 4.86 4.86

1024–2048 4 0.10 12.14 17.01

512–1024 14 0.38 19.05 36.05

256–512 27 0.93 17.43 53.48

128–256 35 1.64 11.23 64.71

64–128 61 2.87 9.92 74.63

32–64 91 4.71 8.01 82.64

16–32 133 7.40 5.61 88.25

8–16 216 11.76 4.66 92.91

4–8 267 17.15 2.85 95.76

2–4 344 24.11 1.85 97.61

1–2 432 32.83 1.15 98.75

0.5–1 481 42.55 0.64 99.40

0.25–0.5 495 52.56 0.33 99.73

0.125–0.25 483 62.32 0.16 99.89

0.0625–0.125 451 71.43 0.08 99.97

o0.0625 1414 100.00 0.03 100.00

a In millions of barrels of oil equivalent (BOE) where 1 barrel of oil¼6 thousand cubic feet.

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FIGURE 3 Histogram showing the size-frequency distribution of oil and gas fields in the Permian basin discovered through1996. One barrel of oil equivalent¼6 thousand cubic feet of gas. MMBOE¼millions of barrels of oil equivalent. Data are

from the Energy Information Administration; field data are from 1998 issue of Oil and Gas Integrated Field File.


where one barrel of crude oil equals 6000 cubic feetof gas or 1.5 barrels of natural gas liquids) account ofonly 0.03% of the hydrocarbons.

The shape of the Permian basin discovery sizefrequency distribution is typical of most plays andbasins; most of the hydrocarbons are found in a fewvery large accumulations or fields. Exploratorydrilling success-ratios (successful wells to wellsdrilled) provide no information about the sizes offuture discoveries. The large number of smallaccumulations determines success ratio levels. Thelargest field, containing nearly 2.6 billion barrels ofthe oil equivalent, is at least six orders of magnitudelarger than the fields in the smallest size class. If thex-axis had not been in log base 2, the size classes forthe smallest category and the largest category couldnot have been graphed without a break in the axis.

Assuming the surface expression of a deposit isroughly proportional to its volume, then even withrandom drilling the average discovery sizes woulddecline with equal increments of exploratory drilling,as the largest deposits are found early in thediscovery process. For example, the surface area ofthe 6 billion barrel East Texas field covers more than200 square miles. Any improvement over purelyrandom drilling quickens the early discovery of largefields and accelerates the decline in the discoveryrate. Figure 4 shows the progression in the average

discovery sizes (in barrels of oil equivalent) from1920 to 1996 in 5-year increments for the Permianbasin. The regularity of the discovery process allowsthe expected yields of future exploration to becomputed with simple analytical models. The dis-covery rate (yield per exploratory well) is controlledby the sizes of fields discovered and the order ofdiscovery.

The exploration histories of many of the basins inthe United States follow predictable patterns. New-field wildcat wells were drilled in unproven plays atlow but irregular rates. After a significant discoveryis made, there is typically an influx of newprospectors and much higher levels of drilling;similar to the 19th century gold rushes. Drillingrates eventually weaken as returns deteriorate andexploration in other plays or basins becomes moreattractive. As other plays in the basin are tested, thenthe process repeats itself following another signifi-cant discovery in an unproven play. An efficientexploration process, where the larger accumulationsare found early, results from physical characteristicsof the size distribution of oil and gas deposits innature even when wells are randomly sited. If theindustry is reasonably efficient in finding the largestand lowest cost accumulations early in the discoveryprocess, then the past discovery sequence providesinformation useful in estimating the magnitude and

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FIGURE 4 Average sizes of fields discovered in 5 year intervals in the Permian basin between 1920 and 1996. Field data are

from the Energy Information Administration, 1998 issue of Oil and Gas Integrated Field File. 1 barrel of oil equivalent (BOE)

equals 6 thousand cubic feet of gas.


characteristics of the undiscovered resources. Forareas where field size is narrowly defined (such as thesum of only proved reserves plus past production),adjustments may be required to the estimated sizes ofrecent finds to allow for their full delineation so asnot to overstate discovery decline in sizes.

