Outside capital sources for microcap companies

Speculative capital is harder to come by. Even for the acquisition of producing properties, the combination of senior debt and mezzanine debt (second-position debt at higher rates, often with an ownership kicker) often isn’t enough to fund the drilling of the proven undeveloped reserves (as defined by the SEC, i.e. the close-in stuff) - where the real economic upside resides.

Firms wanting to drill new projects are having even greater difficulty funding their ideas. Even the firms attempting to acquire producing properties with a relatively low amount of current production compared to the upside drilling have problems.

Typically, they have “farmed out” (organized a promoted joint venture) all or part of these projects to “the industry” (that small group of very knowledgeable drilling capital providers, ranging from individuals up to the larger petroleum companies). This is the basis for the North American Prospect Expo (NAPE), www.napeonline.com, which typically draws more than 10,000 attendees twice a year to Houston.

The funding vehicle that generates the greatest attention on Wall Street, and therefore gets the major part of the financial press coverage, is speculative corporate-level financing, either private common or preferred shares.

Usually the business plan is based on the oil and gas company making a large (at least for that firm) producing property acquisition using the maximum amount of bank debt available, with equity monies focused on upside drilling, as well as new project drilling. Because this form of financing is as much an investment in the management as it is in projects, only the pedigreed management teams usually qualify.

An alternative approach, fitting somewhere between the first two, has been used by a relatively small number of firms. They have developed well-oiled marketing systems and raise funds by selling limited partnerships to the non-petroleum investing community. While this can be focused on an individual project, more likely it is a larger program.

This has accounted for approximately 5% of the wells drilled annually. New firms looking at this source are faced with several barriers to entry:

• Their buddies have a negative opinion of partnerships;
• A fear of securities regulators;
• The initial start-up costs; and
• Becoming associated with a “boiler-room” broker/dealer.

Let’s look at these three forms of financing.

Industry farmouts

A typical deal might be a “third for a quarter at casing point.” Often these deals are done on a single exploratory well basis, which if successful might lead to development wells into the same reservoir.

For the non-petroleum reader, this jargon might be a little confusing. This expression conveys two ideas, the first is the ratio between the cost basis and the final ownership. The “third” doesn’t mean the capital provider (the “farmee”) has to participate for exactly a third of the cost of the well, with two other parties also paying a third, in order to earn a quarter.

It’s really the ratio between the two as applied to whatever part you want to participate in that’s important. Sometimes, the project originator (the “farmor”) will keep some of the at-risk portion of the project. For example if only 50% was sold, the cost basis would be farmor 50% and farmee 50%, and the final ownership would be farmor 62.5% and farmee 37.5%.

The second element of the expression says the promote ends at “casing point” - being that time the well has been drilled to depth and the initial testing has been done. If the decision is run production casing, all parties participate equally from that point forward without any carry or promote. This may also signal that the farmor will be paying for its 25% cost of all development wells resulting from that initial well.

Naturally there is no such thing as a standard industry deal. A variation would be “through the tanks”. This means the promote ends after the well has been completed and equipped. Obviously, this should be a better deal for the farmor since the promote lasts longer. There are so many other variations (how sunk costs are handled, overriding royalties (“ORRI”), etc.), that the only sound advice is to read the actual agreement and don’t rely on the jargon.

From the other side of the deal, one of the more investor beneficial deal structures you can look for would be a delay in the farmor’s “backin” (point in time when the farmor increases its ownership) until payout. This lowers the farmee’s risk before payout (“BPO”) if the reserves are less than expected. The farmor is rewarded after payout (“APO”) if the reserves are larger than projected. The farmor will often have a small revenue stream from an ORRI or carried working interest BPO and convert that into regular working interest (“WI”) after payout.

It isn’t as simple as saying an “at casing point” deal is better than a “through the tanks” deal, or that you should only invest in deals with a payout structure. Better projects probably deserve stiffer terms. The farmee’s evaluation of the project is probably more important than the terms of the trade. For the non-petroleum financial professional, this can be a daunting task. Even with a technical consultant’s report, what does it mean?

From the non-petroleum financial professional’s point of view, the major barrier to entry into this financing arena is this lack of experience. Not only is the oil industry a capital intensive industry, it is also a knowledge intensive industry. It isn’t uncommon for new hires with advanced degrees to undergo years of apprenticeship before being trusted with critical functions. The non-petroleum trained financial professional shouldn’t expect to become an expert overnight.

The typical farmout assumes the prospective investors can supply their own due diligence. The typical farmout letter agreement and joint operating agreement lack the boiler plate common to the limited partnerships (see below). Therefore, a non-petroleum financial professional recommending a farmout to his or her clients would be very exposed if the client was to later turn adversarial.

Despite the fact that the SEC regards oil and gas participation to be a security, the farmor who restricts its solicitation to industry insiders, probably doesn’t run much risk from the regulators. But where is the line between the insider and non-petroleum worlds? Is the operator who allows his brother-in-law dentist to participate safe? What if the brother-in-law introduces the deal to other dentist friends?

NOTE: In future articles in this series, we will look at some of the evaluation techniques developed by the petroleum industry. Additionally, we are recruiting other professionals, including securities attorneys, to address specific issues.

Corporate financing

Let’s consider another form of speculative financing - private debt and/or equity funding with the anticipation that the microcap firm will grow to the point that it can either go public or sell out to a larger firm. We will call this “Wall Street” funding.

The structure of this funding can have a multitude of varieties, but can be divided into two basic forms.

