When evaluating oil and gas investment opportunities, you should know there are two primary methods of investing: the first and most commonly known method is purchasing stock in an oil and gas company; the second is through direct participation programs, which give investors an ownership position in a well and a share of the income it generates. In the case of a stock investor, the returns are reinvested in the company. Direct participation programs, on the other hand, provide investors monthly or quarterly revenue from the cash flow the well generates, giving investors the ability to simply enjoy the supplemental income or reinvest that money in additional projects or other vehicles. Direct participation programs offer investors tax deductions and income potential; however, it's important to understand the nature of the business, the suitability requirements and the terms associated with these programs. Drilling for oil and gas is a complex business complicated by the fact that many wells that are drilled either do not hit adequate commercial reserves or the well being drilled/completed experiences unexpected problems. The business is further complicated by unscrupulous players confusing the marketplace and burdening investors with the onus of finding trustworthy, credible partners with whom to invest and entrust their hard-earned money. The purpose of this article is to help investors make this distinction.
Due to the inherent risk associated with oil and gas investments, the U.S. Securities and Exchange Commission (SEC) has defined certain suitability standards, which help investors determine whether they are an appropriate candidate for this type of investment. Contact us if you're interested in filling out a questionnaire to determine if you qualify for an oil and gas investment or call 1.866.859.7827. When it comes to investing in oil and gas, it's important to understand that it's impractical to approach an oil and gas investment as a one-shot deal. You may have to participate in several projects in order to obtain a paying interest in a well. As a result, in evaluating oil and gas investments, consider the fact that the rewards of a successful drilling project may have to make up for losses on both past and future projects that may come up dry or prove to be uneconomical to produce due to inadequate commercial reserves. That being said, there are three key areas to consider when evaluating an oil and gas investment to avoid being burned: the People, the Deal Structure and the Production Projections.
Who Am I Doing Business With?
When you're evaluating an oil deal, it's important to be prudent and ask critical questions that will help you differentiate between scrupulous and unscrupulous players. Does the oil company sell its projects through a registered broker-dealer? How long has the company been in business? Do they furnish a track record stating the amount of money invested and net amount of cash received by investors by project? Or, are they only telling you the number of wells drilled and completed? A "completed" well may not mean anything. Many wells are completed but never pay out. Are you able to check the credibility of the oil company and its owner. Who operates the wells and do they have the necessary expertise? How do they structure their deals – is it fair? Who evaluates the geology of the projects? How are projects selected? Any reputable company should be happy to answer these questions.
You should also ask to speak with existing investors as a reference for how their experience with the company has been. It's important that the company keep investors informed at every stage of drilling and completion. You should receive regular progress reports as well as essential year-end information in a timely manner.
How Is The Project Structured?
There are nearly as many ways to put together an oil and gas investment in a drilling project as there are oil companies in the industry. Regardless of the project's structure or complexity, however, each can be boiled down to two simple questions: What is the anticipated cost to drill and complete the well? And who gets what percent of the revenue over the projected life of the well?
Most private placement oil and gas drilling projects have several parties involved when it comes time to sharing revenues from a producing well, including: the land or mineral owner, the project manager, and the investor group, which is financing the cost of drilling, completing and producing the well. Let's look at these in turn:
Traditionally, the mineral owner receives a royalty interest of 12.5% to 25% of the total production revenue of a producing well without paying any costs. 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 30%, someone has carved out an overriding royalty interest that is exorbitant. This cuts into the investor's rightful revenue interest. Therefore, it usually doesn't make good investment sense to get involved in an deal where the royalty interest is greater than 30%.
On the cost side, we are looking at the cost of generating the prospect, buying the lease, and drilling and completing the well. Some deals are structured in a manner that the project manager can come back to the investors with additional investment demands in the event of unexpected additional drilling and/or well completion costs. For the investor, I am wary of this type of deal because the investor's risk is not certain or capped. When a deal is capped or turnkeyed, the prudent project manager should add a reasonable allowance to the drilling and completion budget to cover unexpected expenses. If costs overrun this additional padding, the project manager is responsible for any overruns. If the well drilling and completion costs come in below budget, the project manager will keep the difference. At first, this may seem unfair, but in this way the padding acts like an insurance policy paid for by the investor group. 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 can reveal the extent of the markup.
Does the Projected Monthly Production Justify the Money You Are Investing?
In an established oil and gas area, the petroleum geologist makes the production projections on a payout based on the production histories of nearby wells. My 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 less. 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.
Conclusion
In summary, when investing in oil and gas, it's essential that you partner with people you trust, that the terms of the project are fair, and the project has a strong likelihood for paying back your investment in short order. In addition, keep in mind that you may have to participate in several projects before you hit a commercially productive well. To learn more about evaluating oil and gas investment opportunities, call 1.866.859.7827 or email your questions to info@lonestarsecurities.com.