In the United States, a relatively small proportionof the known sedimentary basins (or provinces)contain most of the hydrocarbons discovered to date.

Figure 5 shows the distribution of known recovery(past production and proved reserves of oil, gas,natural gas liquids) in fields discovered through1998, expressed in barrels of oil equivalent for theU.S. onshore basins located in the conterminousUnited States. The distribution represents 57 onshorelower 48 provinces that were delineated and assessedby the U.S. Geological Survey for the 1995 NationalAssessment of Oil and Gas Resources. Table II lists

<0.5 0.5−<1.0 1−<2 2−<4 4−<8 8−<16 16−<32 32−<64 64−<128

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FIGURE 5 Histogram showing the cumulative discovered through 1998 hydrocarbon volumes-frequency distribution for

U.S. basins through 1998. BBOE¼billions of barrels of oil equivalent. Data from NRG Associates, 2000.

TABLE II

The Ten Leading U.S. Onshore Petroleum Provinces of the Conterminous 48 States

Unitsa of oil and gas

(BBO) (TCF) (BBL) (BBOE) Discovery dateb

1. Gulf Coast 25.8 265.8 8.3 75.6 1901

2. Permian Basin 34.4 102.3 6.5 55.7 1920

3. Anadarko Basin 5.0 157.1 5.6 34.8 1916

4. Miss-La. Salt Domes and E. Texas 16.5 84.6 3.5 32.9 1895

5. San Joaquin 15.4 13.2 0.8 18.2 1887

6. Appalachian Basin 3.4 43.0 0.0 11.0 1871

7. Los Angeles 9.0 7.5 0.4 10.5 1880

8. San Juan 0.3 45.5 1.5 8.8 1921

9. Bend-Arch Ft Worth 4.9 13.0 0.9 7.7 1902

10. Cherokee 6.3 2.3 0.0 6.7 1873

aUnits abbreviations: BBO¼ billions of barrels of crude oil, TCF¼ trillions of cubic feet of gas, BBL¼ billions of barrels of natural gas

liquids, BBOE¼billions of barrels of oil equivalent. Gas and natural gas liquids conversion factors the following: 1 barrel of oil

equivalent¼6 thousand cubic feet gas¼1.5 barrels of natural gas liquids.b Discovery date refers to the discovery date of the first field of at least 10 million barrels of oil equivalent.From NRG Associates, Significant oil fields in the United States 2000, database.


the known recovery for the ten leading onshoreprovinces and the discovery date of the first fieldhaving at least ten million barrels of oil equivalent.Four of the 57 provinces with the largest knownrecovery account for 63% of the petroleum dis-covered to date, and the top nine have more than80% of the discovered petroleum. On a worldwidebasis, relatively few provinces contain most of thehydrocarbons discovered to date.

Commercial petroleum was discovered in theUnited States in the middle of the 19th century. Just50 years later, at the end of 1901, petroleumprovinces containing more than half the knownpetroleum recovery (oil and gas) in the onshore lower48 states had reported at least one discovery of atleast 10 million barrels of oil equivalent. By the endof 1920, the basins that contained 94% of oil and gasdiscovered through 1998 had already been exploredsufficiently, so that in each basin at least one field of10 million barrels of oil equivalent had beendiscovered. The exploratory drilling through 1920,however, represented only a small percentage, lessthan 5%, of total exploratory drilling through 1998.Most onshore exploratory drilling since 1920 in thelower 48 states has been follow-up drilling in theseand other less prolific basins.

Exploration access, distance from market, andtechnology are factors determining the order inwhich basins are explored. In the very early periodsof the U.S. petroleum industry, search intensity wasinfluenced by the costs of transporting and marketingpetroleum. Some of the remote prolific basins werenot explored as early as those closer to market areas.

