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340 APPLICATION OP LAW OP EQUAL BZPBCTATION8

year. Find this amount on the left margin and trace the line to the
right to a point where it intersects the family curve, follow the vertical
line through this point upward to its intersection with the future produc-
tion curve, thence to the left margin of the figure. The reading is the future
production of the well selected. For example, take a well that made
20,000 bbl. during the first year, follow the horizontal line to the right
to its intersection with the family curve, thence upward to its inter-
section with the future production curve and thence to the left margin
where 53,000 bbl. is indicated as the average future production of a well
of that output. The estimate would have been correct if the production
of 20,000 bbl. represented the most recent year's production instead of
the first year's production.

Dbtebmining Average Life of Wells of Different Size

In the lower margin of Fig. 2 will be found figures that decrease to the
right. These figures represent the remaining average life of wells and
are determined by counting the years of remaining life for wells of differ-
ent output, as shown by the family curve. For instance, the remaining
life of the well that made 20,000 bbl. during the first year, by reading
downward on the vertical line passing through the point on the family
curve representing 20,000 bbl., is foimd to be 8 years. From this curve,
it is evident that the lives of oil wells vary directly as the volume of
production, for the larger the production, the longer the remaining life.

Ultimate Production Curves

If desired, the future production may be added to the last year's pro-
duction, which will give the ultimate production direct. These statistics
may be plotted for wells of different size and curves thus constructed.
Both this and the av^age future production curves may be plotted if
desired, although the ultimate production may readily be obtained by
first determining the future production and adding to it the past year's
production.

Another Method op Showing Future Production Curve

The curve representing future production may be expressed as an
average appraisal curve if desired. The appraisal curve was named by
Lewis and Beal,* and consists of showing the relation between the first
year's production of a well and its ultimate production. The suggestion
was made that additional curves showing the actual future could be
plotted by subtracting from the ultimate production the past year's



• Trans. (1918) 69, 492.



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CABL H. BSAL AND B. D. NOLAN



341



production. The future production curve, as arrived at by the family
curve, may be expressed in the same way; that is, the past year's pro-
duction may be used as the abscissa and the future production may be
shown as the ordinate. In this way, the curve begins a distance to the
right of the lower left-hand comer, which represents the minimum eco-
nomic production to which the average well in a district can be pumped,
and rises gradually to the right, having the same form as appraisal curves.
There is no particular advantage in this form of curve over curve A,
Fig. 2, which likewise represents future production directly.

Erratic Wells

In any field, certain wells will be found having a decline wholly differ-
ent from that of the family curve of that group; these usually are con-




12



U



10



87 6648210

Remaining Life of Well, ( Years )

Fig. 3. — Pboduction of brbatic wells plottbd on "familt" cubve to show
that such wells ubuallt decline along some part of the cttbye^after ebratic
PERIOD ends; records indicated bt a and B are wells in California field.

sidered abnormal wells. The causes of these wells may be divided
roughly into three classes — geological, accidental, and lack of histories
of wells. Geological causes may be either a very thick series of oil sands
with var3ring gas pressures or the comparatively sudden invasion of edge
water. In certain small districts, such as the area in Sec. 27, T. 19 S.,
R. 15 E. in the Coalinga field, or that near Fellows in the North Midway
field, the thickness of oil-bearing series is from 500 to 700 ft. (152.4 to
213.3 m.). Wells drilled through this thick series of alternating oil sands
and shales often show an increasing production for 2 or 3 years after
inception. After having reached their maximum, however, their de-
cline follows the family curve. The probable explanation of this increase
is as follows: Such wells penetrate a number of rich oil sands, but under



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342 APPLICATION OP LAW OP BQUAL EXPECTATIONS

varying gas pressures. When first brought in only those sands with the
higher gas pressiu-es are able to produce but time permits a lessening and
readjusting of the pressures and all sands are able to contribute to the
well's production. Curve A, Fig. 3, shows the production of a well of
this type and its relation to the family curve. Wells producing from a
sand suddenly invaded by water may show an increase in production just
prior to the appearance of the water, but almost invariably show a
rapid decline and a sudden end.

