Some investors are losing their shirts in SEC-registered drilling programs
Investors sank nearly $700 million in SEC-registered drilling programs in 2005. What can they do to reduce risks and improve their chances of getting a decent return?
Question - Would you, as a financial advisor, recommend a program from a sponsor with a long history of similar programs that all lost money? To be more specific, for each dollar your client invests, shouldn’t he or she expect some possibility of at least receiving the original investment amount back?
Next question - Now that this information is in the public domain, can a brokerage firm continue approving this same sponsor’s newest programs, especially if the sponsor can’t demonstrate revisions to the programs improving the chance that the investment could be profitable?
During 2005, investors sank $696 million into just such drilling partnerships. Similar amounts are going in this year. We are not talking about high-pressure sales made by boiler-room operators, nor are we talking about the many smaller private placement oil and gas investments sold to accredited investors.
Unfortunately, we are talking about the biggest drilling fund sponsors who sell SEC- registered offerings. The prospectus disclaimers state that just because the offering has gone through the SEC registering process, it is not an endorsement or an indication of less risk. They certainly were not kidding.
Where to find the answers
Evaluating the track records of these sponsors is relatively straightforward. You need to extract 3 numbers from the partnership’s SEC annual filings. Determine the dollars invested by the outside investors (including offering expenses) and the dollars returned to date. Then find the net present value (PV10) of the future production. This section of the 10K is usually done by an outside reservoir engineering firm. Insure these 3 numbers are net to the outside investors.
Add the second 2 numbers and divide by the first. This is PVI (present value index). Many in the petroleum industry consider a $1.00 PVI as the minimum acceptable return. This actually means the investment is returning 10% annually. An example a series of annual PVI evaluations for one program might look as follows:
This example assumes by the end of 2002 all funds ($10.0 million) have been invested and the drilling results are known. At that point, the investor owns a future net cash flow with a present value of $1.23 for each dollar invested. During the next several years, the value of the remaining reserves decreases as the net revenue from production increases cumulative distribution. PVI should gradually climb as each year’s discount factor is no longer applied.
| Year | Investor capital ($MM) | Investor distributions (cumulative) ($MM) | Investor share PV10 ($MM) | PVI (distribution + PV10 / capital) |
|---|---|---|---|---|
| 2005 | 10.0 | 11.5 | 3.0 | $1.45 |
| 2004 | 10.0 | 8.1 | 5.2 | $1.33 |
| 2003 | 10.0 | 5.5 | 7.3 | $1.28 |
| 2002 | 10.0 | 0.0 | 12.3 | $1.23 |
Most registered programs lose money
Reviewing the results in table 2, you should notice the overwhelming majority of the programs have a PVI of less than $1.00 for the early years. The increasing commodity prices have helped all programs (i.e. prices have more than made up for the physical volume actually produced), but for most programs not enough to clear this $1.00 PVI threshold.
Even those that did clear the $1.00 PVI hurtle in later years should not be considered a successful investment decision - just a lucky one. When the decision was actually made years ago, no one expected another immediate tripling of commodity price, which had just doubled.
Petroleum investing is first a return of money, afterwards a return on money. At the end, there is no principle returned or significant liquidation of tangible property. A PVI of $1.00 means the investment doesn’t reach payout until approximately 10 years. Most industry insiders use higher thresholds, especially if the geologic or engineering risk increases.
The registered program sponsors might argue that present value isn’t a correct tool to be used. They point out that actual returns can be determined only after production ceases. That may be correct, but can we wait 30 years before we start to rank one sponsor against another? The SEC mandates the use of discounted cash flow analysis for 10K filings. We can use these numbers today to judge the relative success of the investments.
Sponsors also point out that outside reservoir engineering firms are notoriously conservative in their estimates. They can cite examples of ultimate higher success despite years of lower expectations. Again, they are probably correct, but is there a better measurement tool, especially one done by an outside, third-party expert?
In one of their 10K filings, company “D” included a table showing additional reserves they thought the outside reservoir engineering firm had missed. Including those reserves only increased the PVI by $0.10, but the program remains well below $1.00.
This conservativeness is hopefully being applied evenly to all operators. If a sponsor believes its auditor is too conservative, it should hire a new firm. Our goal is to rate the relative success between operators, and we want an independent third party looking at these reserves. A program showing a very low PVI has a bigger problem than just an overly conservative engineering firm.
Sponsors might also argue this study is ignoring the tax deferral aspect of these investments. These sponsors usually include in the offering documents a table showing the after-tax investment and the before-tax return. That type of apples-to-oranges comparison is only designed to hype the program. Calculating a PVI based on an after-tax investment and the after-tax returns should normally result in a lower PVI than the before-tax PVI used in this article.
If tax deferral on current earned income is the investor’s only goal, why not give to the Red Cross? It is simpler and helps victims, not corporate executives. This article is looking at the before-tax results as filed in the public records.
Finally, does the low PVI result of a single program imply that all other programs from that sponsor will also calculate a similar low PVI, especially if it is one being compared to many? Of course it doesn’t.
A sponsor’s track record isn’t a substitute for the technical review of the next program from that sponsor. However, the track record is a demonstration of the management’s technical expertise. It becomes especially important if the next program is a continuation of the same geologic play and we have the results from multiple prior programs in that play.
How did this situation develop?
The broker-dealer community has not demanded the real results from all programs, registered or private, be reported in a standardized method.
Quality due diligence has not been accomplished. Due diligence isn’t complete until 4 areas have been examined: 1) the documentation, 2) professional expertise and background/credit/criminal checks, 3) technical review of the drilling/acquisition projects, and 4) economic modeling. Normally, a single due diligence provider doesn’t have the specialized experience to cover all areas. Separate specialists are required.
Some brokerage and investment advisory firms might reject the implication that their current due diligence methodology has failed. However, the overwhelming number of under-achieving partnerships is proof that whatever these firms are currently doing doesn’t work.
Fortunately, a solution does exist
These registered oil and gas drilling programs are sold to investors directly or through registered financial professionals. The monies raised amounts to less than 10% of the outside capital raised by the petroleum industry. The remainder comes from Wall Street, industry insiders, and institutional investors.
These firms demand and get quality due diligence. Multiple industry-expert, due diligence firms already exist.
This author is not negative on all similar investments - quite the contrary. Look at the big picture. The petroleum industry was achieving record results at the same time the registered program investors were not. Many private placement drilling program investments also made superior returns during that same period.
There are alternatives
The brokerage community needs to stop accepting programs just because the paperwork is correct. Investors should have at least a chance of making money.
It is time that track records are calculated and sponsors held accountable. What are they willing to do to improve these returns in the future?
The author
Steven King [[email protected] and www.petroinvest.com] is the founder and president of PetroInvest LLC, an investment banking firm focusing on microcap oil and gas company project financing. King has 28 years of petroleum industry experience, a bachelors degree in geology, a masters degree in business, and series 7 and 24 securities licenses. He worked for Tenneco Oil Co. and was a founding member of Newfield Exploration Co.
What are PVI and PV10?
Non-petroleum investors and advisors may not recognize these two valuation tools, but both are “best practices” within the oil industry.
PV10 is the net present value of an investment or a series of future payments (negative values) and income (positive values), using a discount rate of 10%. Each year’s 10K is required to include a PV10 value for its proven reserves.
PVI is the PV10 divided by the invested amount. It is similar to ROI (return on investment - i.e. how many dollars will be returned for each dollar invested) except now it is the PV10 value for each dollar invested. A PVI of $1.00 indicates a future cash flow stream worth $1.00 today for each $1.00 invested.