4. EXPLORATION: INDIVIDUALFIRM DECISIONS

Exploration expenditures are direct investmentsmade by individual firms for the purpose of locatingunidentified, but potentially commercial quantities ofoil and gas. For an individual firm, exploration oftenbegins with a hypothesis about the formation ofhydrocarbon accumulations in a specific geologicsetting. The process typically starts with a literaturesearch to identify potential geographic locationswhere the hypothesis might be tested. The selectionof a target area includes review of geologic maps,reconnaissance-type geochemical data and geophysi-cal data compilation from the open literature andfrom commercial vendors. Fieldwork is often re-quired to verify interpretations and to collect

additional data to identify specific drilling targets.During drilling, data are continuously collected andinterpreted to maximize the chances of locatingsignificant accumulations. With the location ofhydrocarbons, additional geologic and economicanalysis will determine chances of a commercialdiscovery.

The economic theory that explains how firms setthe optimal level of exploration expenditures iscomplex and beyond the scope of this article. Thediscussion that follows is highly simplified, but readersprimarily concerned with public policy and trends inexploration and discoveries may wish to skip it.

Economic determinants of exploration investmentare typically studied in the context of a representativefirm’s planning strategy. Suppose we consider arepresentative firm that searches for and producesoil in several areas over several time periods. Theoptimal plan tells the firm how much oil to produceeach time period and the level of investmentexpenditures in production facilities and explorationto make (both regionally and temporally) so as tomaximize the present value of its net cash-flowstream over the planning period.

In general, the optimal strategy is to increase oilproduction (extraction per time period) until themarginal cash profit (revenue minus operating costs)is balanced with the present value of the user costs.Simply, user costs represent the opportunity costsassociated with producing and using a unit ofresource now rather than postponing it. Specifically,it consists of the sum of (1) the future value of a unitof production retained in the ground instead ofproduced and (2) the cost, in terms useful life ofproduction facilities if the unit of resource isproduced at the present time. The value of retainingthe unit in the ground is linked to the ease ofreplacement of that unit. For example, the value ofpostponing production may be small if discoverycosts are low, that is, if replacement is easy, or iffuture resource prices are expected to decline becausea cheaper substitute can fill demand. Marginaldiscovery or finding costs are sometimes used toapproximate user costs. The greater discovery coststo replace that unit, the greater the user costs thatpushes the representative firm to postpone produc-tion of that unit.

Abstracting from effects of uncertainty for themoment, for each time period exploration expendi-tures should be set to where the marginal discoverycosts of new reserves equals the marginal value ofnewly discovered reserves. This value, in turn, isrelated to the user costs associated with the extraction


rule discussed in the previous paragraph. If the firmcan put value on additional variables related to, forexample, its experience in an area, then it should tryto include these benefits in its decision.

Exploration strategy is coordinated with produc-tion and investment strategies to ensure that overallcosts are minimized and the present value of netincome optimized for the entire planning period. Foran individual firm operating in multiple areas, if itsthreshold hurdle rate (required rate of return oncapital) cannot be achieved in the region, or if it has ahost of other more attractive opportunities else-where, then for that area, the firm will withdrawexploration, sell off prospects, and deplete producingproperties.

Uncertainty in the returns to exploration effortleads to a departure from the strategy describedearlier. The magnitude of this effect depends on afirm’s risk tolerances, how uncertainty affects mar-ginal product of exploration, and the perceived riskof ruin. However, viewed at the industry level, thereis a distribution of industry hurdle rates of return andrisk tolerances. This distribution ensures that in-formation generated by the exploration process—that is, marginal discovery costs—is not an artifact ofa single firm’s behavior, but is representative of theindustry and thus has general value for assessingfuture industry prospects.

Though many authors have proposed eleganttheoretical models of how firms make extraction,investment, and exploration decisions, there is still asurprising lack of empirical research that tests andverifies the hypotheses that have been generated.