Accidental causes of erratic wells might also be called mechanical
causes. The ''oil string" may collapse, shutting off its production, or
a redrilling job may be a failure, causing the abrupt ending of the well's
life. In the loose unconsolidated sands of the California fields, shale
may cave in, shutting off the perforations. These accidents usually
cause a sharp break in the decline of the well and a consequent dropping
away from the family curve. After this initial break, its decline through
the remainder of its life usually follows some other part of the family
curve. The decline indicated by B, Fig. 3, is of such a well.

Another class of erratic wells that often cause trouble are those that
have been deepened. When a well is deepened into lower sands or is
redrilled, with a consequent opening of new sands, or possibly shutting
off other oil sands, it must be treated as a new well, and accordingly a
new part of the family curve selected as its decline curve.

Wells varying from the family curve sufl5ciently to be termed erratic
wells are rare, certainly less than 10 per cent, of the total wells in the Cali-
fomia fields. The divergence in most erratic wells takes place during
the first 2 or 3 years of the life of the well. From that time on, the out-
put of the well follows some part of the family curve.

Estimating Future Production op Wells Above and Below the

Average

Most weUs in a field will follow the family curve with fair exactness.
Some will trend slightly above it, follow it for a year or so, and finally
fall below. One is usually safe, however, in making estimates of the
future production, if he assumes the well to be an average well; he is
unwise, however, if he makes no effort to determine the amount a well
i9 above or below the average, for if it deviates far from the average the
estimate may and should be modified accordingly. Fortunately, as
most estimates of future production are made by using the last year's
production, the curve tends to correct itself by automatically shifting
the point on the family curve at which the estimate is made to the right
or left, according to whether the curve is below or above the average.
This may be more clearly shown by taking an example. Suppose well
At Fig. 3, has produced 2 years, as shown by A and A\] the estimate of



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CABL H. BBAL AND E. D. NOLAN 343

future production is made by applying the last year's production (indi-
cated by Ai) to the family curve, thus shifting the point Ai to the left
to where a horizontal line through it intersects the family curve. As
subsequent production from this particular well has proved (see points
A\, A'% and A'4), the estimate of future production would have been
slightly above the average curve.

Another example will serve to show the method by which the esti-
mates of future production of wells below the average will tend to correct
themselves. Suppose well B^ Fig. 3, has produced 2 years {B and B^^
an estimate of its future production will be made from point B\ on the
family curve. Subsequent production would indicate that the well pro-
duced along a curve (B'l, B'% and B'4) almost coincident with the family
curve. K estimates are made yearly, they become closer and closer even
though the well may produce along a curve considerably above or below
the average.

Family Cubvb Applied to Tract ob Pbopebties Production

Where the individual well records are lacking or where the average
well production is quite small, it may be either necessary or convenient
to construct a family curve for a group of tracts rather than for a group
of individual wells. Such curves when constructed from a number of
properties and applied to properties that are sufficiently drilled are quite
accurate.

Value of Family Curve

The greatest advantage of the family curve is the fact that it is based
entirely on history; it usually has no projections and it is not difficult to
prepare. Furthermore, its advantage over the appraisal curve is that it
can be prepared with less data. In fact, the statistics representing
the decline of a dozen wells might suffice for the preparation of a curve,
the decline of which represents the decline of wells of different size in an
area where conditions affecting production are practically equivalent.
The accuracy of the curve, however, is increased in direct proportion
to the number of records used in its preparation.

