You are on page 1of 13

Oil and Natural Gas: Economics

of Exploration
EMIL ATTANASI and PHILIP FREEMAN
United States Geological Survey
Reston, Virginia, United States

1.
2.
3.
4.
5.
6.
7.
8.
9.

Introduction
Fundamental Concepts
Discovery Process of Conventional Oil and Gas
Exploration: Individual Firm Decisions
Industry: Exploration and Public Policy
U.S. Exploration: Market Failure and Regulation
International Oil and Gas Exploration Provisions
Trends in Exploration and Discovery
Conclusions

Glossary
barrel of oil equivalent Approximate energy equivalence
relations where one barrel of crude oil 6 thousand
cubic feet of gas or 1.5 barrels of natural gas liquids.
basin-centered accumulation A regionally extensive and
typically thick zone or unit of hydrocarbon saturated
low-permeability rock in the deep, central part of a
sedimentary basin.
common property resources Resources not under the
control of a single authority and where access is
unrestricted or cannot easily be restricted.
continuous-type accumulation A regionally pervasive hydrocarbon accumulation that is not bounded (delineated) by a hydrocarbon-water contact that commonly
occurs independent of structural and stratigraphic traps.
externality Situation where the welfare of an individual
depends not just on his own actions but directly on
actions of another independent economic agent, such as
when pollution upstream affects the welfare of downstream water users.
inferred reserves Expected cumulative additions to proved
reserves in oil and gas fields discovered as of a certain
date, where such additions come by extensions, additions of new pools, or enhancing hydrocarbon flow to
the well.
known recovery The sum of a fields past production and
its current estimate of proved reserves. Known recovery
is an estimate of field size.

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

market failure Inability of traditional markets to efficiently


allocate the use of a resource.
proved reserves Estimated quantities of hydrocarbons that
geologic and engineering data demonstrate with reasonable certainty to be recoverable from identified fields
under existing economic and operating conditions.
user costs The value of all future sacrifices (or the value of
opportunities foregone) associated with production and
use of a particular unit of in situ resource now rather
than in some future period.

Exploration is the search for undiscovered oil and


gas resources that have development and production
costs no higher than the expected costs associated
with adding and producing reserves from known
deposits. This article explains from theoretical and
empirical perspectives the economic forces that
govern oil and gas exploration. It discuses public
policy issues associated with oil and gas exploration.
The concluding section summarizes statistics relating
exploration efforts to discoveries in the United States
and areas outside of the North America.

1. INTRODUCTION
In many areas of the world outside of North America
and Europe, natural gas is still not an economic
commodity because there are no local natural gas
markets. On a Btu basis, natural gas is almost four
times more costly to transport than oil, so transporting gas to international markets can be prohibitively
expensive. Most of the description of the exploration/discovery process applies to both oil and gas. At
the heart of the discussion, however, is the assumption that gas is commercially valuable. In areas
outside of North America and Europe, it can be
expected that reporting of some gas discoveries and

535

536

Oil and Natural Gas: Economics of Exploration

reserves is incomplete because the gas discovered is


not commercial.
The exploration decisions of firms in a competitive
industry lead to a level of exploration where the
marginal finding (discovery) costs are related to user
cost. User cost is defined as the value of all future
sacrifices associated with production and use of a
particular unit of in situ resources now, rather than in
some future period. Marginal finding costs and
exploration productivity are important leading indicators of the long-term trend in the industrys life
cycle and in the future availability of oil and gas
supplies. The theme of this article is that information
generated by the exploration discovery process for oil
and gas provides the basic data for both industry and
society to assess future resource availability and for
planning and formulating a reasoned energy policy.

2. FUNDAMENTAL CONCEPTS
Proved reserves are estimated quantities of hydrocarbons that geologic and engineering data demonstrate with reasonable certainty to be recoverable
from identified fields under existing economic and
operating conditions. Estimates of proved reserves
are important because they are the leading indicators
of short-term sustainability of oil and gas production. No more than 10 to 15% of proved reserves
(and often much less) can be extracted annually to
avoid reservoir damage. So proved reserve levels
limit annual production to amounts well short of
known recoverable resources.
The objective of oil and gas exploration is to
identify resources that can be added to proved
reserves. These resources should be of such a quality
and quantity that the resource can be commercially
developed immediately. Industry exploration consists
of a variety of activities that include surveying of
surface geology, processing and interpreting newly
collected geophysical data, reprocessing and interpreting previously collected data, acquiring mineral
rights and access, taking subsurface core samples,
and finally drilling exploratory oil and gas wells.
Exploration wells drilled to find reserves are
classified by risk level. Categories for exploration
wells are extension or outpost wells, new pool tests
(shallower or deeper pool), and new field wildcat
wells. Even the standard infill development well is not
without risk; some development wells are drilled that
fail to make contact with the producing reservoir.
Risk, or the probability of failure, on average tends to
increase from infill development wells to exploratory