5. INDUSTRY: EXPLORATION ANDPUBLIC POLICY

At the industry level, production, investment, andexploration patterns are examined for their consis-tency with the representative firm’s optimal strategyand in the context of certain public policy questions.For example, the government might institute incen-tives designed to encourage domestic oil and gasexploration effort in order to maintain domesticproduction capacity. In addition to direct taxincentives and subsidies for exploration, the othergovernment policy instruments include access tominerals on public lands, research and developmentpolicy, import quota/tariff policy, and direct pricecontrols. All of these instruments have, to someextent, been used during the history of the U.S. oiland gas industry.

The standard formulation of the economic theoryof exhaustible resources, as proposed by economistHarold Hotelling, asserts that the net prices of in situfinite resources should increase at the rate of at leastthe current rate of interest. Hotelling’s theory restson the assumption of a fixed stock of reserves thatcan be produced at will. However, proved reserves ofoil and gas can be augmented through exploration orthrough more intense development. Production ratesof oil and gas wells are constrained or limited byreservoir pressures. It is not surprising that manyempirical studies have failed to verify the na.ıvepredictions of the Hotelling theory. When explora-tion is modeled at the industry level, the derivedtheoretical implications are rarely unambiguous.

A broader question relating to public policy iswhether industry exploration costs and actionsaccurately indicate future prospects of oil and gas.If the finding costs accurately reflect the costsassociated with replacement costs of current provedreserves, then trends in such costs could foreshadowfuture supply problems. Finding costs, however, arenot directly observable from industry or governmentdata sources. It may take years for new finds to besufficiently developed so that their size can beaccurately estimated. Though discovery costs arenot directly observable, the locations, search inten-sity, and the apparent risks the industry acceptsreflect its assessment of remaining domestic andworldwide oil and gas exploration prospects.

If it is assumed that each firm will equalize themarginal costs of additional reserves either throughexploration, intensive development that adds re-serves, and purchase, then one can infer from markettransactions prices the approximate industry findingcosts. Empirical studies of oil and gas propertytransactions values show a rather consistent pattern.Developed in-ground oil and gas reserve prices hoverat about one-third wellhead prices or at half of netprices, which are the wellhead prices minus alloperational costs including taxes.

For the individual firm, exploration effort can beexpected to increase until marginal finding costsequal user costs. User cost represents the benefits ofadding resources to reserves. Empirically, user costsare measured as the difference between the in-groundmarket value of the developed proved reserves andthe development costs. User costs embody the futureprice expectations of market agents, just as thevaluation of properties embodies future reserve priceexpectations.

For the U.S. petroleum industry, oil price expecta-tions are set in world markets but natural gas price


expectations are set by the expected demand supplyinteraction within North America. The unprece-dented increase in perceived U.S. user costs duringthe late 1970s and early 1980s led to record drillinglevels and oil finding costs in the lower 48 states butfailed to significantly increase proved reserves. Usercosts as well as exploration activity declined in theUnited States as world crude oil prices plummeted in1986 to half the levels that prevailed in 1985.

The U.S. Energy Information Administrationcompiles and reports the financial accounts, calledthe Financial Reporting System (FRS), for the groupof firms representing the largest domestic crude oilproducers. Although there have been changes in thecomposition of the FRS firms over the years, thesefirms are the leading U.S. oil and gas producers. Thereport includes financial expenditures on explorationincluding numbers of wells drilled, oil and gasproduction by the country where the producingproperty is located, and investment expenditures.

Figures 6 and 7 show U.S. and foreign exploratorywells and expenditures reported for the FRS firms.During the early 1980s, both domestic exploratorydrilling and exploration expenditures substantiallyexceeded exploration outside the United States. Sincethe late 1990s, domestic and foreign explorationdrilling and expenditures by these firms have beenabout equal. The volume of crude oil productionfrom foreign properties for the FRS firms has steadilyincreased, and in 1997 it exceeded oil production atU.S. properties. Within the United States since 1993,more than half the FRS firms’ domestic explorationexpenditures have targeted offshore prospects, prin-cipally in the deep water of the Gulf of Mexico. In

summary, the industry exploration trend demon-strated by the FRS group of firms (representing theindustry leaders) has been to focus exploration effortin the deepwater offshore areas and countries outsideof the United States where the opportunity to dis-cover large accumulations is greater.

