From the January 2003 issue of Investment Advisor • Subscribe!

Drilling Down For Income

Investing in oil and gas limited partnerships can

Here's an alternative investment strategy that deserves your attention: direct investment in producing oil and gas properties. "It's a true means of diversification" for high-net-worth clients, says Lewis Altfest, president of L.J. Altfest & Company, a fee-only financial planning firm in New York. Indeed, oil and gas are negatively correlated with stocks, so when equities head south, energy doesn't necessarily follow. Moreover, direct investments in oil and gas properties are pumping out attractive, double-digit rates of return.

Five States Energy Company in Dallas structures such oil and gas private partnerships, and raises about 70% of its capital from fee-only financial planners. You can usually count on running into a Five States representative at NAPFA events, as I did in November at NAPFA's northeast regional conference in Baltimore, where Arthur Budge, president of Five States, was part of a panel discussing investing in oil and gas properties. I caught up with Budge via phone afterwards, and he says investing directly in oil and gas acts as a great portfolio diversifier because, historically, its rates of return have been competitive with equities. "About 600 basis points over long Treasuries seems to be the norm," Budge says. And "the sector has the lowest correlation coefficient to financial assets. The only [other assets] that come close are gold bullion and Swiss francs."

Forget about trying to get comparable returns from energy stocks. "Exxon is much more correlated to the Standard & Poor's 500 than it is to oil prices," Budge says. Small-cap oil may be equally unrewarding over the long haul. "You look at the history of investing in small-cap oil stocks, and the Nasdaq is just pathetic," he says. "Owning production is a whole lot safer than speculating on oil and gas penny stocks."What about a royalty trust? This is a publicly traded vehicle that owns oil and gas royalties. Sure, they are liquid, and you have a more direct interest in what comes out of the ground. But in the end, royalty trusts "tend to trade more like the [stock] market than a commodity," Budge says. "They're driven by interest rates more than the underlying commodity prices."

Energy vs. Treasuries

Oil and gas private partnerships are also attractive, Budge says, because of their income streams. These partnerships "pay a whole lot higher yield than any security you can buy," he says. "The current yields are easily twice [the yields of] 10-year bonds."

To back up the notion that oil and gas partnerships offer competitive returns, Budge and planner Altfest are working on a study of Five States' private oil and gas partnerships dating back to 1990. They hope to have the study published in an academic journal. "We're going to evaluate [Five States' partnerships] on their own and in a portfolio context," says Altfest, who will be speaking this month about oil and gas partnerships at NAPFA's Advanced Planner Conference in Laguna Beach, California.

But it's important to note that the energy sector is extremely volatile. That's why clients must be accredited investors--having at least $1 million in net worth--to invest in private oil and gas partnerships. "Short-term volatility in the commodity is so large that if investors are over-leveraged and don't have a strong enough balance sheet," it's a bad investment, Budge says. "You have to structure [this type of investment] into your portfolio in such a manner that you can ride that high volatility. But even though you have this high volatility, the long-term trend in average price is up." And because it's a self-liquidating asset, he says, "you have to keep track of how much return of capital you get, and you have to periodically be investing or your allocation self-liquidates."

Tom Gryzmala, president of Alexandria Financial Associates in Alexandria, Virginia, invests 3% to 5% of his high-net-worth clients' portfolios in Five States' partnerships, and can attest to the attractive returns. "Over the last 10 years, [Five States' partnerships] had an average annualized total return on the order of 12% to 15%," he says. "That's good."

Planner Altfest also has "a slew" of his high-net-worth clients in the oil and gas sector, and is particularly pleased with a recent Five States partnership that delivered clients a whopping 50% return in 2001. He notes, "we got in at a very cheap price, and now oil prices are way above" where they were when the partnership interests were first sold. Altfest recommends allocating 5% to 10% of accredited investors' portfolios to oil and gas partnerships.