wells represented by extensions and outposts, new


pool tests, and then to new field wildcat wells.
Historically, an exploratory well is classified as a new
field wildcat well when it is drilled at least two miles
from the nearest productive accumulation. Other
exploratory wells that find reserves through new pool
tests and extension drilling commonly add reserves to
fields already discovered.
Figure 1 is a schematic showing the different types
of test wells (exclusive of new field wildcat wells). In
the United States in the past two decades, the
additions to reserves that are derived strictly from
new field wildcat wells represent a relatively small
proportion of annual additions to proved reserves.
Most of the annual additions to proved reserves are
the result of the drilling of well types represented in
Fig. 1. The reserves found are credited to oil and gas
fields that are already discovered and are recorded
and published as extensions and revisions annually
by the Energy Information Administration. The
application of fluid injection programs and well
stimulation also add reserves to discovered fields.
These procedures facilitate flow of hydrocarbons
fluids through the production well bore.
Estimates of sizes of oil and gas fields are
commonly based on known recovery. A fields known
recovery is defined as the sum of its past production
and most recent estimate of proved reserves. When
additions to proved reserves are credited to a field
already discovered, its field size based on the estimate
of known recovery is said to grow. Resource analysts
call hydrocarbon resources that are expected to be
added to the proved reserves of discovered fields inferred reserves. The movement of known hydrocarbon

1
2

4
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 than
one 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.

Oil and Natural Gas: Economics of Exploration

resources from the inferred to proved reserve category


commonly requires exploratory drilling.
There may be some ambiguity whether new
reserves are classified as either from new fields or
from field growth (see Fig. 1). The U.S. Department of
Energy defines a field as an area consisting of a single
or multiple reservoirs all related to the same individual
geologic structural feature and/or stratigraphic condition. There may be two or more reservoirs in the field
that may be separated vertically or laterally by
impermeable strata. From a practical standpoint, the
definition of an oil or gas field is not exact. The
assignment of pools to fields may be for convenience
in regulation, or it may be an artifact of the discovery
sequence of the pools, rather than for well-defined
geologic reasons. Depending on the time sequence of
discovery, accumulations shown in Fig. 1 may be
assigned to a single field or to more than one field.
Figure 1 shows discrete oil or gas accumulations
that are considered to be conventional and producible with conventional methods. Continuous-type oil
or gas deposits are identified regional accumulations
and are analogous to low-grade mineral deposits. An
example is the Wattenberg continuous-type nonassociated gas accumulation that extends over an area of
more than 1000 square miles in the Denver basin.
The boundary of a discrete accumulation is usually
defined by a hydrocarbon/water contact, but there is
no such clear-cut boundary for a continuous-type
accumulation (see Fig. 2). The geographic locations
of continuous-type accumulations are generally
known although their extent may be uncertain.
Continuous-type hydrocarbon accumulations
commonly have reservoir properties that impede
the flow of hydrocarbon fluids. Most of these
accumulations require that extra measures be taken

Land surface
Structural
accumulation

Discrete-types

Stratigraphic
accumulation

Continuous
basin-centered
accumulation

Tens of miles (kilometers)

FIGURE 2 A schematic diagram that shows the geologic setting


of a continuous-type accumulation in relation to discrete conventional accumulations in a structural trap and in a stratigraphic
trap. Data from U. S. Geological Survey National Oil and Gas
Resource Assessment Team, 1995.

537

to induce additional flow to the well bore in order to


attain commercial production rates. These measures
may include drilling wells with horizontal sections or
fracturing the formation to create passageways for
the resource to migrate to the well bore. Unconventional or continuous-type gas accumulations have
received increasing attention by the U.S. domestic
petroleum industry during the past decade. Basincentered gas accumulations (Fig. 2) may be partially
developed by the recompletion and stimulation of
wells that have depleted shallower conventional
pools. If new wells target the continuous-type
accumulation, the drilling risk is dominated by
failure to stimulate or complete the well so that
commercial flow-rates are attained, rather than by
missing hydrocarbon-charged sedimentary rocks.
Most of the wells drilled in continuous-type accumulations are classified as development wells. In this
article, only exploration for conventional discrete
accumulations is discussed.
Outside of the United States and Canada, oil and
gas exploration is still directed to discrete conventional
accumulations. Nonetheless the in situ hydrocarbon
resources in the continuous-type accumulations are
substantial, and the costs incurred in drilling and
producing such resources provide a backstop or upper
bound to the costs that should be incurred in finding
and developing discrete conventional accumulations.