1. Debt: If the business plan includes a producing property acquisition, the management team might include a lower cost commercial bank loan as part of the overall package. This can be non-recourse (i.e. default liabilities limited to the specific producing properties) or might be a corporate obligation. Sometimes this debt may have some equity provisions. Normally reserve based loans are limited to 60% of the present value of the production and their usefulness is limited. Equity and/or mezzanine debt will also be required.

2. Equity: Most business plans call for drilling, either to exploit the upside on the producing property acquisition or on undeveloped leases. Mezzanine funds might be available for a part of this upside, but the majority of this funding typically comes from equity. This equity can be either private common shares and/or private preferred shares. Unless the management team also invests a significant part of the seed capital, it will have a small minority ownership position in the corporation with some claw back if certain hurtles are cleared.

Since this Wall Street funding can be quite large ($100 million and above often raised in only a few rounds of funding), it is restricted to the pedigreed management teams. These are complete, multi-discipline, management groups who have done it before.

For the non-petroleum investor and his financial advisor, these deals can be excellent opportunities. By the time they become available, the deal and management have been through extensive due diligence and economic analysis.

On the downside, there may be fewer investment opportunities out there compared to demand. During the last oil industry boom 25 years ago the Wall Street method of funding was very popular. Remember the Oil & Gas Journal 500 list? Today that same survey of publicly-traded US oil and gas companies is titled the OGJ200, but in reality is the OGJ149. During the last boom, the majority of wells were drilled by the OGJ500 firms. Today more than 60% of oil and gas wells are drilled by private companies.

Additionally, there are several pedigreed management groups that don’t want to do another Wall Street deal. Typically, even with management risking its own money, the investor side of the deal owns the majority of the company, even after management claws back some ownership by reaching certain economic hurtles.

Wall Street justifies its majority ownership by pointing out that having access to significant amounts of capital allows the management team to grow the company quickly. The result might be that a minority share is worth more than 100% ownership of a small, capital-restrained firm.

Whether increasing commodity prices will increase the availably in the near future or not is uncertain. Some publications that track these issues estimate there have only been 70 energy company IPOs in the last 3 years. The lower supply of available deals and increasing interest from Wall Street might mean the investors will have to settle for less lucrative terms compared to the last boom.

Limited partnerships

A third speculative capital source fits somewhere between farmouts and Wall Street. Significant amounts of money could be accessed from the large pool of investment dollars controlled by non-petroleum, accredited investors. Much of this resides in the brokerage accounts overseen by registered brokers or registered investment advisors.

Significant amounts are also in commercial real estate. Some of this already is invested in oil and gas, but still this is a drop in the bucket of total discretionary funds controlled by the accredited investors. A shift of only a small part of that general capital pool into petroleum could be quite significant.

The private placement of drilling limited partnerships never really went away in the last 25 years. A handful of companies, both public and private, still regard the marketing and maintenance of partnerships as their primary business. They also drill about 5% of domestic wells each year.

The limited partnership deal structure is a cross between the farmout and the Wall Street deal. It is getting a new look with the new domestic landscape and the higher commodity prices. While some are still done on a project basis, most of the money raised is for programs. This allows the management of risk to work.

In many ways it is just another farmout, except the farmout is to an entity also controlled by the oil and gas operator. Assuming the fiduciary responsibilities are not violated, the arrangement has advantages compared to the industry farmout. One company makes the decisions for 100% of the participants.

Unfortunately, this method of funding has a less-than-pristine image. In the 1970s and ‘80s, many unqualified organizers, including some major Wall Street names, set up these limited partnerships. When the commodity prices crashed and the tax laws changed, many failed to be a return of capital, a much bigger sin than failing to be a return on capital.

Many non-petroleum investors and their advisors are just plain afraid. The current marketing system relying on individual wholesalers gathering together a selling syndication is very inefficient and fails to instill confidence. Then there are still the “boiler room” operations.

A major difference between limited partnerships compared to the other methods, is the dissimilarity in technical knowledge between the two sides of the deal. We shouldn’t expect the generalist financial advisor to have the necessary knowledge level. But until they access real industry technical help, they will continue to be the prey of the providers of hype masquerading as real energy companies.

Given the number of available, experienced consultants, there is no justification for limited partnership investors not to benefit from the same level of technical due diligence that Wall Street insists on. Petroleum companies have a long history of allowing potential investors access to the technical details of proposed operations. They wouldn’t have gotten funded otherwise. Not that the average partnership investor should attempt this themselves. That’s the intended role of third-party technical due diligence.

Conclusion

This shift in the makeup between public and private firms in the domestic oil and gas industry has been driven by the decreasing size of the remaining targets being drilled, as well as the increased size and technical qualifications of the independent technical consultants.

For the last 20 years the oil industry has downsized to the extent that the real expertise has moved into the private ranks. Compared to the roughly 4,000 rigs working in the early 1980s, we now support fewer than 1,500.

Acknowledging this major shift in the makeup of the domestic oil industry, the Oil & Gas Financial Journal began publishing its private company survey in July 2005. Called the OGFJ100P, the list of private E&P companies is expected to grow steadily until it eventually encompasses all of the approximately 500 microcap private firms doing business in the US.

The author

Steven D. King [[email protected]] is president and founder of PetroInvest LLC, an investment banking firm specializing in project funding for small petroleum companies. This article is the first of a series written primarily for the non-petroleum finance professional with the intention of improving the dialogue between investors and the oil and gas industry.