Stephen I. Burr, Foley & Lardner LLP, Boston
As the recession recedes, the focus of individual accredited investors will likely shift from concern over protecting assets to concern over inflation and increasing taxes. Tax-advantaged investment opportunities with attractive current returns and/or significant potential residual value will compare well to low-yielding, fixed-return bonds; volatile stocks; or real estate or private equity investments that involve use of leverage to achieve desired return on equity.
After a few tough years, investment programs based on upstream oil and gas assets (and perhaps midstream as well) should return to favor with individual accredited investors. Many of these investors will likely be new to the oil and gas industry. While some will gravitate toward the liquidity of the pass-through publicly traded structures such as master limited partnerships (MLPs) and royalty trusts, others will prefer the greater simplicity and transparency of private placements.
Here are a few simple guidelines for accredited investors new to oil and gas investing through the private placement marketplace:
Types of offerings
Private placements of oil and gas interests typically involve either royalty or "working" interests and are organized either as a direct participation/specified asset offering or a blind pool.
Royalties are a landowner's interest in the cash flow generated by oil and gas production on that landowner's property. The lessee/operator has an obligation to develop the property, to bear all of the development costs and risks, and to pay the landowner "rent" (i.e. a royalty) in the form of a percentage of net cash flow. Once a stable stream of revenue is established the landowner may elect to monetize his interest by selling percentages of his royalty interests, or even "overriding" royalty interests (i.e. royalty interests with a preferred right of payment over other royalty interests) to third parties.
The working interest holder/lessee has both the right and the obligation to drill, operate and maintain wells on the leased property. He retains whatever interest in cash flow is left after paying all of the costs of drilling, operating and maintenance, as well as royalties to the landowner. The holder of the working interest may operate the property himself, i.e. act as his own general contractor, or may delegate that responsibility and risk to a third-party operator.
Offerings of working interests can occur at different stages of development. The land subject to the working interest may be completely undeveloped, that is have no existing wells, partially developed but with more drilling opportunities or partially developed with opportunities primarily to improve production from existing wells (known as "re-works").
Specified properties/direct participation
Oil and gas offerings, particularly by newer sponsors, are typically based on specified properties. In other words, the oil and gas company sponsor tells you exactly what assets are going to be purchased with your money. This type of offering in turn can be structured in two ways. The sponsor may form a fund, typically a limited liability company or limited partnership of which it acts as manager or general partner, which owns the assets and sells membership or limited partner interests to investors, or it may sell direct participation interests.
Purchasing a direct participation interest is the equivalent of getting a deed. The sponsor is selling you a direct interest which you can sell, borrow against or devise to heirs. The sponsor typically offers to "manage" the interest for you, i.e. collect and distribute the revenue and keep an eye on the operator, but you are not obligated to take advantage of this offer. The sponsor may also retain a small percentage of the direct interests in the property as part of his compensation for structuring the offering.
Blind pool offerings are offerings to raise investment dollars to be deployed on certain types of assets, but without the assets being specifically identified. In these offerings the investors are relying on the skill of the acquisition team of the sponsor. They are structured as funds, using a limited liability company or limited partnership structure, with the sponsor as manager or general partner.
Figure 1 shows the general rule of thumb for risk and reward in oil and gas investment structures.
Advantages of oil and gas investing
Investing in oil and gas interests shares common characteristics with investing in other types of alternative investments, the most obvious being real estate, in particular that such an investment is typically specific to a certain type of asset, looks to provide a substantial return through a combination of current income and appreciation upon sale and is generally subject to legal and practical limitations on free transferability.
However, there are some characteristics of oil and gas investments generally which differentiate it from real estate and other alternative investment strategies, including the following:
Absence of leverage
Debt or "leverage," is rarely used in oil and gas offerings. While real estate investors are subject to foreclosure risk when loans default or cannot be refinanced on maturity, the oil and gas investor simply tolerates a reduced return on equity, and has no personal liability on recourse debt or so-called non-recourse carve-out guaranties.
