Do your own due diligence

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.