Another advantage over appraisal curves is that the future produc-
tion of a well from its first year can be estimated more readily when the
decline of the well is above or below the average. Owing to the fact that
the last year's production is used and that erratic wells after their abrupt
change follow a portion of the family curve, the curve reduces error to a
small amount, and tends to correct errors due to its own limitations.
The simplicity and completeness of the curve are the principal arguments
in its favor. One may read direct the future production of a well, its
probable life in years and its probable production in any year in the
future.



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344 ESSSNTIAL FACTORS IN VALUATION OF OIL PR0PBBTIE8



Essential Factors in Valuation of Oil Properties*

Bt Carl H. BsAL^t ^« A., San Francisco, Calif.

(ChioMO Blevting. Septombw. 1919)

The most important factors that should be given consideration in
the valuation of oil lands are: (1) the amoimt of oil the property will pro-
duce; (2) the amount of money this oil will bring (based upon the future
prices of oil); (3) development and production costs; (4) the rate of in-
terest on the investment; (5) the retirement or amortization of invested
capital; and (6) the salvage or ''scrap'' value of the equipment when the
property is exhausted. These factors are of varying importance and
some of them may not enter all valuation problems, but most of them
should be given consideration in any valuation even though only a rough
estimate of the value of the property is desired.

The value of a property may be changed over night by the completion
of important test wells, by the sudden water flooding, or by a change in
the price of oil. The best a petroleum engineer can give is the value of
the property imder the conditions existing at the time the appraisal is
made with a fair forecast of future action of the wells and of the price of oil.

Our experience in the scientific valuation of oil lands is not broad and
there is very little published information on the subject; it, therefore,
becomes necessary in stud3dng such problems to form comparisons with
the factors involved in the valuation of mines — ^the closest parallel.
One of the reasons for the lack of substantial progress in oil-land valua-
tion methods has been the necessity of making an estimate of the
future production of the oil property to be valued. Oil men and ac-
coimtants have not generally conceded that such estimates could be
made with any degree of accuracy. It has been shown, however, in
several recent publications that with certain data available reasonably close
estimates can be made. The accuracy of an appraisal depends chiefly
on the accuracy of the estimates of future production and of the future
price of oil. The accuracy of the former is sometimes necessarily based
on geological inferences. Geology is not an exact science and geological
data in connection with oil production cannot always be mathematically
evaluated.



* Published by permission of Director, U. S. Bureau of Mines,
t Petroleum Technologist, U. S. Bureau of Mines.



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CABL H. BSAL 345

FuTUBB Oil ob Expectation

In considering the factor of future oil, two related questions must be
answered: How much oil will the property produce? At what rate will
the oil be produced? If we can determine the future annual production
of an oil property, we may easily determine the total future production
by addition, so we will consider only the question of rate of future oil
production.

A satisfactory answer to this question is the ke3mote to the whole
valuation; for, although our work, has, by no means, been completed
after the question has been disposed of, the work of determining the value
of the property is greatly simplified, for on the yearly output of oil depends
the yearly gross income. From the gross income the annual net return
is computed, each year's return being considered in the light of a profit
available at a future date. The present value of these deferred profits
is then determined by discounting them at a rate of interest compatible
with the risk involved.

No uniform yearly revenue can usually be expected from an oil prop-
erty, for the annual output, and thus the annual income, depends on
the rate of production. Only under exceptional conditions can a steady
oil production be maintained for long unless the property is old and pro-
duction well settled. The future annual oil output Unges on the rapidity
with which new weUs are drilled and on the rate of production of the
individual weUs which, with very few exceptions, always declines.

RaU (UWhichOilWiUBeObtatned.—Thente of production of thewdls
will affect not only the rate of output of the old wells, but will regulate
that of the wells to be drilled. Furthermore, the decline in the initial
output must be considered; the longer the development of the proved
acreage is deferred, the less will be its ultimate production, for, under
usual conditions, the weUs on the drilled acreage cause a decrease in gas
pressure over the undrilled acreage, which results in decreased initial
production of the wells eventually drilled there. The rate at which oil
wells will produce is the resultant of many complex factors, which will
not be discussed here. For more information on this subject, the reader
is referred to a bulletin by the author.^

The most trustworthy method of determining the rate of production
of the weUs of a group is to prepare a production curve that will give the
average yearly output of weUs of different initial yearly output. It is
necessary to determine this for weUs of different initial production, be-
cause wells of different output decline in production at different rates —
other factors being equal.