Unlike many partnership promoters, Five States only offers "no-load deals," Budge says. "So only the fee-only [advisors] will go with us." The company structures its partnerships akin to a private REIT, in that it puts together private investment funds to buy producing oil and gas properties, instead of real estate. Five States is the general partner and participating advisors are limited partners.

The Fees, Please

Limited partners pay Five States 2% of revenue to cover the expenses Five States incurs to administer the partnership. But Five States gets only 1% of profits until all of the limited partners have gotten a full return on their investment. "At the end of the quarter there's a certain amount of pre-cash flow that's available from the partnership, and that's split 99 to 1 until the investors get all of their money back," Budge says. "So every quarter when you get a $1,000 distribution, $300 of that is return of your own principal," Gryzmala adds. "By seven to eight years, you've gotten all your money back and meanwhile [the well is] still pumping oil--that's free profit to you." A partnership consists of 100 units and each unit sells for $100,000, but quarter units can be purchased for $25,000.

Owning interests in producing oil properties does entail "more tax compliance work" than owning stocks, Budge warns. With natural resources, investors are given an annual depletion allowance. Oil and gas limited partnerships generally pass the allowance on to limited partners to use to reduce tax liabilities. This depletion allowance also requires filing a separate tax form with the IRS. "Typically when you own a partnership interest, everything is filed on [an IRS] K1 form," Budge says. But there is no IRS form that allows for depletion, he says, so Five States performs the necessary calculations "and staples it to the tax return."

This practice is well known among accountants in oil-producing states, Budge says. But for investors and their accountants in non-oil-producing states, Five States provides special instructions to walk them through the filing process. The instructions are even detailed enough for investors who prepare their own taxes.

Five States also provides a once-a-year opportunity to sell back limited partnership interests. From time to time, it also helps facilitate trades among advisors of partnership interests. Periodically, Budge says, "a planner will call up and say, 'I've got a new client who doesn't have any Five States [holdings]. If anybody tenders an old partnership, I'd like to buy those [units] so I can get her invested faster than waiting for years'" for a new partnership to be launched.

You may remember the Wall Street firms' public oil and gas partnerships that blew up in the 1970s and '80s. "The whole model was based on the expectation that oil prices were going to go up," Budge says. "There was too much leverage and not enough return. In a lot of cases, the companies had debt in their capital structure and oil prices were up in the $25 to $30 per barrel range and all economics predicted that oil prices would go higher; instead, they collapsed, and it wiped everybody out because nobody was structured for $18 oil."

Falling Prices?

Today, though, Budge says he's expecting oil prices to go down. "Nobody's saying that oil prices are going to go from $25 a barrel to $50 a barrel so we're going to make a gazillion dollars," he says. These private partnerships are "really an income play where we're trying to make a double-digit rate of return." And because Five States expects oil prices to decline over the next three years, the energy company "isn't using any leveraging to buy oil and gas wells, which is good because it's not debt," notes planner Gryzmala.

David Meier, executive vice president for marketing and sales at Murvin & Meier Oil Company in Olney, Illinois, took part in the panel discussion at NAPFA's event in Baltimore. He predicts a worldwide increase in demand for energy in the next 30 years. The significant gain will be seen not just in developing countries, but in the U.S., Canada, and Mexico as well. He also thinks the need for natural gas in the United States will rise over the next 20 years.

A greater need for natural gas and oil means more drilling, but "developmental wells" in the U.S. are producing less these days, Meier says. The good news is that "the commodity price has increased to compensate people for the decrease in overall production from these wells," he says. "So where you've lost some production, you've probably gained in price. We're going to have be drilling in more risky, more expensive types of drilling areas, and in order to do that, investors need to be reassured that if they are going to assume greater risk, that pricing of that commodity is going to deliver" adequate returns.

For income-oriented high-net-worth investors able to stomach the energy sector's volatility, direct investments in oil and gas partnerships may be worth a look. No one is promising a gusher, as they did decades back. But those monthly checks sure can bring a smile to your clients' faces.

Reprints Discuss this story
This is where the comments go.