How To Pick An Oil Gas Deal

These investments have become increasingly risky. But there are ways to avoid coming up dry.

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Among the most popular investments in today's tax-shelter marketplace are oil and gas drilling programs. Organized as limited partnerships to maximize tax writeoffs, these programs provide investors with a more direct participation in drilling operations than can be enjoyed through purchase of the common stock of oil majors. As many as 130 Securities and Exchange Commission-registered "public" drilling programs will go on the block in 1981 and raise in the neighborhood of $2.5 billion. Ten times that amount may be raised through private placements that are not registered with the SEC.

Given the popularity of these programs, it's amazing how little the average investor knows about buying one intelligently. The desire for quick up-front tax breaks often obscures the intrinsic merits -- or defects -- that set one program apart from another. And as the whole oil and gas marketplace becomes more competitive, as profits flatten, as the conservation ethic takes hold and the world's inventories of oil rise, picking the right deal out of a greatly enlarged field becomes even more difficult. The guidelines below are important criteria for those considering putting money into one of these deals.

Objectives. It's not at all uncommon for a program to be successful by its own standards, yet fail to meet the income or shelter needs of an investor who didn't match these standards to his own. Different investors have different reasons for buying into oil and gas programs: Speculators like the long odds and chances for big payoffs while the well-to-do may seek only to preserve, rather than enhance, their capital. Each should carefully review the prospectus (which can run to 200 pages). As a general rule, exploratory drilling programs are best suited to those who want large, up-front deductions and a chance for returns that probably won't materialize for years -- if at all. Developmental drilling programs, on the other hand, are more for the income-oriented investor seeking early returns.

Track record. The great desire of the public to buy into oil and gas drilling programs has attracted many relatively inexperienced program organizers into the field in recent years. Sometimes these are real estate or leasing syndicators who take on a few old oil hands and sell a deal, or simply newer companies that are organizing a few smallish programs as a means of developing a sales network that will be able to handle a larger offering at a later date. Given the exceptional competition in today's oil business for everything from choice drilling sites to adequate rigs and piping, an investor who doesn't stick with the most experienced firms has an excellent chance of losing his money. The prospectus will describe an organizer's prior deals and their outcomes.

Program size. With insurance companies and pension and other funds newly moving into the oil and gas marketplace (influenced by the liberalization of legal restrictions, they invested $750 million in 1980 alone), and with ample money flowing in from a host of other sources, one of the biggest temptations facing program organizers who have had successful prior deals is to substantially increase the size of their present offerings. They may jump, for example, from a $10-million program to a $30-million one. This temptation is often seconded by the broker-dealers who sell the programs at a whopping 7.5% commission -- well above what they receive for handling stocks and bonds. From the investor's point of view, there is little difference between larger and smaller programs in terms of return. But if a program has to spend more money just because it has been raised, that's a sure prescription for getting a lot of second-rate property. The dollar size is not necessarily bad in itself, but a program organizer who expands too rapidly just to exploit a good track record should be approached with caution.

In-house resources. Finding and operating good oil and gas properties requires the services of geologists, land-men, engineers, and numerous other professional and nonprofessional types -- all in short supply in today's oil fields. The programs in which you invest should have direct access to such people. Unfortunately, it isn't at all uncommon to see syndicators with almost no professional staffs organizing large programs.They must then turn around and contract out all the functions of program management at premium prices. Obviously, this can't help but cut into investor returns.

Soft costs. These are costs that do not go into either drilling or property. Public oil and gas programs are better than public real estate deals in this respect -- the latter often take as much as 30% to 40% off the top for everything from acquisition fees to sales commissions. Oil and gas investors, however, should also look carefully at management and sales costs. A management fee of more than 5% is suspect; sales commissions of more than 7 1/2% to 8% can mean that a syndicator is anxious to provide extra incentives to his sales network -- and hang it if the extra costs cut into investors' equity.

Conflicts of interest. The negative connotations of this term are easy to exaggerate. Indeed, there should be substantial conflicts of interest among a syndicator's oil and gas programs, arising from the fact that an active syndicator usually runs other programs to which he must devote time, staff, and opportunity, and he may also be drilling for his own account. Much of this is mutually beneficial. The conflicts that deserve special attention are those that can cut directly into your returns. If a syndicator who runs income funds as well as drilling programs, for example, is not prohibited from selling interests in the drilling operation's producing wells to his income funds, you have a conflict-of-interest situation that will cost some investors money.

Tax write-offs. Unlike the write-offs in certain leasing and real estate deals, deductions in most oil and gas programs are standard and not subject to challenge by the Internal Revenue Service. An exception to this rule is sometimes seen in end-year programs, however. In an attempt to generate higher write-offs for the current tax year, syndicators may "expend" program revenues on paper in ways that are not acceptable to the revenuers (such as by a letter of agreement without an actual expenditure). Investors should therefore study very carefully the tax projections of programs purchased between Labor Day and the first of the new year.

Pay-out potential. The "pay-out" in an oil and gas program comes when an investor has gotten back all the money he originally put up cash-on-cash, i.e., dollar for dollar, excluding tax savings. By this definition, only about 30% to 40% of the programs in this market ever pay out, and the speculative nature of the whole field must always be emphasized. Even those programs that do return their original capital may do so in a manner that is not totally acceptable to some investors. If returns don't start within a few years, money is being tied up that could be attracting large returns elsewhere. Investors must calculate whether the opportunity cost of putting capital into these programs is more than outweighed by their tax benefits and ultimate return potential.

Liquidity. Tax shelters are by nature not liquid investments. Money is meant to be committed without easy access.In essence, the government is providing tax breaks to encourage investors to sink dollars for long periods into economic activities that would otherwise have little appeal. There is a type of liquidity, however, that is developing in a few oil and gas deals. This involves a program organizer that is also a publicly traded company. These companies (of which there are several listed on the New York Stock Exchange) sometimes trade their shares for interests in a drilling program that has producing properties. More often, though, such liquidity as exists in oil and gas deals comes at a penalty. Sometimes a syndicator will agree to buy back a certain percentage of program interests two or three years after it is launched, provided that there are proved reserves. The buy-back offer, however, usually writes in large discounts from the value of such reserves. So one-sided a buyback may not be to the liking of investors, but at least it does free some quick cash.

But, given the complexities of taxes and the speculative nature of drilling and exploration, things could be a lot worse. Indeed there might not be any cash left at all for the investor unaware of the pitfalls of these types of programs.