The Hazards Of Investing In $100 Oil: Part I

Investors are always looking for ways to cash in on current events; be it new technology, the pandemic, the recovery from the pandemic, or a war.

One result of the pandemic recovery, combined with the war in Ukraine, is the prices of oil and natural gas have jumped. Oil at $100 per barrel and natural gas bounding up to $7 per thousand cubic feet—more than double the prevailing price over the past several years—have brought real opportunities to market along with maybe just a few scammers. The policies of the Biden administration may certainly raise costs for the U.S. oil and gas companies, but the prices have increased even more.

As an investor, what do you do? Do you play this with publicly traded companies? Do you go in with your dentist/CPA/golf buddies on a “sure thing?” How about a commodities fund or ETF—even further removed from the action? Transparency in the oilpatch has never been a high priority. It is a truism that some oil and gas companies earn more money from their investors than they do from drilling wells. Marvin Davis, Sir Philip Watts, Aubrey McClendon, Jim Hackett, and the apocryphal Dryhole Dave played this game.

Rising markets mask the pedestrian frauds and only the egregious, serial offenders are discovered. Falling markets uncover everything, and we learned a lot during the Saudi price wars. As Warren Buffet says, “Only when the tide goes out do you discover who’s been swimming naked.” Most, if not all these schemes are legal or allow for some degree of “plausible deniability” for the management teams. If anyone gets thrown under the bus, it is usually a clueless patsy deep within the accounting department. Buyer beware.

We’ll start by looking at two schemes endemic to the oil industry; the overstatement of reserves and underpayment of royalties.

Overstatement of reserves

One rule in the oilpatch is if you can’t marry rich, you better find religion. Let’s start with the most visible overstatement of oil and gas resources by a management team. In 2004, when the Board finally realized that the company had overstated its reserves by 20%, Sir Philip Watts was sacked from his job as the Chairman of the Board of Royal Dutch Shell along with his lieutenant, the CEO of Shell’s exploration and production business, Walter van de Vijver. Auditors are not required to check on the numbers produced by engineers and geologists, so the board must exercise its due diligence to protect the shareholders. Sanity checks on the numbers are part of the responsibilities of an effective board, but many oil and gas companies—just like in other industries—do not have independent directors with any expertise in the underlying business. Sir Philip is now a priest in the Church of England.

Another oil company executive who turned to the cloth is Jim Hackett. He formerly headed Anadarko during a time when the company went through a bunch of chief financial officers before he departed for Harvard’s divinity school. Upon returning from Cambridge, he headed up a SPAC (a special purpose acquisition company) that acquired the little oil company Alta Mesa. This transaction was valued at an eye-popping $3.8 billion based on very preliminary production and reserve estimates from a very few wells. Barely 10 months later Alta Mesa wrote down the value of the reserves by $3.1 billion. A bankruptcy filing ensued and the litigation seemingly against everyone involved continues, even though the money has gone up in smoke.

Royalty underpayments

Many investors have been lured into royalty trusts or royalty funds. Promoters bundle together fragments of ownership interests in oil and gas wells, or oil and gas leases, to sell privately or publicly. These funds are attractive to investors because they do not require capital investment to drill wells but instead rely upon the operator of the property to raise capital to drill new wells to produce more. As the price increases, the royalty investors hope that operators can drill more wells to expand cash flow for the investors. If, however, the operator goes bankrupt in a down market such as that of the past 6 years, the royalty fund faces a very uncertain future with that source of cashflow.

Another question a prospective investor should ask is how does the management team prove the ownership of the underlying royalty interests? Due to a Supreme Court decision in SEC v. C. M. Joiner Leasing Corp., 320 U.S. 344, 64 S. Ct. 120 (1943) interests in oil and gas leases are considered securities and, of course, both federal and state securities laws apply to their purchase and sale. Remember that auditors do not have to verify that a company actually owns what it says it owns.

In practice, the royalty shenanigans employed by some operators can almost be classified as Oil & Gas 101. Short-paying royalty owners is de rigueur for many companies. It overstates revenues and cash, and CPAs are unlikely to uncover it in audits. Why? CPAs audit balances, not how the accounts picked up those balances. CPAs rarely check the companies’ contracts and performance required by those contracts. The corporate rationalization goes something like this: If I shortchange my royalty owners out of $100 but only 20% of them complain, I still gain $80. There are various state laws that sometimes come to the aid of cheated royalty owners, but first, royalty owners must find out about the short payments. Today many oil companies outsource the royalty payment function to data companies, and this provides more layers of plausible deniability and red tape. Royalty owners can occasionally utilize the Federal hammer against both data services and the operators because each monthly short payment can create a new felony offense of mail fraud, wire fraud, securities fraud, and conspiracy offenses—a target rich environment for prosecutors.

The expanded shale plays have opened a new scheme. Because these plays require horizontal wells that may extend for miles, the wells can traverse lands and minerals rights owned by different parties. One well can have the surface location on owner A’s property, cross owner B’s property and then terminate with the bottom hole location on owner C’s property with production originating from all three properties. If the property owners have different royalty rates, the operator frequently pays only the lowest rate. Owner B is ordinarily the one cheated because the operators only report to state agencies based on surface and bottom hole locations. Many state regulatory agencies and county clerks allow operators to claim confidentiality on their activities: minerals leases, well locations and production. They think that they are accommodating the operators, but they do so at the expense of their residents, tax jurisdictions, and taxpayers who would happily pay more in taxes if they had access to their rightful revenues.

The slow pay of royalties is a way that oil companies gain “free” loans. George Mitchell, the hero of effective hydraulic fracturing for shale plays, was occasionally singled out by North Texas property owners who inserted “no George” clauses in their oil and gas leases according to one Dallas attorney who frequently represented the property owners. Mitchell’s company would lease acreage and drill wells but then withhold royalty payments because of “title issues,” underlying problems with the true legal ownership of the royalty interest (even though that such a defect did not hold up drilling). In this manner, the royalty owners were burdened with long, expensive delays before his company would issue royalty checks. Cleverly, Mitchell could “borrow” interest-free.

But this was not his only maneuver in the business. In one interview before his death, Mitchell was asked if he had ever been to the brink of bankruptcy. With a grin, he said that he was broke at least five times in his career but that no one had ever called him on it—which would have forced him into bankruptcy. On one such occasion, he related how he had told one group of investors that their well had come in but soon realized that he had misspoken. He drove home. Cleared out his birthday presents from his closet. Sold them. Took the proceeds and paid his investors.

Chesapeake Energy was famous for layering in odd costs to its royalty interest owners. During Chesapeake’s early heyday under cofounder Aubrey McClendon (RIP), landowners in Johnson County, Texas sued Chesapeake because the royalty paid by Chesapeake was less than half that paid by partner XTO Energy in a number of Barnett Shale wells that were 50/50 operated by Chesapeake and XTO under the same lease. Legal discovery found that Chesapeake had added back costs that were not allowed in addition to underreporting the production of the wells. The moral of that story from Chesapeake’s perspective is “know your royalty owners,” and don’t screw the County Engineer who has a key to all the producing pads and can read the gas meters himself.

In Part Deux, we will discuss the divergence between the General Partners and Limited Partners in oil companies and how, contrary to the hopes and dreams of many petroleum engineers, a barrel of oil may be the energy equivalent of 6,000 cubic feet of natural gas, but it is not the economic equivalent…