What it means
Oil and gas exploration is a game of probabilities. Geologists use seismic surveys and other data to choose drilling locations, but nobody can be certain what lies thousands of feet underground until the well is drilled.
Even in good areas, a significant share of exploratory wells find nothing commercial. A well can be dry for several reasons.
It may find no hydrocarbons at all, it may find them in amounts too small to justify the cost of production, or the rock may be too tight for the oil or gas to flow. In each case the company has spent millions of dollars and must decide whether to plug and abandon the well, which means sealing it safely and restoring the site.
The accounting treatment depends on the method the company uses. Under the successful efforts method, the cost of drilling a dry exploratory well is expensed immediately, which reduces profit in that period.
Under the full cost method, all exploration costs, including dry holes, are added to a pool of capitalised costs and written off gradually as production occurs. Because of this difference, two companies with identical results can report different profits in the same year.
Analysts therefore look at measures such as the exploration success rate, the finding cost per barrel and the cash flow before exploration costs. Investors also check how much of a company's budget is going into high-risk exploration compared with lower-risk development drilling.
Companies manage the risk in several ways. They share wells with partners so that no one bears the entire cost, they drill a portfolio of prospects rather than a single bet, and they use better technology to improve their odds.
Tax rules in some countries also allow deductions for dry hole costs, which softens the blow.
In practice
Real-world examples.
Example
A small oil company drills an exploratory well at a cost of $7,000,000 and finds only water. Under the successful efforts method, the finance team records the entire $7,000,000 as an expense in the period. The company's quarterly profit falls sharply as a result.
Example
A large energy group takes a 20% share in a risky offshore well alongside partners. The well is dry, and the group's share of the loss is 20% of $50,000,000, or $10,000,000. Spreading the risk means that a single failure does not threaten the group.
Example
An investor compares two exploration companies. One reports a 40% success rate and the other a 15% success rate, but the second drills in untested areas where one success could be very valuable. The investor decides that the figures must be judged along with the size of potential discoveries.
Formula
Calculation
Cost per successful well = Total drilling cost of all wells / Number of successful wells
Exploration success rate = Successful wells / Total wells drilled
Worked example: a company drills 8 exploratory wells at $5,000,000 each, and 2 of them find commercial oil.
Step 1: Total cost = 8 x $5,000,000 = $40,000,000
Step 2: Dry holes = 8 - 2 = 6, with a cost of 6 x $5,000,000 = $30,000,000
Step 3: Success rate = 2 / 8 = 25%
Step 4: Cost per successful well = $40,000,000 / 2 = $20,000,000
Each successful well effectively costs $20,000,000 once the dry holes are included, which is four times the cost of drilling one well.Case study
Seen in the real world.
Sandstone Ridge Petroleum is an illustrative, fictional company with a drilling budget of $60,000,000 for the year. It planned six exploratory wells at $10,000,000 each, expecting about one in three to be commercial.
Four of the wells turned out to be dry, and two found oil. The dry holes cost $40,000,000, which was expensed under the successful efforts method, so the company reported a loss for the year even though the two discoveries had considerable future value.
The chief financial officer explained to investors that the loss reflected the accounting rules and that the cash cost per discovery was $30,000,000. The illustrative lesson is that dry holes are a normal cost of exploration, but they must be planned for and explained clearly.
Watch out
Common mistakes.
- Treating a dry hole as a sign of poor management, when even skilled teams drill unsuccessful wells.
- Comparing profits of companies using different accounting methods, when dry hole costs are treated differently.
- Ignoring the cost of plugging and abandoning, when closing the well safely adds to the total cost.
Questions
People also ask.
What is the difference between a dry hole and a producing well?
A producing well finds oil or gas in commercial amounts, while a dry hole does not.
How is a dry hole recorded under successful efforts?
The drilling cost is expensed in the period, which reduces reported profit immediately.
How do companies reduce dry hole risk?
They use seismic data, drill several prospects, share costs with partners and apply lessons from previous wells.
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