6. U.S. EXPLORATION: MARKETFAILURE AND REGULATION

The U.S. petroleum industry is a mature industry. U.S.crude oil production reached its peak in 1970, andgas production reached its peak in 1971. In 2000, theUnited States produced 5.86 million barrels per dayof crude oil, or 8.7% of the world’s production. Italso produced 20.1 trillion cubic feet of gas, whichrepresents about 23% of the world’s gas production.During the history of oil and gas exploration in theUnited States, the combination of private ownershipof mineral rights and the competitive market forcesproduced excesses in exploration and production thatultimately resulted in government regulation. Actionsthat were rational from an individual firm’s perspec-tive turned out to be very costly from society’sstandpoint. Although some of these inefficiencies arein the past, they are reviewed here to provide insightinto the regulatory environment.

6.1 Externalities and Regulation

In the United States, mineral rights can be ownedeither privately and by the federal and state govern-ments. Government-owned mineral rights are typically

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transferred to the private sector for exploration andproduction. Several systems were used to transfermineral rights to the private sector in the past. Acomprehensive analysis of these systems with respectto economic efficiency and government’s ability tocapture economic rents is beyond the scope of thisarticle. However, where significant hydrocarbons areexpected, the method now used to transfer of oil andgas rights to the private sector is the sale of leasesthrough a competitive bidding system.

Private ownership of mineral rights resulted inwhat economists refer to as market failures and ledto governmental regulations to remedy these failures.Because an oil or gas pool can extend over severalparcels, there could be a number of differentproperty owners with a claim to the oil or gas in acommon pool. This is the common property or poolexternality. An externality occurs when the welfareof an individual depends directly not just on theindividual’s activities, but also on activities con-trolled by some other economic agent. For example,pollution generated upstream affects the welfare ofdownstream water users.

In the absence of regulation, oil and gas resourceswere subject to the rule of capture. Historically, theowner who first discovered the pool would startimmediately to intensively drill and produce theresource. In the subsurface, oil and gas flows towhere there is a reservoir pressure differential; so byquickly drilling production wells, the first producercould drain resources from neighboring owners. Theneighboring owners must exploit their part of the poolas quickly as possible just to avoid losing resources tothe early producer. This practice accelerated explora-tion and resulted in too much exploration and toorapid production of the resource. The acceleratedproduction reduced the quantity of the resource thatcould ultimately be recovered from the pool.

Even when oil prices collapsed, production wouldnot decline because each producer feared havingone’s own part of the pooled drained by a neighbor.In the leading oil-producing states, governmentregulators instituted pro-rationing that limited pro-duction for each well to an allowable rate per monthand set minimum spacing for wells. Well-allowablerates were set to restrict oil supply in order toestablish a floor on wellhead prices. For many states,pro-rationing remained in effect until the early1970s, when the first Arab oil embargo occurred.State regulatory commissions and the federal govern-ment now require that production of newly dis-covered pools be unitized among the owners to avoidthe common pool externality and to assure that

potentially recoverable resources are not lost by earlyoverproduction.

Information is crucial to the competitive explora-tion process. During the period when the rule ofcapture rewarded early exploration, a system ofscouting services was developed in the industry. Thedomestic and international scouting services reportto subscribers land acquisition transactions, well-permitting applications, drilling activities, and post-drilling actions of firms exploring an area. Theinformation generated by discoveries and dry holes isvaluable to neighboring leaseholders and otherexploration firms who have not taken the risk ofactually drilling. The benefits from observing theoutcome of drilling without bearing the risk is anexternality known as an information spillover. Infact, some Canadian provincial governments leasetracts in a checkerboard fashion to maximize theirbenefits as the ultimate owner of the resource of suchinformation spillovers.