3. DISCOVERY PROCESS OF
CONVENTIONAL OIL AND GAS
Physical properties of the occurrence of oil and gas
fields tend to cause regularity in the process of oil and
gas discovery. The regularity provides the basis of
predicting yields of future exploration from estimated undiscovered resources. Oil and gas deposits
occur in sedimentary basins. Within a basin, discoveries are typically classified into sets of geologically similar deposits that are called petroleum plays.
The petroleum industry uses the concept of the
petroleum play, commonly identified in terms of a
geologic formation or strata, as a basis to classify
targets in a basin geologically.
The observed size-frequency distributions of discoveries in most petroleum plays and provinces are
highly skewed. A very small proportion of the
accumulations contain most of the discovered
resource. Figure 3 shows the frequency-discovery
size distribution of oil and gas fields discovered
in the Permian basin of the United States through
1996, and Table I shows volumes of hydrocarbons

538

Oil and Natural Gas: Economics of Exploration

4000

Number of oil and gas fields

3500
3000
2500
2000
1500
1000
500
0
0.5<1 1<2 2<4 4<8 8<16 16 32 64 128 256 512 1024
<32 <64 <128 <256 <512 <1024 <2048
Field size (MMBOE)

FIGURE 3 Histogram showing the size-frequency distribution of oil and gas fields in the Permian basin discovered through
1996. One barrel of oil equivalent 6 thousand cubic feet of gas. MMBOE millions 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.

TABLE I
Proportion of Total Petroleum in the Permian Basin Contained in Various Size Classes of Fields
Fields
Size classa (BOE)

Number

Petroleum

Cumulative percentage

Percentage in size class

Cumulative percentage

20484096

0.02

4.86

4.86

10242048

0.10

12.14

17.01

5121024

14

0.38

19.05

36.05

256512

27

0.93

17.43

53.48

128256

35

1.64

11.23

64.71

64128

61

2.87

9.92

74.63

3264
1632

91
133

4.71
7.40

8.01
5.61

82.64
88.25

816

216

11.76

4.66

92.91

48

267

17.15

2.85

95.76

24

344

24.11

1.85

97.61

12

432

32.83

1.15

98.75

0.51

481

42.55

0.64

99.40

0.250.5

495

52.56

0.33

99.73

0.1250.25
0.06250.125

483
451

62.32
71.43

0.16
0.08

99.89
99.97

1414

100.00

0.03

100.00

o0.0625
a

In millions of barrels of oil equivalent (BOE) where 1 barrel of oil 6 thousand cubic feet.

associated with each discovery size class. The


Permian basin, located in Southwest Texas and
Eastern New Mexico, is the most prolific oilproducing basin in the conterminous United States.

The largest 27 fields (or 0.55% of the fields) contain


more than half of the hydrocarbons discovered to
date, whereas the 1414 fields in the smallest size class
(less than 60 thousand barrels of oil equivalent,

Oil and Natural Gas: Economics of Exploration

discovery sizes (in barrels of oil equivalent) from


1920 to 1996 in 5-year increments for the Permian
basin. The regularity of the discovery process allows
the expected yields of future exploration to be
computed with simple analytical models. The discovery rate (yield per exploratory well) is controlled
by the sizes of fields discovered and the order of
discovery.
The exploration histories of many of the basins in
the United States follow predictable patterns. Newfield wildcat wells were drilled in unproven plays at
low but irregular rates. After a significant discovery
is made, there is typically an influx of new
prospectors and much higher levels of drilling;
similar to the 19th century gold rushes. Drilling
rates eventually weaken as returns deteriorate and
exploration in other plays or basins becomes more
attractive. As other plays in the basin are tested, then
the process repeats itself following another significant discovery in an unproven play. An efficient
exploration process, where the larger accumulations
are found early, results from physical characteristics
of the size distribution of oil and gas deposits in
nature even when wells are randomly sited. If the
industry is reasonably efficient in finding the largest
and lowest cost accumulations early in the discovery
process, then the past discovery sequence provides
information useful in estimating the magnitude and

where one barrel of crude oil equals 6000 cubic feet


of gas or 1.5 barrels of natural gas liquids) account of
only 0.03% of the hydrocarbons.
The shape of the Permian basin discovery size
frequency distribution is typical of most plays and
basins; most of the hydrocarbons are found in a few
very large accumulations or fields. Exploratory
drilling success-ratios (successful wells to wells
drilled) provide no information about the sizes of
future discoveries. The large number of small
accumulations determines success ratio levels. The
largest field, containing nearly 2.6 billion barrels of
the oil equivalent, is at least six orders of magnitude
larger than the fields in the smallest size class. If the
x-axis had not been in log base 2, the size classes for
the smallest category and the largest category could
not have been graphed without a break in the axis.
Assuming the surface expression of a deposit is
roughly proportional to its volume, then even with
random drilling the average discovery sizes would
decline with equal increments of exploratory drilling,
as the largest deposits are found early in the
discovery process. For example, the surface area of
the 6 billion barrel East Texas field covers more than
200 square miles. Any improvement over purely
random drilling quickens the early discovery of large
fields and accelerates the decline in the discovery
rate. Figure 4 shows the progression in the average

250

200
Million of BOE per discovery

150

100

50

9596

9094

8589

8084

7579

7074

6569

6064

5559

5054

4549

4044

3539

3034

2529

0
2024

539

5-year average starting 1920

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.

