Considerations in direct investment in oil and gas wells...

Investing in gas wells is not for the faint of heart. Let’s get that on the table right up front. If you’re known about town as an investor, it’s likely you’ve had the opportunity to see direct investment deals in oil and gas. Oil and gas drilling has been with us since 1859, and it’s not going away anytime soon. Recent technology breakthroughs in horizontal drilling and hydraulic fracturing have brought an onslaught of activity in the gas shale plays – the Marcellus shale, Haynesville shale, Fayetteville shale, Eagle Ford shale, Woodford shale, and others. Invariably as drilling booms occur, arm chair investors will have opportunity to invest in direct participation drilling deals. Direct participation investing in gas wells means you are investing at the grass roots level, owning a working interest in a specific natural gas well or wells. If you’re considering jumping in, read on for further understanding of the risks and rewards. 

 “Why did this deal come my way”? 
 This is an overriding question of primary importance. It speaks to a poignant issue regarding any capital intensive project - the issue of matching appropriate capital with the venture. Appropriate capital comes from investors educated in the art of the deal who understand the legal and technical issues at play, are able to evaluate the risks properly, AND who can afford total loss of capital. Make no mistake about it, investing in gas wells is a risky proposition – not for the faint of heart. “Wildcatters go to Vegas to calm their nerves” is no misplaced statement. 

Thus, while there are legitimate answers to the question, one should always make peace with why a project demanding highly engineered analysis – technical, economic, geological, and mechanical – is looking to the every day investor for money. Sometimes, it’s because industry experienced people don’t see it as an attractive proposition. Thus it finds its way to the country club crowd, seeking takers who may not evaluate the risks properly. In fairness, many have ample capital to allocate to risky ventures, and as such, direct participation gas wells fits the bill. If so, so be it. One can get very well, very quickly in a soundly executed play (oil and gas lingo for drilling projects). So, having considered both sides of the coin, let’s look over some of the risks of gas well investing. 

People Risk
Simply put, this should rank high on the list of the judgment calls one must make. Not enough ink can cover the topic of confirming the honesty, integrity, professional ability, and history of the people involved in the deal. Is the proposed operator of the well an experienced operator? Has he drilled in the area? Is there extraordinary environmental exposure? Is the company financially sound? Is proper insurance in place? Is he putting hard cash in the project? You’ve got plenty of additional risks ahead. The last thing you want are questionable players at the helm. 

Mechanical Risk
Drilling in the earth a mile or two deep, cementing steel casing, perforating it exactly in the right spot, and outfitting it to bring that precious natural gas to the surface is no walk in the park. Sure it’s done everyday, but often with expensive hiccups along the way. A poor cementing job allows channeling of gas or water behind the casing. Sometimes reservoir attributes demand sand screens, and even specialized chemicals, which often aren’t friendly to steel pipe. Oh, and did I mention temperatures often exceeding 200 degrees Fahrenheit? How about a hydraulic fracture job that just doesn't go right? 

 In short, there is plenty that can go wrong mechanically between the start of drilling and putting the first million cubic feet of natural gas down the line. Reality is that the private investor has no way to mitigate mechanical risk once the well is underway. You’ll be relying on the expertise of the operator and the drilling contractor.
Reserve Risk 
 The size (and producing characteristics) of the gas reservoir you tap into has a LOT to do with whether or not a drilling project ultimately makes economic sense. If you’ve put a straw into something the size of a swimming pool, well… you get the picture. Remember, this is a gas deal – you’re looking for a greater than 4 to 1, and hopefully a 20 to 1 payoff. The point to understand is that recoverable reserves can vary widely, the determination dependent upon educated guesses – well control, seismic evaluation, and the area’s historical production, to name just a few. 

Thus, striking a gas sandstone or shale does not a Jed Clampitt make. It’s got to be of sufficient size to matter. 

Price Risk 
OK, let’s say you’ve been fortunate enough to tap into a nice reservoir. Now, it must be sold. Raw natural gas is commodity product – meaning you’ll sell yours at exactly what the market will bear – no more, no less. As with all commodities, numerous factors go into determining their value, all of which you have no control over. The simple thing to remember is that you (nor the company operating your well) have any meaningful influence on the price at which you sell your product. 

Reasoned forecasts are the best you can do unless a price hedge has been put in place, and of course that has risks in it as well. 

The “You” Risk
Are you able to manage yourself? Drilling for gas demands decisions from you along the way. For instance: Do you agree to set casing on the well? This is usually the first and most fundamental of questions. You are essentially making a call as to the estimated productivity of the well – electing either to continue spending more money to complete the well, or declaring it a duster. Other possible emotional strains can come in the form of decisions about going forward in light of lost items in the hole requiring expensive “fishing” procedures, or “squeeze” jobs to cut off unwanted water, or long waits for pipeline hookups, or… - you get the picture. 

Bottom line 
Go in with your eyes open. Be sure you understand the scope of decisions you may have to make. Again I say, investing in gas wells is a narrow niche, not fit for everyone. 

Deal Structure Risk
Assuming all the planets have aligned thus far, now take a hard look at the specific terms of the deal. How much of your entry capital is going to direct costs - is this clearly determinable? Who and to what extent are others getting “carried” (i.e. carried along as a participant without any obligation to put their money in the deal). Is the difference in your NRI (net revenue interest) and your WI (working interest) reasonable? Remember, all the paying partners have to bear their portion of the gas royalty paid to the landowner – he’s getting a free ride (after all, it’s his gas you’re after). Read the Operating Agreement (that should be provided you), which addresses ongoing operational terms. Is the monthly management fee reasonable? You’ll (hopefully) be paying it for a long time. And, don’t forget to consider how this project might affect your tax situation. Finally, take a look at the others in the deal. Little speaks louder than a sponsor’s money invested alongside on similar terms as yours. There is no doubt that the U.S. provides opportunity for the private investor to make himself into an oil or gas man. And, there are reputable operators who are more than willing to let you join them. There are risks aplenty, but if you’ve got the stomach and the cash to play, you too might join in singing “Ole Jed’s a Millionaire".