With the general adoption of forced unitization ofnew discoveries during the last half of the 20thcentury, major integrated companies followed thestrategy of taking large land positions around aprospect and farming out small parcels to anindependent firm (operator) in exchange for drillinga risky wildcat well. In many cases, the independentoperator has a lower cost of capital than the majorfirm, because the independent can fund the wellthrough limited partnerships that provide tax benefitsto individual investors. With this system, the firm thatactually drilled the discovery well received only asmall fraction of the actual discovery. For example, inthe Denver basin from 1949 through 1974, theindependent firms were credited with drilling dis-covery wells for fields representing 75% of thereserves but ended up owning only 21% of thereserves in those deposits. The remaining reserveswere credited to the major companies because of theirdominant land positions.

6.2 Federal Policies toPromote Exploration

The federal government has encouraged oil and gasexploration during most of the 20th century byfavorable income tax treatment, specifically througha provision known as the percentage depletionallowance. Favorable tax treatment for petroleuminvestments enabled promoters and operators ofindependent firms to raise significant amounts ofmoney by offering tax shelter plans to fund this


drilling. During the peak years of exploratory drillingfrom 1981 to 1982 in the United States, most of theexploration wells drilled were funded through sucharrangements. This funding was reduced dramati-cally when the Tax Reform Act of 1986 significantlyreduced tax rates and rescinded part of the tax codefavorable to such tax shelter funds.

During the 1950s and the following decade, thefederal government imposed quotas on importedcrude oil. The stated purpose was to maintaindomestic crude oil production capacity for nationalsecurity reasons. The quotas had the effect ofinsulating domestic prices from lower world pricesand providing the necessary incentives for explora-tion and production of domestic resources. Importquotas were rescinded as domestic oil productionapproached its peak in 1970 and it was clear thatsupply would not grow as rapidly as U.S. demand.

7. INTERNATIONAL OIL AND GASEXPLORATION PROVISIONS

Since the early part of the 20th century, British,Dutch, and French oil companies have explored forand produced oil internationally, starting with theirformer colonies. After World War II, all major U.S.companies initiated international exploration tovarious degrees.

Outside the United States, national governmentstypically control ownership of mineral rights. Therights to exploration concession areas are negotiatedwith the central governments. Although some of theEuropean countries with North Sea productionfollow an auction system, in some ways similar tothe U.S. system, they still maintain tight control ofresource development. Many leading oil and gas-producing countries require separate exploration andproduction agreements. For some countries, includ-ing those in the Middle East, Mexico, and Venezuela,petroleum exploration and production is almostentirely controlled by the state oil company, andforeign companies, if allowed at all, are used on acontract basis.

For countries that permit foreign participation,exploration concessions typically require a workcommitment including investment in data collectionand a specified number of wells drilled in exchangefor the right to explore. The concession areas aresufficiently large so that a field will have a singleowner, thereby eliminating common pool external-ities. In addition, the concession contract will specifythat all data collected by the concessionaire should

revert to the government for use by subsequentconcessionaires. The agreement will also specify whatrights, if any, the exploration firm might have in theevent of a discovery. Once a discovery is made, aproduction concession is negotiated, often requiringthe private company to share production with thestate oil company or to assume the role of contractproducer with payments taken in kind as a percentageof production.

Each government has a different set of contractprovisions and production taxes designed to attain aspecific set of policy goals. These goals may includetraining and employment of local workers, construc-tion of infrastructure, and provision of social servicesto the local communities. Moreover, the governmentstypically reserve the right to tailor provisions on anindividual basis. A description of these provisions iswell beyond the scope of this article.

