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