The Hazards Of Investing In $100 Oil: Part 2

$100 oil and $7 natural gas make it tempting to invest, but there are all sorts of ways things can go wrong, as history shows. Changing market conditions often expose pitfalls even for experienced investors, including the challenges that arise when a general partner of an oil and gas investment vehicle decides to manage more for their own account than yours.

PDC Energy, Inc., formerly known as Petroleum Development Corporation, settled a lawsuit in 2015 with investors that highlighted a divergence between the interests of general partners, those who manage a partnership, and limited partners, those who do not have a say in how the partnership is run because they do not want the liabilities associated with running the partnership. PDC syndicated oil and gas limited partnership interests to high net worth individuals for years. With the money from limited partners, LPs, PDC acquired mineral rights and drilled wells on favorable terms for the investors—frequently just one well per tract if the first well was not a gusher, with some tracts containing as much as 640 acres. Producing, albeit at modest rates, these single wells provided their investors a tax-advantaged investment with ongoing cashflow and held the acreage around the well to be available for future development.

The advent of the shale plays in the Denver-Julesberg changed the game for the PDC partnerships there. Because there are multiple targets in the layer cake deposits of oil in the basin, one 640-acre tract could be drilled with multiple horizontal wells—64 wells per tract is not unheard of—with each well more prolific than the single vertical drilled by PDC years earlier.

The limited partners in these partnerships alleged that PDC engaged in self-dealing when the company attempted to buy back the limited partners’ interests at prices well below that of neighboring tracts. They alleged PDC argued that the limited partners’ interests were encumbered by the onerous terms of the partnership agreements, which included a provision that no further fundraising could be undertaken by said partnership!

Today, it is more common to see investments made by the wellbore rather than by acreage. This approach limits the upside available to the investor. The general partner retains the upside and has their investors pay for risk.

The late oilman and Hollywood producer Marvin Davis was more forthright. The late Gay Land of Vale Petroleum raised $100 million in the 1970s to join Davis Petroleum in drilling wells. Under the terms of the partnership, Davis operated what is known as a blind pool—in other words, Davis would drill the wells, and Vale Petroleum had no say in what was drilled. As Land explained, his investors wound up drilling and owning all the dry holes while the Davis Petroleum wells were successful. One for me, none for you.

The GP/LP game is also played by private equity. During the runups in the shale plays, endowments and pensions funds could not help themselves and poured more and more money into private equity in the hope of obtaining “uncorrelated returns” and “protection against inflation.” At one industry conference in 2006, MBAs representing four private equity funds touted that they were investing $25 billion that year, or more than ExxonMobil’s
XOM
entire exploration budget for that year.

The GPs start their funds with a stated goal of grabbing 70% of their fund’s value for themselves, and it was not unusual for ABC Oil Fund Manager to have three operating funds in different stages of their lifecycle. The fund managers would often flip their weak portfolio companies into their most recently started fund, or in a clever maneuver, into another private equity firm’s fund at an increased valuation, so that later investors literally paid for the mistakes that were stuck in the earlier funds. This game did not originate with oil investment funds, it comes directly from the savings and loan crisis of the mid-1980s, and the technique was also practiced by venture capital funds during the tech bubble of the late 1990s.

Some limited partners always lost. Their private equity managers would enter the auctions for prime portfolio companies and properties. With a finite amount of known oil-bearing formations in the U.S., the large institutionally backed private equity managers often found themselves bidding against each other for the same property. ABC Oil Fund Manager vs. DXY Energy vs. QRS Oil & Gas bid higher and higher, using their limited partners’ monies. The losers in the auction were the endowments and pension funds that had invested with all three.

The various drilling, royalty, and other partnerships in the oil and gas industry in the early 1980s were frequently sold as investments, where the general partner would absorb all the non-deductible costs and the limited partners would receive all the immediately deductible costs, which were enhanced, frequently, with borrowed money. It seemed like a great deal because of the tax code at the time, this would mean that the limited partners would sometimes receive deductions that were more than what they invested. As part of the transaction, the general partner would receive management fees, which were usually much higher than those that were charged among industry partners, but it provided a source of income from the investor limited partners, sometimes to the extent that a producing well would operate at a loss, so far as the partnership was concerned. The real surprise came when the partnership was dissolved, and the limited partners recaptured all the “income” from the disproportionate allocations. That is, income without cash, and the investors would have a tax liability. It ruined a lot of people’s days. And while a few old promoters miss those days, CPAs who are not familiar with partnership accounting can still today take honest losses and create awful tax liabilities.

It was also a ripe time for con men. Operating out of what were termed “boiler rooms,” they sold interests in oil and gas deals, a point at a time – depending on how many points were sold, those points usually amounted to an extremely small ownership percentage in a well. The well might or might not exist or even be drilled, but by the time the investor figured that out, the con men had moved to a new telephone number. State and federal securities investigators spent a lot of time tracking these people down, and, in some instances postal authorities and the FBI were involved, as well.

Sometimes, the general partner would sell more than 100% of a limited partnership or more than 100% of a well—planning for a failure and hoping no one finds out, or perhaps out of desperation, or both, as in Perry Mason’s “The Case of the Wary Wildcatter” or Mel Brooks’ “The Producers.”

When is a BOE a BOE?

A BOE is a barrel of oil equivalent, and it is often used in the context of natural gas production. Why? The prolific production of natural gas from the U.S. shale plays drove the price down from the low teens to under $4 per thousand cubic feet (mcf) from 2008 to 2012. The gain to U.S. consumers can not be denied. As the price fell, however, natural gas producers looked with envy at their oil company compatriots, who did not have to deal with such a long-term price decline. Natural gas producers began to report their performance in BOE, using the approximate conversion that 6 mcf of natural gas has the energy equivalent content of one barrel of oil. So far, so good?

This conversion makes sense in economies where natural gas and refined products from oil are direct substitutes. But in the U.S., natural gas and refined products are not ordinarily substitutes for electricity generation (not since the early 1970s) and not for transportation. If indeed they were, there would be equivalent economic value because we could decide whether to fill up with gasoline or natural gas, and the prices would converge. In spite of this not being the case, many natural gas companies report results as BOE hoping that some of the public can be fooled some of the time. So, at press time, natural gas is trading at $7 per mcf on NYMEX and oil is up-and-down around $100 per barrel. $100 per barrel is much more than $7 X 6 = $42 per energy equivalent. Maybe the investing public won’t notice?

This analysis is different in Europe just now. While the price of natural gas is at $7 per mcf here, it is approximately $32 per mcf in Europe. $32 X 6 = $192 per BOE. Natural gas is significantly more valuable than oil in the EU. Residents of Boston experienced this phenomenon several times this past winter as they ran short of domestic supply and had to import LNG to keep their lights on and houses warm. (Keep in mind that U.S. deliveries of natural gas as LN
LN
G to Europe is max’ed out—do not fall for a pitch that offers drilling in the U.S. and delivery in Europe without some serious due diligence!)

How can you determine which is which? Under SEC rules, publicly held companies are supposed to delineate their proportionate production of natural gas and oil. A sharp analyst can make quick work of it by noting the reported production costs per BOE. A natural gas heavy producer will have lower costs per BOE because natural gas production is powered naturally by the formations and not by pumps.

For the forthcoming Part 3, we will look at games in the oilpatch and the gaming of oil markets—this is under the heading: “Can you rely on MBS and Putin?”