The benefits of diversification are notable primarily in royalty offerings, where risk can be spread through packages of royalties across different fields, counties and states, across predominantly oil or predominantly gas producing properties (or a balanced mix of both), across relatively mature and less developed properties and across a broad range of qualified operators and distribution networks. The opportunities for diversification are less evident in working interest offerings, although some sponsors are including more than one opportunity in an offering, and mixing existing production, rework and drilling opportunities into the same package.
There is a long history of fractionalized oil and gas interests. Direct participation royalty interests are generally freely transferable without the types of securities law concerns and other obstacles which make fractionalized real estate interests difficult to transfer. Working interests and interests in funds are less transferable.
Many oil and gas programs, particularly working interest programs, involve significant tax benefits. Be cautious of programs that appear to "push the envelope" on tax benefits, and always review the offering with your personal tax advisor before investing.
Risks common to oil and gas investments
Outlined below are some of the risks unique to oil and gas investing, both with respect to royalty interest and working interest offerings. Most of these risks are common to both the royalty and working interest offerings. Royalty interests are essentially income strips, more separated from the risks inherent in operating and developing oil and gas wells than working interests. On the other hand, holders of royalty interests tend to have less control over what happens on an oil and gas property than holders of working interests. If additional production is important this can be a negative, although generally the interests of royalty holders and operators are aligned.
Working interests carry the potential for more reward and therefore not surprisingly more risk. The risks inherent primarily in only working interests are specifically identified below. The first two risks listed below are the most significant for both royalty and working interest offerings.
Real estate investors are used to cycles in the value of real estate, typically spread over years with a few key indicators, e.g. overbuilding, interest rates, etc. Oil and gas prices are much more volatile over much shorter periods of time than real estate, and can be affected by many more factors, e.g. foreign wars or insurrections, decisions by cartels, hurricanes, technological advances, pollution concerns, etc. An offering involving primarily natural gas wells projected to produce a 10% return assuming natural gas prices at $5/million btu can look pretty sad if prices fall to $2/million btu. Here are a few ways to mitigate that risk:
- Take a long view. As with real estate, an investor looking for a quick buck is likely to be disappointed. If you believe that over time oil and gas prices should at least keep pace with inflation, and you have patience, you will sleep better.
- Look for balance. Oil and gas prices do not always move in tandem (witness the last two years). Give some more weight to offerings with a combination of oil and gas production.
- Sensitivity analysis. The offering document for an oil and gas deal should have a sensitivity analysis, assuming production at current levels, based on oil and gas prices at different levels. If you are trying to achieve an 8% return at $50/barrel oil and $4/million btu gas and today's prices are $70 and $5 respectively, you have some room for error.
Depletion and decline
Perhaps the largest risk, which is also the least understood in oil and gas investing, is the risk of depletion. Oil and gas wells are depleting assets. In other words, all wells run dry over some period of time. It is important to understand not only when the wells are likely to be fully depleted, but also what the rate of decline is. Thirty percent (30%) less production in the second year will of course dramatically affect the yield to investors even if prices are stable. Unlike real estate, there are no alternative uses for the assets in these offerings. They either produce or they do not. Here are a few ways to mitigate that risk:
- Diversification. Wells in certain fields, counties, states and regions deplete faster than others. Oil wells and gas wells can also deplete at different rates within the same field. The best protection against these variances in depletion rates is diversification. Look for portfolios being offered which have product and geographic diversification.
- Replacement wells. Offerings which include interests in properties where existing wells are widely spaced afford opportunities for additional drilling. The risk associated with this drilling is not being assumed by the investors, at least in royalty interest offerings, but they can reap the benefit if the new wells are successful. If old wells are regularly supplemented by new, "in-fill" wells, production can reasonably be projected to remain stable for extended periods.
- Secondary or Tertiary Recovery. Waterflood, carbon dioxide injection or injecting fluids to fracture oil or gas bearing rock formations are ways to stabilize or increase production. They also involve additional costs, regulatory requirements and environmental concerns.
