Chapter 6: |
With oil and gas moving toward historically high levels, many investors are looking for opportunities to invest in oil and gas by making direct investments in drilling projects known as Direct Participation Programs. These private placement drilling projects offer high net-worth / high-income investors tax deductions and high income potential. But drilling for oil and gas is a risky business due to its inherent nature and dependence upon natural resources. And, as previously explained, drilling is a complex business. Many wells that are drilled either do not hit commercial reserves or the well being drilled/completed experiences unexpected problems.
Who Am I Doing Business With?When evaluating an oil and gas drilling project, we look first at the people who originated the deal, and we recommend the same to investors considering various investment opportunities. You must know who you're doing business with, their track record, how long they've been in business, and their staff. When oil prices are high, more and more people enter the oil business and start assembling and marketing oil and gas deals. Therefore, look first at the company offering the project to determine how long they have been in the oil business and in what capacities. We suggest looking for a company with at least five years experience in managing projects. This criterion will help keep you out of deals with people who are inexperienced and less likely to manage the project properly. Lone Star Securities, Inc. has been managing projects for over 20 years. It's equally important to know the management team and the geologists they work with to identify and select projects. The geologist(s) will look at the geology and related data on a project and give their evaluation of its likeliness for success. While prospect-generating geologists are almost always reputable, they will have a certain natural bias towards their project. But while they may be focusing on a good prospect, there may be even better prospects elsewhere. That's why it's important that the management team tasked with selecting the projects it will ultimately offer to investors have long-term experience in the industry. When looking at a project's issuer, we suggest you request to speak with existing / previous investors to learn about their experience with the company. It's important that investors be kept well informed as to the drilling status, which includes receiving timely progress reports as well as monthly well production and year-end reports. Sadly, not all companies are prompt in providing monthly progress reports or supplying essential year-end information that's needed for filing timely tax returns. So, ask to talk with the project manager's investors who have participated in prior drilling and production projects to see how the company has performed in these areas as well as the project's outcome. When discussing a company's track record, beware that "completing" a well does NOT mean the well was successful. The well's production is the only thing that matters in terms of the well's outcome, so be sure to ask specifically if the well produced at commercial levels. How Is The Project Structured?There are nearly as many ways to put together an oil and gas investment in a drilling or production project as there are oil companies in the industry. However, regardless of the project's structure or complexity, each can be boiled down to answering two simple questions: Who gets what percent of the revenue over the life of the project? And, are the anticipated costs within a reasonable range? Most private placement oil and gas drilling projects have the following parties involved when it comes time to share revenues from a producing well: the landowner / mineral owner; the project manager; and the investor group that is financing all the cost of drilling, completing and producing the well. Let's look at these in turn: Traditionally, the landowner or mineral owner receives between 12.5% to 25% of the total production revenue of a producing well without paying any costs. This is called a royalty interest. The remainder of the revenue interest is divided up between the project manager and the investor group. When the deal is structured with a royalty interest greater than 25% it is usually because someone has carved out an overriding royalty interest.
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On the cost side we are looking at the cost of buying the lease, drilling, and completing the well. The investor pays these costs on either an "invoice-cost" basis or a "turnkey" or fixed-cost basis. The invoice-cost basis means the investor will pay the actual invoice cost associated with drilling and completing the well plus a small management fee to the issuer. The invoice-cost structure allows the project manager to come back to the investors with additional investment demands in the event of unexpected additional drilling and/or well completion costs. However, this rarely happens because the project manager will add a contingency to his estimates that usually cover any overruns. This contingency will be returned if not used. If the investor is concerned about being on an invoice-cost basis and wants his risk certain or capped, he should participate on a turnkey or fixed-cost basis. When a deal is capped or turnkeyed, the prudent project manager will add a reasonable allowance to the drilling and completion budget to cover unexpected expenses. This additional allowance will usually be more than the contingency mentioned above. If costs overrun this additional padding, the project manager will have to pay the additional expenses out of his pocket. If the well drilling and completion costs come in below budget, the project manager will keep the difference. The padding acts like an insurance policy paid for by the investor. The investor has a cap on his liability and the project manager assumes the added risk. The project manager should provide the drilling and completion costs estimate, called an AFE (Authorization for Expenditure), to the investor. A few calls to service companies and the drilling contractor used by the project manager could possibly reveal the extent of any markup on a turnkey basis. In the State of Louisiana, the Louisiana Mid-Continent Oil and Gas Association, www.imoga.com, offers average drilling cost information for previously drilled wells in areas based on depths so it's not difficult to get a pretty good feel for the amount of drilling/completion costs for any well. Does the Projected Monthly Production Justify the Money You Are Investing?
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In an established oil and gas area, the petroleum geologist makes the production projections on a payout based on his or her analysis of the production of nearby wells. A simple rule of thumb is that you want to see projections that (at current oil and gas prices) will return your entire investment in 24 months or sooner. If the projected production doesn't support a 24-month return or better on the investment, the investment risk is too high given the expected return. Allowing for the fact that a good portion of all wells drilled will be non-producing, you want to make certain that the ones that do produce make up for the ones that do not.
Acid Test: Evaluating Oil and Gas Projects
Potential investors are cautioned to look at oil and gas projects carefully. Investors need a reasonable opportunity for reward versus their investment. We advise you to look at the potential payout of a proposed project versus your investment. You'll need to do a little math to compare the risk/rewards associated with various project offerings. For example, suppose you are being offered a 1.25% net revenue interest in a project for $90,000. For your investment to break even, the well will need to produce a total of $7,200,000 in revenue ($90,000/.0125 = $7,200,000). If oil averages $50 a barrel, your investment well will have to produce at least 144,000 barrels over its productive life ($7,200,000/$50 = 144,000 barrels). You can do the same math for gas or combination oil and gas projects using an anticipated price for thousand cubic feet of gas. Now here's the acid test: Look at the surrounding wells or fields and see if any have yielded the amount of gas and/or oil your project will need to produce to return your investment. You always want to use a conservative price for oil and gas. If you buy into a project as a speculative bubble is growing for oil and gas, you don't want to get caught when the speculative bubble pops. Of course, if the project does pass the acid test, you still need to examine the geology to evaluate the risk. Investing in a single oil and gas drilling project should not be looked at as a one-shot proposition. Most investors will have to experience a certain number of non-producing projects before they hit a producing project. When you do hit that producing well you want to be in partnership with people you trust, and you want to be in a project that's fair, and one that has a good likelihood for paying back your investment in short order. We believe the above guidelines will go a long way toward helping you achieve those objectives. page 27 Return to Chapter 5 Return to Table of Contents |