Meredith G. Traudt, REISA, Indianapolis, Ind.

Oil and gas direct participation programs can help diversify investor capital as well as provide opportunities for tax deferral and other tax benefits. However, investors must recognize that despite the many benefits, investing in oil and gas is not without risk. Therefore, investors should be certain that appropriate due diligence is conducted prior to placing money into an oil and gas investment.

Appropriate due diligence will depend in part upon the type of direct participation program involved. Investors have the option of investing in direct participation programs involving royalty, overriding royalty, and/or working interests and each carries with it unique risks that must be addressed in the due diligence process.

The terms of turnkey contracts are important for working interest investors because they govern how much such investors will pay for the drilling and completion of program wells. Such contracts also specify whether certain well operations are not covered and, consequently, would require additional contributions from investors in order to be performed.

Sponsors will typically increase the price of a turnkey contract to accommodate cost overruns so they will not have to pay out of pocket. The sponsor retains any unused portion of turnkey contract proceeds, which increases the load ultimately paid by the investor. Thus, the price of a turnkey contract should be investigated so the investor knows how much of a premium they are paying for drilling and completion.

It is important to know your sponsor company, to look at their experience in syndicating oil and gas investments, and the performance of their prior deals. If an investor is seeking a quality royalty investment, a sponsor with years of experience in syndicating royalty programs may be a better choice than a sponsor with experience syndicating working interest programs. In addition, a sponsor with a history of selecting quality oil and gas properties that have provided solid returns may provide a more promising outcome for investors than would a sponsor with inconsistencies in the success of their deals.

A thorough analysis of a sponsor should also reveal the extent of their due diligence in the acquisition and syndication of the oil and gas investments. Good sponsor companies conduct thorough due diligence before acquiring oil and gas properties and know the sellers well. Some sponsor companies become acquainted with the royalty properties years before the acquisition and the seller at least six months before the acquisition, which helps ensure that quality properties are acquired that will likely produce oil and/or gas.

A thorough analysis of the companies operating the wells is a necessity for all oil and gas investments. An inexperienced operator may mean drilling errors that result in low production or no production, whereas an experienced operator may be able to utilize new drilling techniques to produce oil from formations that are typically difficult to access.

Royalty and working interest owners do not get paid unless oil and gas are produced in commercial quantities, so they should be well-informed of the length of time the operators have been in business, whether the experience gained during their uses in business is similar to the formations to be accessed and the drilling techniques required in the potential investment program. An analysis of prior performance is also imperative as an operator's pattern of poor performance or inconsistent performance does not bode well for an investor.

The financial stability of an operator is also a point of interest since an operator with financial issues has the power to cease operations and interrupt revenue streams to investors. A new operator would likely need to be engaged, which could require the contribution of additional funds by investors.

Royalty owners must realize that they only get paid if wells are drilled and producing oil and gas, yet do not have control over whether and when wells are drilled and other well operations. Thus, it is important for royalty owners as well as working interest owners to review the terms of the operating agreement and understand the circumstances in which well operations may cease.

Regardless of the type of direct participation program, it is important for investors to know the projected life of the well or wells that are included in an investment program. A longer well life is more advantageous since a short well life provides less time for investors to recover their principal investment and earn a return. Investors should not take a sponsor company's word for the projected life of a well. Rather they should look to third-party petroleum engineering reports for evidence supporting the sponsor's projections.

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"Now may be a good time for companies to purchase oil and gas properties and syndicate offerings as the prices of oil and gas are at their lowest since 2004, and are expected to increase over the long term. Stress-testing of the sponsor's projections is consequently imperative and should be found in any comprehensive third-party due diligence report. Stress-testing will reveal how large of an impact various price declines will have on investors' returns."

Market conditions at the time the working interests were acquired are also of great importance. Higher oil and gas prices at the time of purchase followed by a decline in prices could result in a loss of investor capital as returns deteriorate. The reason is that inflated oil and gas prices increase the value of oil and gas properties, and a decline in prices will then prolong the length of time wells must produce before reaching payout (the time at which the wells have produced revenue equal to the investors' initial investment).

Now may be a good time for companies to purchase oil and gas properties and syndicate offerings as the prices of oil and gas are at their lowest since 2004, and are expected to increase over the long term. Stress-testing of the sponsor's projections is consequently imperative and should be found in any comprehensive third-party due diligence report. Stress-testing will reveal how large of an impact various price declines will have on investors' returns.

The location and number of wells included in an investment program is integral since it is indicative of risk. A program with only one well is much more risky than a program involving over 50 wells. Programs with multiple wells, especially when the wells are located in multiple oil fields and access different formations, offer investors a hedge in the event some wells are dry holes, have low production, or are destroyed by a natural disaster.

The location of the wells is important because it is indicative of the likelihood of success. Wells drilled in prolific oil fields have a better chance of producing oil and/or gas than wells drilled in fields with unproven reserves, so inquire as to the success and production rates of wells previously drilled in the field in which the program wells are located.

Working interest programs structured as direct investments in wells carry unlimited liability and leave investors financially responsible for any personal or property damage or environmental problems caused by their investment wells. However, working interest investments may also be structured as interests in limited liability entities that own oil and gas properties so that investors are protected against such liability.

1031-eligible working interest programs are not typically structured to provide limited liability to investors. Thus, investors will need to determine how much liability they are willing to carry in exchange for tax deferral.

If an investor chooses a program in which they own a direct interest in wells, the experience and track record of the well operator is especially important. A seasoned operator may help minimize the chance of property damage and environmental contamination.

Oil and gas investments, especially drilling programs, involve much risk. Consequently, due diligence prior to making an investment is a necessity. A comprehensive third-party due diligence report on an oil and gas offering should contain the information specified above.

About the author

Meredith G. Traudt, Esq. is a member of the Real Estate Investment Securities Association (REISA) and works as a due diligence analyst for FactRight, focused on energy, managed futures, and real estate offerings. She previously worked as a compliance analyst for Robert W. Baird & Co. where she researched trade activity, conducted branch audits, and held FINRA series 7, 9, 10, and 66 registrations. In addition, she has worked for Northwestern Mutual Financial Network, analyzing various tax and business succession planning issues. She is a graduate of William Mitchell College of Law and the University of Wisconsin-Madison.

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