540

Oil and Natural Gas: Economics of Exploration

characteristics of the undiscovered resources. For


areas where field size is narrowly defined (such as the
sum of only proved reserves plus past production),
adjustments may be required to the estimated sizes of
recent finds to allow for their full delineation so as
not to overstate discovery decline in sizes.
In the United States, a relatively small proportion
of 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 through
1998, expressed in barrels of oil equivalent for the
U.S. onshore basins located in the conterminous
United States. The distribution represents 57 onshore
lower 48 provinces that were delineated and assessed
by the U.S. Geological Survey for the 1995 National
Assessment of Oil and Gas Resources. Table II lists

30

Number of USGS provinces

25

20

15

10

0
<0.5

0.5<1.0

1<2
2<4
4<8
8<16 16<32
Known recovery for province (BBOE)

32<64 64<128

FIGURE 5

Histogram showing the cumulative discovered through 1998 hydrocarbon volumes-frequency distribution for
U.S. basins through 1998. BBOE billions 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
3. Anadarko Basin

34.4
5.0

102.3
157.1

6.5
5.6

55.7
34.8

1920
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

a
Units abbreviations: BBO billions of barrels of crude oil, TCF trillions of cubic feet of gas, BBL billions of barrels of natural gas
liquids, BBOE billions of barrels of oil equivalent. Gas and natural gas liquids conversion factors the following: 1 barrel of oil
equivalent 6 thousand cubic feet gas 1.5 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.

Oil and Natural Gas: Economics of Exploration

the known recovery for the ten leading onshore


provinces and the discovery date of the first field
having at least ten million barrels of oil equivalent.
Four of the 57 provinces with the largest known
recovery account for 63% of the petroleum discovered to date, and the top nine have more than
80% of the discovered petroleum. On a worldwide
basis, relatively few provinces contain most of the
hydrocarbons discovered to date.
Commercial petroleum was discovered in the
United States in the middle of the 19th century. Just
50 years later, at the end of 1901, petroleum
provinces containing more than half the known
petroleum recovery (oil and gas) in the onshore lower
48 states had reported at least one discovery of at
least 10 million barrels of oil equivalent. By the end
of 1920, the basins that contained 94% of oil and gas
discovered through 1998 had already been explored
sufficiently, so that in each basin at least one field of
10 million barrels of oil equivalent had been
discovered. The exploratory drilling through 1920,
however, represented only a small percentage, less
than 5%, of total exploratory drilling through 1998.
Most onshore exploratory drilling since 1920 in the
lower 48 states has been follow-up drilling in these
and other less prolific basins.
Exploration access, distance from market, and
technology are factors determining the order in
which basins are explored. In the very early periods
of the U.S. petroleum industry, search intensity was
influenced by the costs of transporting and marketing
petroleum. Some of the remote prolific basins were
not explored as early as those closer to market areas.

4. EXPLORATION: INDIVIDUAL
FIRM DECISIONS
Exploration expenditures are direct investments
made by individual firms for the purpose of locating
unidentified, but potentially commercial quantities of
oil and gas. For an individual firm, exploration often
begins with a hypothesis about the formation of
hydrocarbon accumulations in a specific geologic
setting. The process typically starts with a literature
search to identify potential geographic locations
where the hypothesis might be tested. The selection
of a target area includes review of geologic maps,
reconnaissance-type geochemical data and geophysical data compilation from the open literature and
from commercial vendors. Fieldwork is often required to verify interpretations and to collect

541

additional data to identify specific drilling targets.


During drilling, data are continuously collected and
interpreted to maximize the chances of locating
significant accumulations. With the location of
hydrocarbons, additional geologic and economic
analysis will determine chances of a commercial
discovery.
The economic theory that explains how firms set
the optimal level of exploration expenditures is
complex and beyond the scope of this article. The
discussion that follows is highly simplified, but readers
primarily concerned with public policy and trends in
exploration and discoveries may wish to skip it.
Economic determinants of exploration investment
are typically studied in the context of a representative
firms planning strategy. Suppose we consider a
representative firm that searches for and produces
oil in several areas over several time periods. The
optimal plan tells the firm how much oil to produce
each time period and the level of investment
expenditures in production facilities and exploration
to make (both regionally and temporally) so as to
maximize the present value of its net cash-flow
stream over the planning period.
In general, the optimal strategy is to increase oil
production (extraction per time period) until the
marginal cash profit (revenue minus operating costs)
is balanced with the present value of the user costs.
Simply, user costs represent the opportunity costs
associated with producing and using a unit of
resource now rather than postponing it. Specifically,
it consists of the sum of (1) the future value of a unit
of production retained in the ground instead of
produced and (2) the cost, in terms useful life of
production facilities if the unit of resource is
produced at the present time. The value of retaining
the unit in the ground is linked to the ease of
replacement of that unit. For example, the value of
postponing production may be small if discovery
costs are low, that is, if replacement is easy, or if
future resource prices are expected to decline because
a cheaper substitute can fill demand. Marginal
discovery or finding costs are sometimes used to
approximate user costs. The greater discovery costs
to replace that unit, the greater the user costs that
pushes the representative firm to postpone production of that unit.
Abstracting from effects of uncertainty for the
moment, for each time period exploration expenditures should be set to where the marginal discovery
costs of new reserves equals the marginal value of
newly discovered reserves. This value, in turn, is
related to the user costs associated with the extraction