1 Carl H. Beal: Decline and Ultimate IVoduction of Oil WeUs with Notes on the
Valuation of Oil Properties. U. S. Bureau of Mines Bull 177 (1919).



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346 ESSENTIAL FACTOBS IN VALUATION OF OIL PBOPEBTIE8

DriUing Program. — The rate of the productionof the property depends
not only on the rate at which the individual wells will produce oil but also
on the rapidity with which new wells are added to the producing list;
this depends on the drilling program. The valuation should not be
attempted until a drilling program is decided upon. But before a drill-
ing program can be determined, it is necessary to know the amount of
land that certainly will support commercially productive wells; trust-
worthy estimates of future oil production can be made only for the drilled
acreage and for the imdrilled proved acreage. Only such land furnishes
a concrete basis of value, for the annual production of oil can be esti-
mated; other land has a speculative value that varies with the uncertainty
of obtaining oil in commercial quantities. These tracts, if included,
should be valued separately and on a different basis.

Although there is no case exactly parallel in metal mining, the metal-
mining engineer refuses to commit himself on the value of a prospective
mine. The petroleiun engineer may determine the magnitude of the
risk and compute mathematically the probability of obtaining oil on a
tract of land; but the author is inclined to agree, in a measure, with
Rickard' that 'Hhe doctrine of probabilities has been stultified too
often to allow of its being stated as a scientific thesis."

In valuing the proved oil land, the engineer should compute the
value of the output of the property based on a drilling program that
will bring the maximum return in profits to the investor. It is true
that a variation in the drilling program sometimes will greatly reduce
the profits eventually gained from a property, but there can be only
one maximiun value and this is the one to be determined.

Classification of Land to be Valued

Before the future annual production can be estimated, it is necessary
to classify the land to be valued, to determine the amount of acreage
that will support new weUs. For this purpose the land is first divided
into drilled and undrilled. These two classes of acreage must be valued
separately.

Estimating the future production of the old wells usually is not
difficult, if production curves are available. Our greatest difficulty
lies in making estimates of the probable future production of the proved
undrilled acreage. Here we must be guided by imdergroimd geologic
conditions and by what the new wells probably will produce by comparing
the conditions under which they are to produce with the conditions
under which the nearby old wells are producing. The imdrilled oil



' T. A. Rickard: Valuation of Metal Mines. International Engineering Congxvn,
1915.



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GABL H. SEAL 347

land may usually be divided into the following four general classes:
Proved acreage, probable acreage, prospective acreage, and conimercially
non-productive acreage. Some engineers use much more detailed
classifications. These, the writer believes incompatible with the un-
certainty of imderground conditions. The following definitions are
advanced tentatively:

Proved acreage should include that in which drilling involves practi-
cally no risk. The following definition is proposed, which has been
modified from that given by R. P. McLaughlin.' ''Proved oil land is
that which has been shown, by finished wells supplemented by geologic
data, to be such that other wells drilled thereon are practically certain to
be commercial producers."

Probable oil land includes those areas generally adjacent to produc-
ing oil and gas wells where the existence of oil is not proved, but where
geologic evidence indicates a good chance of obtaining oil in commercial
quantities.

Prospective oil land includes those areas usually not adjacent to
producing oil and gas wells, where the existence of oil is not proved, but
where geologic data justifies drilling a test well. Land in this class is
distinguished from the probable oil land by the greater uncertainty of
obtaining oil owing, usually, to its location some distance from producing
oil and gas wells.