8. TRENDS IN EXPLORATIONAND DISCOVERY

8.1 Drilling Activity

Summaries of the total numbers of wells drilledoutside the United States are published by country inthe journal World Oil and the American PetroleumInstitute’s Petroleum Data Book. Data show that thepercentage of worldwide annual drilling representedby the wells drilled in the United States went from80% in 1970 to 30% in 2000. In 1950, the UnitedStates accounted for 52% of the world’s crude oilproduction, but by 2000 its share had fallen to lessthan 9%. The time profiles of new field wildcat wells(successful and dry) drilled each year since 1950 foreach of three country groups are shown in Fig. 8. Thedrilling records for some countries are undoubtedlyincomplete, but the graph illustrates the decline inU.S. new field wildcat drilling as well as the decline inthe U.S. share of world new field wildcat drillingafter 1981. The U.S. share declined from over 90%in 1950 to around 55% by the late 1990s.

8.2 Past Discoveries

There are no internationally accepted standards forreporting reserves or sizes of discoveries. In somecountries such as the United States and Canada,reserve definitions are very conservative becausethey are tied to production facilities and econo-mic conditions. In other countries, the definitionof reserves is broader, reflecting the volumes of


hydrocarbons that are technically recoverable with-out reference to being commercial. The discoverydata presented in Figs. 9 and 10 must be viewed withthis caveat in mind.

Figure 9 shows the annual oil discovery rate,averaged over 5-year intervals, that started in 1915and annual production. The reported discoveries arein fields that can be produced with conventionalproduction methods. The dominance of the EasternHemisphere is striking. It is likely that new discoverieswill be revised upward as these fields are delineatedand developed, so the sharp decline in overalldiscoveries is likely to be moderated. The peak levelsof discovery from 1955 to 1965, however, will not berepeated. During this period, the Middle Eastaccounted for about half of the discoveries worldwide.World production declined in response to the econom-ic recession between 1980 and 1985, but it began toincrease after 1986. It now appears to substantiallyexceed the past two decades of discoveries.

Figure 10 shows the natural gas discovery rate andproduction for the world. The Eastern Hemispherediscoveries dominate. The best years for discoveriesof gas worldwide were from 1965 to 1970. Duringthis period, the former Soviet Union accounted fortwo-thirds of all gas discoveries. During the 1970s,many of the largest gas discoveries were in theoffshore areas of the North Sea and the Middle East.Figure 10 shows that gas production accelerated

during the late 1980s. Estimates of the size of gasreserves are probably underreported because gas isnot commercially marketable in many parts of theworld. Consequently, the reported discovery ratesshown in Fig. 10 are probably underestimated.

9. CONCLUSIONS

This discussion has identified the determinants ofoil and gas exploration, considered the effects of

0

10

20

30

40

50

Cru

de o

il in

bill

ions

of b

arre

ls p

er y

ear

1910 1930 1950 1970 1990

Years

Westernhemisphere

Easternhemisphere

Annualproduction

FIGURE 9 Estimated world annual crude oil discovery rateaveraged over 5-year periods and annual production. Bottom

section of bar is Western Hemisphere and top is Eastern Hemi-

sphere. From U.S. Energy Information Administration, I.H.S.Energy Group, International Petroleum Exploration and Produc-

tion Data Base, 2002, and Canadian Association of Petroleum

Producers, Statistical Handbook, 2002.

0

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Nat

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gas

in tr

illio

ns c

ubic

feet

per

yea

r

1910 1930 1950 1970 1990

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Annual production

Westernhemisphere

Easternhemisphere

FIGURE 10 Estimated world annual natural gas discovery rateaverages over 5-year periods and annual production. Bottom

section of bar is Western Hemisphere and top is Eastern Hemi-

sphere. From U.S. Energy Information Administration, I.H.S.

Energy Group, International Petroleum Exploration and Produc-tion Data Base, 2002, and Canadian Association of Petroleum

Producers, Statistical Handbook, 2002.

0

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4,000

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Year

United StatesMexico, Canada, S. AmericaEastern Hemisphere

FIGURE 8 Time profile of new-field wildcat wells drilled in theUnited States, Eastern Hemisphere countries, and the group

consisting of South America, Canada, and Mexico from 1950 to

2000. Data from I.H.S. Energy Group, International Petroleum

Exploration Production Data Base, 2002, 2002 API PetroleumData Book.


mineral property ownership on exploration rates,and examined empirical data showing the worldwideoil and gas discovery rates. Because of the way oiland gas occurs in nature, the statistics generated bythe discovery process provide the basis for predictingthe potential future availability of resource supplyfrom conventional accumulations. As discovery ratesinevitably decline and discovery costs increase,resources that are brought to market will, in alllikelihood, come increasingly from oil and gasaccumulations that are unconventional.

