WHY SHOULD FINANCIAL PLANNERS CONSIDER DIRECT OIL & GAS INVESTMENT PROGRAMS FOR THEIR CLIENTS? BY Martin J. Cohen, Cfp tm And Steven King, President Petroinvest Llc Should asset allocation in direct participation oil & gas programs be part of your client s diversification strategy? Quite likely if the client is sophisticated and open to a long term consistent investment strategy. In the search for the perfect asset allocation portfolio construction, direct energy investments have recorded one of the lowest correlations to other traditional investment classes. Peng Chen and Joseph Pinsky (Ibbotson Associates, Journal of Investing, February 2002) demonstrated that direct energy investments offer potentially significant diversification benefits and a long term inflation hedge, establishing them as a viable asset classes to be considered when constructing a long term investment allocation policy. They also demonstrated that publicly traded oil and gas equities didn t provide the same effect. Global oil supply and demand is becoming a hot topic in today s evening news, not just in the economic news. Twenty years ago the world consumed 58 million barrels of oil per day; now it uses 84 million barrels each day. Once the peak of world oil production is reached, which many experts believe is happening right now, production is estimated to decline at 1% 2% per year while world demand will grow at about 2% per year. With conditions like this, oil prices might never see $20 again and $40 per barrel may be the floor. The Association for the Study of Peak Oil includes Matthew Simmons, a chief energy adviser to the Bush Administration, who states Oil is far too cheap at the moment. The figure I d use is $182 a barrel. We need to price oil realistically to control energy demand. That is because global production is peaking [Fig. 1]. If we price correctly, it could give us time to find bridge fuels to fill the gap between the oil economy and a renewable economy. I don t see that happening. Natural gas in North America is already past its peak production. ʺThe U.S. is in a natural gas crisisʺ, stated Andrew Liveris, CEO of Dow Chemical before a Senate Committee on October 6, 2005. Natural gas effects more than just heating and electrical generation. The crunch is already squeezing industrial America, and will ultimately impact U.S. consumers in the form of other higher prices. Current stocks of natural gas are 151 billion cubic feet less than in 2004 and it appears that the U.S. has entered a cold winter. Together this could draw natural gas stocks all the way down to the 500 billion cubic feet the pipeline network must retain to stay pressurized. The message is clear that with the expanded use of natural gas as a clean fuel, the demand for natural gas in the U.S. is likely to outstrip supply over the next decade, keeping gas prices high. What is the long term demand potential for oil & gas? China & India industrial expansions are causing global energy demand to explode. The estimated demand increase is 24 billion barrels from these multi billion population countries. On the supply side of the equation, for every one new barrel of oil discovered the world consumes four barrels. Geologists indicate that 80% of all existing oil fields are in their decline phase. This suggests that the price of oil & gas will rise during the balance of this decade.
Why haven t more financial planners used private placement oil and gas programs to hedge clients against these macro economic trends? Their concerns might be summarized in three phrases Other planners aren t recommending these investments, I can t risk my client s assets, or I don t know were to find these programs. Possible solutions to these concerns are detailed in this article, but to summarize (following the old military maxim tell them what you are going to say, tell them, and tell them what you just said ), the authors (both Air Force aviators a long time ago) believe the solution is the development of investment banking firms and sector funds, which will specialize in project financing instead of corporate financing. Industry knowledgeable managers in these firm will require a new level of due diligence, including for the first time a geologic/engineering investigation. Anything less than this level of review is inadequate. Investors are purchasing these investments in greater numbers. According to the most recent data compiled by Robert A. Stanger & Co. and the Investment Program Association, Sales of [registered] oil and gas programs totaled $110.5 million through June of 2005 just a little below the $116 million posted in all of 2003 and on a pace to equal the $199.5 million in 2004. However, this report only covered the smaller part of the market, the registered programs sold primarily to non accredited investors. Private programs sold to accredited investors are estimated to be seven times greater. Consider what would happen if financial planners, instead of just registered broker dealers, recommended direct participation programs to their clients. Instead of ignoring a potential asset class that may provide superior portfolio non correlation benefits and which is already accepted by many wealthy investors, a client focused planner should consider employing direct ownership oil and gas investments as an option. In short, a financial advisor who learns more about oil and gas direct participation investments might find that accredited clients will seek him out as a sophisticated advisor. The second issue, I can t risk my client s assets, appears to justify why many advisors don t recommend energy, i.e. the client could lose everything with a dry hole. First, let s be clear oil and gas investments should only be part of a well constructed mix of investment assets. A single well Investment is not recommended. Advisors should only recommend diversified, risk managed oil and gas programs with proven operators. Then the client should be in multiple programs, not just one. This approach reduces client risk and provides exposure to owning valuable, income producing oil & gas properties combined with the potential for substantial return on investment. A question that usually pops up at this point is what type of program should the investor look at? Oil and gas projects can range across the risk/reward spectrum, from wildcatting to producing property acquisition. The investment community might find the answer by
investigating where the oil industry puts it money, then find programs that emulate that, i.e. follow the money. The petroleum industry drills three times as many wells [Fig. 2] for what s called conventional resources in the mainstream areas running from the Gulf of Mexico northwards. This is despite the fact the US Geological Service estimates there is more undeveloped natural gas in the nonconventional areas of the eastern states and the Rocky Mountains [compare Fig. 3 and Fig. 4]. The same thing can basically be said for oil except the proportional difference in size of the same two categories for oil is much greater (there is very little non conventional oil), but the total size of all oil resources is smaller than natural gas. Conventional oil and gas occurs in areas where dry holes are a fact of life [Fig. 3]. However the economics are such that one successful well usually quickly pays for itself and the dry holes, plus can make a serious profit. Typically in the non conventional areas [Fig. 4], 100% of the wells are completed and many produce for long periods. But when analyzed using well accepted petroleum industry methods, a program of these 100% success wells is often less profitable than a mixed success program in the conventional areas. Over time the successful oil and gas companies usually pursue multiple well programs with a percentage of the capital allocated to low risk development wells or acquiring producing oil & gas properties, and the rest of the capital dedicated to high potential exploratory wells. This structure is designed to provide the company with a return of capital over a reasonable time in the worst case yet provide exposure to significant upside. Individual investors and their advisors can do the same if they carefully select the right investment opportunities. We believe a risk balanced investment program is preferable because it is the closest match to what the petroleum industry does as a whole. Private placement investing does require proper due diligence. This due diligence will encompass both the operator s financial and industry background, as well as the program s geologic/engineering attributes; resulting in both qualitative and quantitative analysis that correctly evaluates the investors economic benefits and risks. The authors believe this is the biggest hurtle facing the CFP TM. The key to effective due diligence is 1) to find and employ highly qualified, independent financial analysts, petroleum engineers and geologists and 2) look at the economics of the proposal, not just the legality of the documents and backgrounds of the management. What should you look for when evaluating the evaluator? Due diligence firms should employ oil and gas financial specialists who have been trained in the industry and are capable of analyzing the financial reporting of prior programs, current program and tax validity. All due diligence firms should provide you with their due diligence check list and their process for evaluating the economics of oil and gas projects.
