Partnership drilling contracts - a wolf in sheep’s clothing?

Steven D. King, PetroInvest LLC, Houston

While the investor and his financial advisor equate fixed price with less risk, many drilling program sponsors offer turnkey contracts for an entirely different reason. They rely on extreme mark-ups to generate the lion’s share of their corporate profit.

What other reason can explain why the mainstream oil and gas industry uses variable price contracts (day-rate contracts) for the vast majority of the approximately 35,000 wells drilled annually, but most partnership wells (+/-3000 annually) are drilled under fixed-price turnkey contracts?

Last month in Oil & Gas Financial Journal, I reviewed tax-motivated drilling programs. One of the key elements, especially for the year-end programs, was the use of turnkey drilling contracts. Properly used, these allows the investor to off set some of the current year’s ordinary earned income by activity commenced in the first quarter of next year.

The non-petroleum industry investor might like the turnkey’s “no-cash call” element, but in general, this is all they know about these contracts. Some mistakenly believe the turnkey contract protects them from geologic failure (i.e. a successfully drilled well that is a geologic dry hole).

Exactly what is a turnkey drilling contract? Since the largest portion of the investors’ dollar goes into drilling operations, it is critical that investors have this information. Readers not completely familiar with the industry jargon should first read the definitions at the end of this article, and then come back.

Day-rate vs. turnkey contracts

Under both types of contracts, the contractor owns the rig; is responsible for its supplies and maintenance; and hires, trains, and manages its crew. However, other tasks are allocated differently, according to the contractual arrangement. Most important are the specific decisions about how the well is drilled, including what type of bit to use, when to change bits, how much pressure to apply to the bit, what mud weight to use, and when to vary the orientation of the bit relative to the vertical line, among others.

Under a day-rate contract, the “company man,” an employee of the operator who is physically stationed on the rig, makes these decisions. Under a turnkey contract, it is the contractor’s staff.

For the same well without problems, a turnkey contract should be more expensive. There should be a premium over the normal AFE estimate. Think of it as insurance. If nothing goes wrong, the driller keeps the insurance premium, but if there are problems, it may lose money. In a perfect world, the turnkey contractor should break even plus make a reasonable profit. If it makes money on every operation, it is probably overpricing.

A place to learn more is the International Association of Drilling Contractors website (http://www.iadc.org). There are 547 members classified as “Land Drilling Contractors.”

Program “Turnkey Contracts”

In many partnership programs, wells are drilled using day-rate contracts, but the investor pays a turnkey price, usually to an intermediary set up by the program organizer. Investors should closely examine these arrangements:

• If the turnkey is a critical part of a year-end, tax-motivated program, were all contracts signed and paid for before Dec. 31?
• Are the operations clearly defined and measurable? The cost has to be more than a deposit on unknown future operations?
• Are these “arms-length” contracts, fairly priced and negotiated?
• Does the intermediary have the financial resources to pay for cost overruns?

The key for both the investor and the turnkey provider is the pricing of the turnkey premium. Simple wells, such as the coal bed methane or the shallow Eastern USA wells should have a small markup. Wells drilling into abnormal pressure that require intermediate casing should have higher markups.

I can’t give you any numbers because it is a moving target, but I can say that due diligence isn’t complete until a reliable, third-party industry expert has examined this area. There is just too much money involved in this one expense category to assume anything.

There is an additional danger for the investor. The Internal Revenue Service could disallow part of the IDC deduction because the drilling charge was in excess of normal industry rates. It will be the investor and his tax preparer making these claims on the individual tax returns, and it is the investor who will be responsible for unpaid taxes and penalties if the program sponsor is wrong.

Program sponsors might argue that there hasn’t been an IRS inquiry into their past programs. Just because they haven’t been audited so far doesn’t mean you are safe. All it would take is an unrelated issue to cause an audit of one of the other investors, which leads the IRS to this issue and then causes the IRS to ask the organizer of a list of all investors.

Consumer beware

A properly priced turnkey might be a very desirable investment attribute. However, this is one area where the investor should be extremely watchful. This is especially true in those regions with poor oil and gas economics to start with. When the wells typically don’t payout for 10 years or more, the main profit center for the organizer has been the excessive turnkey mark-ups.

It’s a Catch-22 situation because the excessive cost makes the wells all the more marginal for the investor. I have seen some coalbed methane well programs charging $400,000 for wells that actually cost less than $100,000. These are simple wells and the only danger was cost inflation.

This is also the one area where the lawyers, who caution the investor with pages and pages of bold print warnings about every other risk possibility, completely miss this big issue. I can’t recall any memorandum I have read that discusses the fact the investor might be paying more than a fair turnkey price.

Other variations

If the goal of using a turnkey drilling contract was to avoid a cash call before the start of production, there are other alternatives. Note I qualified this as being during the initial capital-spending phase. Even the typical “no cash call” program has to have some mechanism to handle later capital needs, especially after the investor has converted from an at-risk general partner to a limited partner.

Fixed cost/variable ownership: One of the larger program sponsors charges what looks like a fair turnkey markup. If the well cost is less, the program organizer keeps the difference. If the actual well cost exceeds the fixed cost, the organizer pays the cost overrun. The investor doesn’t receive an AFE call.

But there is a twist. As the organizer spends in excess of the turnkey price, the investor’s ownership share of the well decreases. This is on top of the organizer’s free carried working interest. In other words, the major risk to the organizer is the well costs more than the turnkey price and the well was dry. If it cost more and was a producing well, the organizer has a better chance of recovering his cost.

Properly priced, this may be a better method than a straight turnkey for the single or double well programs, especially when there is lower mechanical drilling risk.

Fixed cost/variable number of wells: One other variation is to fix the investor’s capital cost but vary the number of wells. One of the largest program sponsor s uses this idea (and to its credit doesn’t try to pass it off as a turnkey). Here the organizer drills until the money runs out. The investor pays actual costs, plus a very small management fee.

This approach maximizes the opportunities. If the program organizer drills nothing but dry holes (statistically unlikely in a multi-well program), more opportunities are tested. This is because the completion cost not spent in the dry holes goes into more wells. This is a reverse Catch-22 situation. As more opportunities are drilled, the probability of nothing but dry holes reduces.

The risk of any single well cost overrun is borne by the investors in the sense that the number of wells drilled is reduced. The most likely outcome of a mix of dry holes and completed wells should have a higher value to the investor than would the same dollar amount going into fewer turnkey wells, especially in a larger program of moderate to lower risk wells. A minor variation would be to guarantee a minimum number of wells that would be drilled.

Conclusion

There are times when partnerships should use a real turnkey contract with a drilling contractor. For these high drilling risk wells, both the investor and organizer are protected. If the potential is there, then the extra turnkey cost may be more than justified. Where the organizer is financially fit, the organizer-provided turnkey could suffice.

For the single or double well programs, provided they are not extremely high drilling risk, the fixed cost/variable interest should maximize the investors’ economic return. The fixed cost/flexible number concept probably works better for the multi-well, lower to moderate drilling risk programs.

All variations eliminate cash calls during the initial investment phase. The last two provide more bang for the buck than the turnkey - hopefully at a reasonable risk.

The author