542

Oil and Natural Gas: Economics of Exploration

rule discussed in the previous paragraph. If the firm


can put value on additional variables related to, for
example, its experience in an area, then it should try
to include these benefits in its decision.
Exploration strategy is coordinated with production and investment strategies to ensure that overall
costs are minimized and the present value of net
income optimized for the entire planning period. For
an individual firm operating in multiple areas, if its
threshold hurdle rate (required rate of return on
capital) cannot be achieved in the region, or if it has a
host of other more attractive opportunities elsewhere, then for that area, the firm will withdraw
exploration, sell off prospects, and deplete producing
properties.
Uncertainty in the returns to exploration effort
leads to a departure from the strategy described
earlier. The magnitude of this effect depends on a
firms risk tolerances, how uncertainty affects marginal product of exploration, and the perceived risk
of ruin. However, viewed at the industry level, there
is a distribution of industry hurdle rates of return and
risk tolerances. This distribution ensures that information generated by the exploration process
that is, marginal discovery costsis not an artifact of
a single firms behavior, but is representative of the
industry and thus has general value for assessing
future industry prospects.
Though many authors have proposed elegant
theoretical models of how firms make extraction,
investment, and exploration decisions, there is still a
surprising lack of empirical research that tests and
verifies the hypotheses that have been generated.

5. INDUSTRY: EXPLORATION AND


PUBLIC POLICY
At the industry level, production, investment, and
exploration patterns are examined for their consistency with the representative firms optimal strategy
and in the context of certain public policy questions.
For example, the government might institute incentives designed to encourage domestic oil and gas
exploration effort in order to maintain domestic
production capacity. In addition to direct tax
incentives and subsidies for exploration, the other
government policy instruments include access to
minerals on public lands, research and development
policy, import quota/tariff policy, and direct price
controls. All of these instruments have, to some
extent, been used during the history of the U.S. oil
and gas industry.

The standard formulation of the economic theory


of exhaustible resources, as proposed by economist
Harold Hotelling, asserts that the net prices of in situ
finite resources should increase at the rate of at least
the current rate of interest. Hotellings theory rests
on the assumption of a fixed stock of reserves that
can be produced at will. However, proved reserves of
oil and gas can be augmented through exploration or
through more intense development. Production rates
of oil and gas wells are constrained or limited by
reservoir pressures. It is not surprising that many
empirical studies have failed to verify the na.ve
predictions of the Hotelling theory. When exploration is modeled at the industry level, the derived
theoretical implications are rarely unambiguous.
A broader question relating to public policy is
whether industry exploration costs and actions
accurately indicate future prospects of oil and gas.
If the finding costs accurately reflect the costs
associated with replacement costs of current proved
reserves, then trends in such costs could foreshadow
future supply problems. Finding costs, however, are
not directly observable from industry or government
data sources. It may take years for new finds to be
sufficiently developed so that their size can be
accurately estimated. Though discovery costs are
not directly observable, the locations, search intensity, and the apparent risks the industry accepts
reflect its assessment of remaining domestic and
worldwide oil and gas exploration prospects.
If it is assumed that each firm will equalize the
marginal costs of additional reserves either through
exploration, intensive development that adds reserves, and purchase, then one can infer from market
transactions prices the approximate industry finding
costs. Empirical studies of oil and gas property
transactions values show a rather consistent pattern.
Developed in-ground oil and gas reserve prices hover
at about one-third wellhead prices or at half of net
prices, which are the wellhead prices minus all
operational costs including taxes.
For the individual firm, exploration effort can be
expected to increase until marginal finding costs
equal user costs. User cost represents the benefits of
adding resources to reserves. Empirically, user costs
are measured as the difference between the in-ground
market value of the developed proved reserves and
the development costs. User costs embody the future
price expectations of market agents, just as the
valuation of properties embodies future reserve price
expectations.
For the U.S. petroleum industry, oil price expectations are set in world markets but natural gas price

Oil and Natural Gas: Economics of Exploration

12000
Millions of dollars per year

2500
2000
1500
1000
500
0

10000
8000
6000
4000

19
77
19
79
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
19
9
19 7
99
20
01

2000

Year
United States

Foreign

19
77
19
79
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
19
9
19 7
99
20
01

Exploratory wells per year

3000

543

Year
United States

Foreign

FIGURE 6 Number of total oil and gas exploration wells


drilled by the group of Financial Reporting System (FRS)
companies in the United States and foreign countries. Data from
EIA, Performance profiles of major energy producers 2001, 2003.

