What it means
Oil and gas companies use exploratory wells to test a theory. Geologists study rock formations and seismic images (sound-wave maps of underground layers) and then pick a spot they believe may hold hydrocarbons.
The only way to be sure is to drill, which is why these wells are sometimes called wildcat wells. An exploratory well that finds oil or gas in commercial quantities is called a discovery.
One that finds nothing, or too little to be worth producing, is a dry hole. Industry success rates are low enough that many companies budget for most exploratory wells to fail.
The financial stakes are high because drilling costs are paid in full up front and before anyone knows the result. A single offshore well can cost tens of millions of dollars.
For this reason, companies often share the risk by forming partnerships, with each partner paying a portion of the cost in return for the same share of any discovery. Accounting treatment depends on the method the company has chosen.
Under the successful efforts method, the cost of a dry exploratory well is charged to expense when the failure is clear, which hits profit straight away. Under full cost accounting, the cost stays on the balance sheet as part of a pool of exploration spending and is written off gradually.
Success changes everything. A discovery leads to appraisal wells (wells that measure how big the find is) and then to development drilling, with the earlier exploratory spend recognised as part of the cost of the asset.
A decision to go ahead depends on whether the discovered volume can pay back all of these costs at a conservative oil price. Managers outside the energy sector can think of an exploratory well as a research and development bet.
Most individual attempts lose money, but a portfolio of them can still deliver a strong return if the occasional winner is large enough. The skill lies in sizing each bet so that a string of failures does not threaten the whole business.
In practice
Real-world examples.
Example
A small energy company with limited cash sells a 50% stake in its planned wildcat well to a larger partner. The partner pays half of the drilling bill in return for half of any discovery. The small company can now afford to drill two wells instead of one.
Example
An exploration firm drills a well that finds gas but at pressures too low to produce profitably. Because the find is not commercial, the well is classed as a dry hole and its cost of $12,000,000 is expensed under successful efforts. Profit for the year falls by that amount.
Example
A government-owned oil company awards drilling blocks to private firms that must commit to a number of exploratory wells. The firms pay for all the drilling in exchange for the right to recover their costs from any oil found. If they find nothing, the state loses nothing.
Formula
Calculation
Expected value of a well = (probability of success x value if successful) - cost of drilling
Suppose a company plans an exploratory well that costs $15,000,000. Geologists estimate a 20% chance of success, and a discovery would be worth $200,000,000 in present value after development costs. Expected value = (0.20 x 200,000,000) - 15,000,000 = 40,000,000 - 15,000,000 = $25,000,000. The well fails four times out of five, but the average outcome is still positive, so it is worth drilling if the company can survive a dry hole.Case study
Seen in the real world.
Kestrel Ridge Petroleum is an illustrative, fictional company that drilled six exploratory wells over three years. Five were dry holes costing $10,000,000 each, and one made a discovery worth about $300,000,000 in present value.
The board nearly stopped the programme after the third dry hole because reported profit had turned negative. The finance director showed that the expected value of the programme was positive and that the company had enough cash to survive several failures in a row.
In this fictional case the sixth well succeeded, and total spending of $60,000,000 produced a project worth five times as much. The lesson is that exploration should be judged on the portfolio and not well by well.
Watch out
Common mistakes.
- Judging a drilling programme by one well, when the economics only make sense across a portfolio of attempts.
- Assuming a discovery equals profit, when the find still has to be appraised, developed and produced before cash comes back.
- Forgetting that the accounting method decides whether a dry hole hits profit immediately or is spread over time.
Questions
People also ask.
What is a dry hole?
It is a well that finds no oil or gas, or not enough to be commercially worth producing.
Why do companies share exploratory wells with partners?
Sharing spreads the large up-front cost and the risk of failure across more than one balance sheet.
What is the difference between an exploratory well and a development well?
An exploratory well tests for oil or gas in a new area, while a development well is drilled in a proven field to produce it.
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