SEE ALSO THEFOLLOWING ARTICLES

Markets for Natural Gas � Markets for Petroleum �

Natural Gas Resources, Global Distribution of � Oiland Natural Gas Drilling � Oil and Natural GasExploration � Oil and Natural Gas Leasing � Oil andNatural Gas Liquids: Global Magnitude and Dis-tribution � Oil and Natural Gas Resource Assessment:Classifications and Terminology � Oil-Led Develop-ment: Social, Political, and Economic Consequences �

Oil Price Volatility � Petroleum Property Valuation

Further Reading

Adelman, M. A. (1992). Finding and development costs in the

United States 1945–1986. In ‘‘Advances in the Economics of

Energy and Resources’’ (J. Maroney, Ed.), pp. 11–58. JAI Press,

Greenwich, CT.Adelman, M. A. (1993). Modeling world oil supply. Energy J. 14,

1–32.

Adelman, M. A., De Silva, H., and Koehn, F. (1991). User cost in

oil production. Res. Energy 13, 217–240.

Adelman, M. A., and Watkins, G. C. (1997). The value of United

States oil and gas reserves: Estimation and application. In‘‘Advances in the Economics of Energy and Resources’’(J. Moroney, Ed.), pp. 131–183. JAI Press, Greenwich, CT.

Attanasi, E. D., and Root, D. H. (1995). Petroleum reserves (oil

and gas reserves). In ‘‘Encyclopedia of Energy Technology

and the Environment,’’ pp. 2264–2277. John Wiley and Sons,New York.

Bohi, D. R., and Toman, M. A. (1984). Analyzing nonrenewable

resource supply. Resources for the Future, Washington DC.Devarajan, S., and Fisher, A. (1982). Exploration and scarcity.

J. Pol. Econ. 90, 1279–1290.

Drew, L. J. (1990). ‘‘Oil and Gas Forecasting.’’ Oxford University

Press, New York.Drew, L. J. (1997). ‘‘Undiscovered Petroleum and Mineral

Resources: Assessment and Controversy.’’ Plenum, New York.

Energy Information Administration (2002). U.S. Crude oil, natural

gas, and natural gas liquids reserves, 2002, Annual Report.DOE/EIA-0216(03).

Energy Information Administration (2003). Performance profiles

of major energy producers, 2001, January, DOE/EIA00206(01)

at http://www.eia.doe.gov/emeu/perpro/perfpro2001.pdf.Hotelling, H. (1931). The economics of exhaustible resources.

J. Pol. Econ. 39, 137–175.

Klett, T. R., Ahlbrandt, T. S., Schmoker, J. W., and Dolton, G. L.(1997). Ranking of the world’s oil and gas provinces by known

petroleum volumes. U.S. Geological Survey Open File Report

97–463, one CD-ROM. Washington, DC.

McDonald, S. L. (1994). The Hotelling principle and in-groundvalues of oil reserves. Energy J. 15, 1–17.

Securities and Exchange Commission (1981). Regulation S-X Rule

40–10, Financial Accounting and Reporting Oil and Gas

Producing Activities, Securities and Exchange CommissionReserves Definitions, Bowne & Co. Inc., March 1981, New York.

Society of Petroleum Engineers (1987). Definitions for oil and

gas reserves, Journal of Petroleum Technology, May 1987,pp. 557–578.

U.S. Geological Survey Assessment Team (1995). 1995 National

Assessment of United States Oil and Gas Resources. U.S.

Geological Survey Circular 1118. Washington, DC.Yergin, D. (1991). ‘‘The Prize.’’ Simon & Shuster, New York.


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