FIGURE 7 Total oil and gas exploration expenditures by the


group of Financial Reporting System (FRS) companies in the
United States and foreign countries. Data from EIA, Performance
profiles of major energy producers 2001, 2003.

expectations are set by the expected demand supply


interaction within North America. The unprecedented increase in perceived U.S. user costs during
the late 1970s and early 1980s led to record drilling
levels and oil finding costs in the lower 48 states but
failed to significantly increase proved reserves. User
costs as well as exploration activity declined in the
United States as world crude oil prices plummeted in
1986 to half the levels that prevailed in 1985.
The U.S. Energy Information Administration
compiles and reports the financial accounts, called
the Financial Reporting System (FRS), for the group
of firms representing the largest domestic crude oil
producers. Although there have been changes in the
composition of the FRS firms over the years, these
firms are the leading U.S. oil and gas producers. The
report includes financial expenditures on exploration
including numbers of wells drilled, oil and gas
production by the country where the producing
property is located, and investment expenditures.
Figures 6 and 7 show U.S. and foreign exploratory
wells and expenditures reported for the FRS firms.
During the early 1980s, both domestic exploratory
drilling and exploration expenditures substantially
exceeded exploration outside the United States. Since
the late 1990s, domestic and foreign exploration
drilling and expenditures by these firms have been
about equal. The volume of crude oil production
from foreign properties for the FRS firms has steadily
increased, and in 1997 it exceeded oil production at
U.S. properties. Within the United States since 1993,
more than half the FRS firms domestic exploration
expenditures have targeted offshore prospects, principally in the deep water of the Gulf of Mexico. In

summary, the industry exploration trend demonstrated by the FRS group of firms (representing the
industry leaders) has been to focus exploration effort
in the deepwater offshore areas and countries outside
of the United States where the opportunity to discover large accumulations is greater.

6. U.S. EXPLORATION: MARKET


FAILURE AND REGULATION
The U.S. petroleum industry is a mature industry. U.S.
crude oil production reached its peak in 1970, and
gas production reached its peak in 1971. In 2000, the
United States produced 5.86 million barrels per day
of crude oil, or 8.7% of the worlds production. It
also produced 20.1 trillion cubic feet of gas, which
represents about 23% of the worlds gas production.
During the history of oil and gas exploration in the
United States, the combination of private ownership
of mineral rights and the competitive market forces
produced excesses in exploration and production that
ultimately resulted in government regulation. Actions
that were rational from an individual firms perspective turned out to be very costly from societys
standpoint. Although some of these inefficiencies are
in the past, they are reviewed here to provide insight
into the regulatory environment.

6.1 Externalities and Regulation


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

544

Oil and Natural Gas: Economics of Exploration

transferred to the private sector for exploration and


production. Several systems were used to transfer
mineral rights to the private sector in the past. A
comprehensive analysis of these systems with respect
to economic efficiency and governments ability to
capture economic rents is beyond the scope of this
article. However, where significant hydrocarbons are
expected, the method now used to transfer of oil and
gas rights to the private sector is the sale of leases
through a competitive bidding system.
Private ownership of mineral rights resulted in
what economists refer to as market failures and led
to governmental regulations to remedy these failures.
Because an oil or gas pool can extend over several
parcels, there could be a number of different
property owners with a claim to the oil or gas in a
common pool. This is the common property or pool
externality. An externality occurs when the welfare
of an individual depends directly not just on the
individuals activities, but also on activities controlled by some other economic agent. For example,
pollution generated upstream affects the welfare of
downstream water users.
In the absence of regulation, oil and gas resources
were subject to the rule of capture. Historically, the
owner who first discovered the pool would start
immediately to intensively drill and produce the
resource. In the subsurface, oil and gas flows to
where there is a reservoir pressure differential; so by
quickly drilling production wells, the first producer
could drain resources from neighboring owners. The
neighboring owners must exploit their part of the pool
as quickly as possible just to avoid losing resources to
the early producer. This practice accelerated exploration and resulted in too much exploration and too
rapid production of the resource. The accelerated
production reduced the quantity of the resource that
could ultimately be recovered from the pool.
Even when oil prices collapsed, production would
not decline because each producer feared having
ones own part of the pooled drained by a neighbor.
In the leading oil-producing states, government
regulators instituted pro-rationing that limited production for each well to an allowable rate per month
and set minimum spacing for wells. Well-allowable
rates were set to restrict oil supply in order to
establish a floor on wellhead prices. For many states,
pro-rationing remained in effect until the early
1970s, when the first Arab oil embargo occurred.
State regulatory commissions and the federal government now require that production of newly discovered pools be unitized among the owners to avoid
the common pool externality and to assure that

