The Dangers of Investing in $100 Oil: Part 2
Oil at $100 and natural gas at $7 make it tempting to invest, but there are all sorts of ways things can go wrong, as history shows. Changing market conditions often present 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 for the your.
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 don’t have a say in how the partnership is run because they don’t want the responsibilities associated with running the partnership. PDC has syndicated oil and gas limited partnership interests to high net worth individuals for years. With money from sponsors, the LPs, PDC acquired mineral rights and drilled wells on investor-friendly terms – often only one well per plot if the first well was not a flowing well, with some plots containing up to ‘at 640 acres. Producing, albeit at modest rates, these unique wells offered their investors a tax-efficient investment with continued cash flow and kept the acreage around the well available for future development.
The advent of shale play in Denver-Julesberg has been a game-changer for PDC partnerships there. Because there are multiple targets in the oil seam deposits in the basin, an area of 640 acres could be drilled with multiple horizontal wells – 64 wells per area is not uncommon – with each well more prolific than the single one. vertical drilling by PDC years earlier.
The limited partners of these partnerships alleged that PDC engaged in insider trading when the company attempted to buy out the limited partners’ interests at prices well below those of neighboring lands. They alleged that PDC argued that the interests of the limited partners were burdened 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 wellbore rather than by area. This approach limits the upside potential available to the investor. The general partner retains the increase and makes his investors pay the risk.
The late Hollywood oilman and producer Marvin Davis was more blunt. Vale Petroleum’s late Gay Land 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 drilled the wells and Vale Petroleum had no say in what was drilled. As Land explained, his investors ended up drilling and owning all the dry holes while Davis Petroleum’s wells were successful. One for me, none for you.
The GP/LP game is also played by private equity. During the shale booms, endowments and pension funds couldn’t help themselves and poured more and more money into private equity in hopes of getting “ uncorrelated returns” and “inflation protection”. At an industry conference in 2006, MBAs representing four private equity funds announced that they were investing $25 billion that year, more than those of ExxonMobil.
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 at different stages. of their life cycle. Fund managers would often flip their weak portfolio companies into their most recently launched fund, or in a clever move, into another private equity firm’s fund at an increased valuation, so subsequent investors literally paid for errors that were stuck in previous backgrounds. . This game was not born from oil investment funds, it comes directly from the savings and credit crisis of the mid-1980s, and the technique was also practiced by venture capital funds during the bubble technology of the late 1990s.
Some sponsors have always lost. Their private equity managers would participate in auctions for portfolio companies and prime properties. With a limited number of known oil formations in the United States, large, institution-backed private equity managers have often found themselves bidding against each other for the same property. ABC Oil Fund Manager vs. DXY Energy vs. QRS Oil & Gas offered higher and higher, using their sponsors’ money. The losers in the auction were 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 often sold as investments, where the general partner absorbed all non-deductible costs and the limited partners received all immediately deductible costs, which were frequently supplemented with borrowed money. This seemed like a lot because the tax code at the time meant that limited partners sometimes received deductions in excess of what they had invested. As part of the transaction, the general partner would receive a management fee, which was typically much higher than that charged to industrial partners, but it provided a source of income for the investing limited partners, sometimes to the extent that a producing well would operate at loss, as far as the partnership is concerned. The real surprise came when the company was dissolved and the limited partners recovered all the “income” from the disproportionate allocations. That is, income without cash and investors would have to pay tax. It ruined a lot of people’s day. And while a few former promoters are missing these days, CPAs unfamiliar with partnership accounting today can still incur honest losses and create huge tax liabilities.
It was also a good time for scammers. Operating out of what were called “boiler rooms”, they sold interests in oil and gas deals one point at a time – depending on how many points were sold, these points usually represented an extremely low percentage of ownership in a well. The well may or may not exist or even be drilled, but by the time the investor realized this, the scammers had changed their phone number. State and federal securities investigators have spent a lot of time tracking down these people, and in some cases, postal authorities and the FBI have also been involved.
Sometimes the general partner would sell more than 100% of a limited partnership or more than 100% of a well – in anticipation of failure and hoping no one would find out, or perhaps out of desperation, or both. , as in “The Case of the Wary Wildcatter” or “The Producers” by Mel Brooks.
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 shale fields in the United States drove the price of teens to less than $4 per thousand cubic feet (mcf) from 2008 to 2012. The payoff for American consumers cannot be denied. However, when the price fell, natural gas producers looked enviously at their fellow oilmen, who didn’t have to deal with such a long price drop. Natural gas producers have begun to report their output in boe, using the approximate conversion that 6 mcf of natural gas has the equivalent energy content of one barrel of oil. So far, so good?
This conversion makes sense in economies where natural gas and refined petroleum products are direct substitutes. But in the United States, natural gas and refined products generally do not replace electricity generation (not since the early 1970s) or transportation. If that were the case, there would be an equivalent economic value because we could decide to fill up with gasoline or natural gas, and the prices would converge. Although this is not the case, many natural gas companies report results to the BOE hoping that some part of the public may be misled from time to time. So, at press time, natural gas is trading at $7 per million cubic feet on the NYMEX and oil is fluctuating around $100 per barrel. $100 a 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 today. While the price of natural gas is $7 per mcf here, it is around $32 per mcf in Europe. $32 X 6 = $192 per boe. Natural gas is much more valuable than oil in the EU. Boston residents experienced this repeatedly this past winter when they ran out of domestic supply and had to import LNG to keep their lights on and their homes warm. (Keep in mind that US deliveries of natural gas as LN
How can you tell which is which? Under SEC rules, public companies are supposed to delineate their proportionate production of natural gas and oil. A sharp analyst can do a quick job of noting the reported production costs per boe. A large natural gas producer will have lower costs per boe because natural gas production is fed naturally from the formations and not from pumps.
For the next Part 3, we’ll be looking at games in the oil sector and games in the oil markets – it’s under the title: “Can you rely on MBS and Putin?”