Commercially non-productive oil land is that on which commercially
productive wells cannot be drilled at present. The existence of oil
under the areas of this class may be proved, probable, or prospective.

Ebcceptions undoubtedly will be foimd in every class. For instance,
under some conditions, a person may feel warranted to place land in the
probable class when it is favorably located geologically, even though it
is several miles from producing wells, for the reason that the occurrence
of oil and gas with relation to certain geologic structures in that region
may be so certain as to make the chance of not obtaining some oil very
small. Furthermore, the classification of land may change rapidly,
owing to the drilling of new wells, damage by water, or change in price.
For example, an area that may be rated as commercially non-productive
may become commercially productive and proved with an increase in
the price of oil.

Future Pbice op Oil

The accuracy of any valuation depends on the price that is to be
received for the oil, for on it depends the net profit per barrel of oil
marketed. A small variation in the price of oil may mean the difference



* R. P. McLaughlin: Petroleum Industry of California. California State Mining
Bureau BuU. 69 (1914) 13.



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348 B8SENTIAL FAOTOBS IN VALUATION OF OIL PBOPEBTIES

between gain or loss. In fact, since the working out of new and mpre
trustworthy methods for more accurately estimating future oil produc-
tion, the estimation of the future price has become one of the most uncer-
tain elements to be contended with in oil land valuation.

The engineer, to make sound predictions as to the probable price of
oil, even during the immediate future, must possess a broad knowledge
of the petroleiun situation as regards supply and demand. Either
prices will be allowed to adjust themselves in accordance with the law
of supply and demand, or they will be manipulated by monopolies or
controlled by the Federal Government. If manipulation or government
control exists, or if there is a strong probability of their coming into
existence, the engineer should be guided accordingly. Otherwise, the
question of price must be answered solely by the domestic and foreign
oil situation. The past range of prices has often been great, but the
future probably will never see such low prices of oil. The market is
now more stable because the demand for the commodities made of
petroleum is greater and new oil fields are much more scarce and more
costly to develop.

The reason for the great demand for oil is primarily because of the
great demand for one of its products — gasoline. The great demand for
gasoline is created by the phenomenal development of the internal-
combustion engine. This development is, probably, by no means, com-
pleted. The adoption of oil as fuel by the great navies of the world and
the development and adoption of the Diesel engine have greatly increased
the demand for the heavier products of petroleum. Very likely the
future demand for oil and its products will not decrease.

The upward limit of prices is set by the cost of importing oil and
the cost of developing a supply of oil from oil shales, of which there are
immense deposits in this coimtry. By considering the status of the in-
dustry at the present time and these two limiting factors, the engineer
should be able to make reasonably sound estimates of the price of oil
for the next few years. Some engmeers find it advisable to use the present
prices as a basis of estimating the value of the property or to determine
the value of the property at several different prices of oil, and thus allow
the investor to select the one that, in his judgment, will best meet future
conditions.

Cost op Production and Development

In determining the future net receipts from each barrel of oil, the
cost of producing the oil must be subtracted from the gross income or
selling price. For the purpose of estimating future production costs,
including drilling charges, tankage, and, in fact, every charge that con-
tributes to the final total cost of production, the appraiser should refer to
trustworthy statistics and should be able to interpret these statistics in



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GABL H. BBAL 349

terms of probable future conditions. This, again, requires not only a
broad knowledge of the oil industry but also detailed knowledge of costs
in the locality where the property is situated.

Intxbbst on Imyesthent

The proper rate of interest to be received from an investment must
be such that capital will ^be attracted to the enterprise. If the risk
attached to the investment is great, the rate of interest on the money
invested must be high or investors cannot be found. The returns from oil
investments are always speculative to some degree, so the interest
demanded is usually high. If there is no risk, the investor can afford to



Online LibraryMetallurgical American Institute of MiningTransactions of the American Institute of Mining, Metallurgical, and Petroleum Engineers, Incorporated → online text (page 37 of 60)