potentially recoverable resources are not lost by early


overproduction.
Information is crucial to the competitive exploration process. During the period when the rule of
capture rewarded early exploration, a system of
scouting services was developed in the industry. The
domestic and international scouting services report
to subscribers land acquisition transactions, wellpermitting applications, drilling activities, and postdrilling actions of firms exploring an area. The
information generated by discoveries and dry holes is
valuable to neighboring leaseholders and other
exploration firms who have not taken the risk of
actually drilling. The benefits from observing the
outcome of drilling without bearing the risk is an
externality known as an information spillover. In
fact, some Canadian provincial governments lease
tracts in a checkerboard fashion to maximize their
benefits as the ultimate owner of the resource of such
information spillovers.
With the general adoption of forced unitization of
new discoveries during the last half of the 20th
century, major integrated companies followed the
strategy of taking large land positions around a
prospect and farming out small parcels to an
independent firm (operator) in exchange for drilling
a risky wildcat well. In many cases, the independent
operator has a lower cost of capital than the major
firm, because the independent can fund the well
through limited partnerships that provide tax benefits
to individual investors. With this system, the firm that
actually drilled the discovery well received only a
small fraction of the actual discovery. For example, in
the Denver basin from 1949 through 1974, the
independent firms were credited with drilling discovery wells for fields representing 75% of the
reserves but ended up owning only 21% of the
reserves in those deposits. The remaining reserves
were credited to the major companies because of their
dominant land positions.

6.2 Federal Policies to


Promote Exploration
The federal government has encouraged oil and gas
exploration during most of the 20th century by
favorable income tax treatment, specifically through
a provision known as the percentage depletion
allowance. Favorable tax treatment for petroleum
investments enabled promoters and operators of
independent firms to raise significant amounts of
money by offering tax shelter plans to fund this

Oil and Natural Gas: Economics of Exploration

545

drilling. During the peak years of exploratory drilling


from 1981 to 1982 in the United States, most of the
exploration wells drilled were funded through such
arrangements. This funding was reduced dramatically when the Tax Reform Act of 1986 significantly
reduced tax rates and rescinded part of the tax code
favorable to such tax shelter funds.
During the 1950s and the following decade, the
federal government imposed quotas on imported
crude oil. The stated purpose was to maintain
domestic crude oil production capacity for national
security reasons. The quotas had the effect of
insulating domestic prices from lower world prices
and providing the necessary incentives for exploration and production of domestic resources. Import
quotas were rescinded as domestic oil production
approached its peak in 1970 and it was clear that
supply would not grow as rapidly as U.S. demand.

revert to the government for use by subsequent


concessionaires. The agreement will also specify what
rights, if any, the exploration firm might have in the
event of a discovery. Once a discovery is made, a
production concession is negotiated, often requiring
the private company to share production with the
state oil company or to assume the role of contract
producer with payments taken in kind as a percentage
of production.
Each government has a different set of contract
provisions and production taxes designed to attain a
specific set of policy goals. These goals may include
training and employment of local workers, construction of infrastructure, and provision of social services
to the local communities. Moreover, the governments
typically reserve the right to tailor provisions on an
individual basis. A description of these provisions is
well beyond the scope of this article.

7. INTERNATIONAL OIL AND GAS


EXPLORATION PROVISIONS

8. TRENDS IN EXPLORATION
AND DISCOVERY

Since the early part of the 20th century, British,


Dutch, and French oil companies have explored for
and produced oil internationally, starting with their
former colonies. After World War II, all major U.S.
companies initiated international exploration to
various degrees.
Outside the United States, national governments
typically control ownership of mineral rights. The
rights to exploration concession areas are negotiated
with the central governments. Although some of the
European countries with North Sea production
follow an auction system, in some ways similar to
the U.S. system, they still maintain tight control of
resource development. Many leading oil and gasproducing countries require separate exploration and
production agreements. For some countries, including those in the Middle East, Mexico, and Venezuela,
petroleum exploration and production is almost
entirely controlled by the state oil company, and
foreign companies, if allowed at all, are used on a
contract basis.
For countries that permit foreign participation,
exploration concessions typically require a work
commitment including investment in data collection
and a specified number of wells drilled in exchange
for the right to explore. The concession areas are
sufficiently large so that a field will have a single
owner, thereby eliminating common pool externalities. In addition, the concession contract will specify
that all data collected by the concessionaire should

8.1 Drilling Activity


Summaries of the total numbers of wells drilled
outside the United States are published by country in
the journal World Oil and the American Petroleum
Institutes Petroleum Data Book. Data show that the
percentage of worldwide annual drilling represented
by the wells drilled in the United States went from
80% in 1970 to 30% in 2000. In 1950, the United
States accounted for 52% of the worlds crude oil
production, but by 2000 its share had fallen to less
than 9%. The time profiles of new field wildcat wells
(successful and dry) drilled each year since 1950 for
each of three country groups are shown in Fig. 8. The
drilling records for some countries are undoubtedly
incomplete, but the graph illustrates the decline in
U.S. new field wildcat drilling as well as the decline in
the U.S. share of world new field wildcat drilling
after 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 for
reporting reserves or sizes of discoveries. In some
countries such as the United States and Canada,
reserve definitions are very conservative because
they are tied to production facilities and economic conditions. In other countries, the definition
of reserves is broader, reflecting the volumes of