Without such experienced personnel, important deal structure aspects of the investment could be missed and/or marginal projects might be approved. Either might result in a program passing despite the fact it is very unlikely that the investment will ever payout. It isn t that these industry experts can make the project less risky than nature has already made it. It s that these experts can more properly evaluate the risk and report that to you and your client. But this still leaves us with the last set of concerns access to these investments. The foundation of these potential investment products is huge. Over sixty percent of the oil and gas wells in the United States are drilled by the small, non public, oil & gas companies (18,855 wells out of 31,253 during 2004). More likely then not, these wells are drilled using partial outside funding. These companies are managed by seasoned professionals, often trained by the major oil and gas companies during the last oil and gas boom over 25 years ago, and who have since become successful entrepreneurs. Larger institutional investment firms often employ petroleum industry experts to assist them. You find geologists and engineers working as Wall Street analysts and commercial bankers. And there are the boutique investment banking firms specializing in petroleum. However, these all firms tend to focus on investment packages larger than $20 million. This is more than most smaller oil & gas companies need (or should be given) at one time. Therefore, the smaller project financing deals fly below Wall Street s radar screen. Because most CFP s tm are associated with smaller firms lacking petroleum industry connections, you don t see these deals either. But these opportunities are out there. One example is the North American Prospect Expo held twice a year in Houston (http://www.napeonline.com/documents/aboutnape.jsp). Last winter it drew over 10,000 attendees and 664 companies, most looking for capital. The authors believe the solution is the development of investment banking firms and sector funds that will specialize in private placement oil & gas project financing instead of corporate financing. This will have the added benefit of having industry knowledgeable managers raising the level of due diligence as we talked about above. In conclusion, the authors believe oil and gas investments belong in more investment portfolios. We also believe those advisors who make the effort to become knowledgeable will have clients searching for them instead of them searching for clients. The main reason for a client to invest in an oil and gas programs is to have a high probability of ultimately owning production that will provide substantial annual cash flow and a very high return on investment. That can only be done by drilling where such potential exists. A low risk (100% completed wells) program typically will also be located in areas of low return. If the
100% success area had a high return potential, the majority of the petroleum industry would be there now. They aren t. Consider the big picture. The petroleum industry is a major component of the US Gross National Product, and one in which many small companies (examples: Apache Corporation [APA], Chesapeake Energy Corporation [CHK], Swift Energy Company [SFY]) have successfully evolved into major corporations in relatively short periods of time. All these companies offered private placement oil & gas programs during the earlier parts of their corporate growth. Today there are many high quality independent operators hoping to take that same path. The authors also believe most investment advisors would be better served by finding petroleum knowledgeable investment banking firms and sector funds that specialize in oil & gas project financing. Let these intermediaries set the standard for due diligence and acceptable risk/reward forecasts. There are many seasoned, independent operators available who could provide high quality programs to the financial planning community if you make an effort to find them.
The authors: Steven King, the founder of PetroInvest LLC, the Private Placement Drilling Program Exchange, has 28 years of petroleum industry experience, including the last nine years in the finance/securities industry focusing on Oil and Gas. After eight years as a pilot in the USAF, he began his O&G career in 1978 with Tenneco Oil Company and later was a founding member of Newfield Exploration Co (now a $4.3 billion NYSE listed company). Starting in the early 90 s he consulted for various domestic and foreign petroleum companies, financial institutions, and one foreign government; on offshore and onshore, domestic and international projects; mainly focusing on deal structure, economic evaluations and later on capital formation. King has a bachelors degree in geology, a masters degree in business, and Series 7 and 24 securities licenses. He can be reached at 713-667-5692 or at sking@petroinvest.com. Martin Cohen CFP tm, is president of Balanced Financial Securities, an NASD Broker Dealer specializing in alternative investment services for investment advisers and broker dealers. He is co-founder of the Dallas IAFP Chapter, founder of the Dallas Society of Certified Financial Planners, and served two years on the national board of the Institute for Certified Financial Planners. He has been licensed in securities sales for 48 years, earned his CFP tm in 1978 and has specialized in due diligence of managed accounts and alternative investments for financial planning implementation.
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