- Engineering. Offerings should be supplemented by internal and third-party engineering. Great strides have been made in recording the historical performance of wells or fields and projecting that performance into the future, as well as in three-dimensional mapping of underground formations. Look for this information, and review it with someone who has the appropriate technical expertise.
Operating risk (primarily a working interest risk)
As the name implies, working interests involve the risk and reward of increasing production, whether by drilling new wells or improving the production of existing wells. The investors' capital in these deals pays not only for the real estate interest, i.e. the right to drill, but also in many cases for the cost of drilling.
In a royalty deal the investor is essentially buying an income strip in producing wells, and the risks are primarily price volatility and depletion. The price paid for the royalty interest is presumably closer to the actual value of the asset being purchased than the amount invested in a working interest deal.
Another way of saying this is if you pay the cost of exploration, and the exploration is unsuccessful, you have a greater chance of losing a significant portion of your investment in a working interest deal than in a royalty interest deal. You also have a greater upside.
In addition, state and federal laws impose potential liabilities on holders of working interests which are not imposed upon holders of royalty interests, e.g. environmental, property damage, personal injury, plugging, and subsurface damage. It is difficult to separate the investor from personal liability for these risks. Some ways to mitigate these risks with respect to working interests are:
- Established fields. Look for offerings focused on historically successful locations in historically successful fields.
- Costs. Understand what costs you are being asked to cover, whether those costs are reasonable and capped by a creditworthy contractor, and whether the capital being raised will cover those costs with a reasonable margin for error. No one likes to receive notice of an additional capital call.
- Tax benefit offsets. The increased economic risks in working interest deals can be partially offset by increased tax benefits. Caution: do not count on these without expert tax advice, as the rules governing such benefits are more complex than those for real estate, and in any event never invest based only on apparent tax benefits. In particular, trying to assure maximum tax benefits may be inconsistent with trying to shield the investor from personal liability.
- Track record. Nothing is a better predictor of future success than past performance. Look for a table of prior performance on the sponsor in the offering document, and make sure that that performance is recent and presented in a transparent manner.
Quality of sponsors
The segment of the oil and gas industry offering oil and gas interests to private investors as securities tends to be non-institutional and thinly capitalized, without audited financial statements. Many of the sponsors are newly formed with little track record, whether in terms of delivering the returns they project, asset management, financial reporting or investor relations. A few suggestions:
- Experience. Some experience is better than none. Try to find sponsors who have some, even if limited, history of delivering what they promise. If they do not have any history, view the projections with additional caution.
- Breadth and depth of resources. Look for sponsors who have made a substantial investment of time and money to enter the business, and have not only acquisition and sales people, but due diligence, asset management, financial reporting, and investor relations personnel.
- Third-party reports. Look for third-party sponsor and project due diligence reports done by credible third party due diligence firms, as well as third-party engineering.
- Avoid Ponzi schemes. A good way to minimize the risk of being victimized by Ponzi schemes is to request a letter from the principals of the sponsor in which they certify that (i) any investor funds will only be used to acquire assets and pay the costs of the offering; and (ii) any distributions made to investors will be paid only from income generated by the assets. Be very cautious of any offering that projects an immediate high return or suggests that the return is "guaranteed."
Who is doing the selling?
Look for offerings that are being marketed either through a credible managing broker dealer or through securities representatives who have made a commitment to understanding the industry. Historically, the greatest portion of private oil and gas offerings have been sold under exemptions in the securities laws by sponsor principals. While this approach eliminates the cost of broker-dealer commission, which can run 8% to 10% of the equity raised, they significantly increase the risk, as the only information you are relying on comes from the seller.
Obviously no investment is without risk, but by following these simple guidelines risk can be reduced significantly.
About the author
Stephen I. Burr is a partner at Foley & Lardner LLP in the firm's Boston office and a member of the firm's finance and financial institutions and real estate practices.