546

Crude oil in billions of barrels per year

Oil and Natural Gas: Economics of Exploration

New field wildcat wells per year

10,000
8,000
6,000
4,000
2,000

40
30

Western
hemisphere

20
10

0
1910

1930

FIGURE 8 Time profile of new-field wildcat wells drilled in the


United 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 Petroleum
Data Book.

hydrocarbons that are technically recoverable without reference to being commercial. The discovery
data presented in Figs. 9 and 10 must be viewed with
this caveat in mind.
Figure 9 shows the annual oil discovery rate,
averaged over 5-year intervals, that started in 1915
and annual production. The reported discoveries are
in fields that can be produced with conventional
production methods. The dominance of the Eastern
Hemisphere is striking. It is likely that new discoveries
will be revised upward as these fields are delineated
and developed, so the sharp decline in overall
discoveries is likely to be moderated. The peak levels
of discovery from 1955 to 1965, however, will not be
repeated. During this period, the Middle East
accounted for about half of the discoveries worldwide.
World production declined in response to the economic recession between 1980 and 1985, but it began to
increase after 1986. It now appears to substantially
exceed the past two decades of discoveries.
Figure 10 shows the natural gas discovery rate and
production for the world. The Eastern Hemisphere
discoveries dominate. The best years for discoveries
of gas worldwide were from 1965 to 1970. During
this period, the former Soviet Union accounted for
two-thirds of all gas discoveries. During the 1970s,
many of the largest gas discoveries were in the
offshore areas of the North Sea and the Middle East.
Figure 10 shows that gas production accelerated

1950

1970

1990

Years

FIGURE 9 Estimated world annual crude oil discovery rate


averaged over 5-year periods and annual production. Bottom
section of bar is Western Hemisphere and top is Eastern Hemisphere. From U.S. Energy Information Administration, I.H.S.
Energy Group, International Petroleum Exploration and Production Data Base, 2002, and Canadian Association of Petroleum
Producers, Statistical Handbook, 2002.

Natural gas in trillions cubic feet per year

Year
United States
Mexico, Canada, S. America
Eastern Hemisphere

Annual
production

Eastern
hemisphere

19
50
19
55
19
60
19
65
19
70
19
75
19
80
19
85
19
90
19
95
20
00

50

300
250
Annual
production

200
150
100

Eastern
hemisphere
Western
hemisphere

50
0
1910

1930

1950

1970

1990

Years

FIGURE 10 Estimated world annual natural gas discovery rate


averages over 5-year periods and annual production. Bottom
section of bar is Western Hemisphere and top is Eastern Hemisphere. From U.S. Energy Information Administration, I.H.S.
Energy Group, International Petroleum Exploration and Production Data Base, 2002, and Canadian Association of Petroleum
Producers, Statistical Handbook, 2002.

during the late 1980s. Estimates of the size of gas


reserves are probably underreported because gas is
not commercially marketable in many parts of the
world. Consequently, the reported discovery rates
shown in Fig. 10 are probably underestimated.

9. CONCLUSIONS
This discussion has identified the determinants of
oil and gas exploration, considered the effects of

Oil and Natural Gas: Economics of Exploration

mineral property ownership on exploration rates,


and examined empirical data showing the worldwide
oil and gas discovery rates. Because of the way oil
and gas occurs in nature, the statistics generated by
the discovery process provide the basis for predicting
the potential future availability of resource supply
from conventional accumulations. As discovery rates
inevitably decline and discovery costs increase,
resources that are brought to market will, in all
likelihood, come increasingly from oil and gas
accumulations that are unconventional.

SEE ALSO THE


FOLLOWING ARTICLES
Markets for Natural Gas  Markets for Petroleum 
Natural Gas Resources, Global Distribution of  Oil
and Natural Gas Drilling  Oil and Natural Gas
Exploration  Oil and Natural Gas Leasing  Oil and
Natural Gas Liquids: Global Magnitude and Distribution  Oil and Natural Gas Resource Assessment:
Classifications and Terminology  Oil-Led Development: 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 19451986. In Advances in the Economics of
Energy and Resources (J. Maroney, Ed.), pp. 1158. JAI Press,
Greenwich, CT.
Adelman, M. A. (1993). Modeling world oil supply. Energy J. 14,
132.
Adelman, M. A., De Silva, H., and Koehn, F. (1991). User cost in
oil production. Res. Energy 13, 217240.

547

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. 131183. 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. 22642277. 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, 12791290.
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, 137175.
Klett, T. R., Ahlbrandt, T. S., Schmoker, J. W., and Dolton, G. L.
(1997). Ranking of the worlds oil and gas provinces by known
petroleum volumes. U.S. Geological Survey Open File Report
97463, one CD-ROM. Washington, DC.
McDonald, S. L. (1994). The Hotelling principle and in-ground
values of oil reserves. Energy J. 15, 117.
Securities and Exchange Commission (1981). Regulation S-X Rule
4010, Financial Accounting and Reporting Oil and Gas
Producing Activities, Securities and Exchange Commission
Reserves 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. 557578.
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.