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Is Your Broker Recommending Dry Holes?

By Matt Badiali, editor, S&A Resource Report
Friday, November 10, 2006

Would you buy a mutual fund that’s lost money every year since its inception?
I hope not. However, some SEC-registered oil-drilling programs have records unblemished by success. In fact, most of these programs lose money. The added insult is that financial advisors are recommending drilling partnerships, which allow individual investors to sink their money into oil wells ($696 million in 2005).
That’s either colossal stupidity or calculated thievery. Either way, I’m concerned.
And, according to an article in Oil and Gas Financial Journal, these aren’t sold by phone banks in some boiler room...
“Unfortunately, we are talking about the biggest drilling fund sponsors who sell SEC-registered offerings. The prospectus disclaimers state that just because the offering has gone through the SEC registering process, it is not an endorsement or an indication of less risk. They certainly were not kidding.”
While I’m no oil tycoon, I’ve considered investing in privately owned oil wells. I understand the risks – which are considerable – and I certainly wouldn’t do it with my retirement account. However, I’m an oil bull, and I think oil and gas wells will be worth a lot of money down the road.
I have a good friend who invests in rare guitars with abandon. He rationalizes it because he believes they are undervalued and that baby-boomers will desire them as they age. In the end, my friend has a cool guitar. His risk is that no one will want to buy it from him when he’s ready to sell.
On the other hand, writes Oil and Gas Financial Journal, “petroleum investing is first a return of money, afterwards a return on money. At the end, there is no principle returned or significant liquidation of tangible property.”
There are two big problems with oil well investing. First, you might not find oil at all. Second, you only have so many years before the well dries up. The returns during that producing window have to be really big – big enough to pay off your initial investment, cover your investments in dry holes, and make your profit.
Imagine placing a stock order with your broker, and he calls back and says, “Sorry, we couldn’t buy that stock. Oh, and we used all the money up trying to get it.”
That’s a big risk. It happens, even when your advisors are good and honest. I met a reader at the Alliance Conference in Aspen whose first four investment wells were dry holes. Four times! That’s really bad luck.
He kept at it, and now gets several nice monthly royalty checks.
The key is, he was investing money he could afford to lose. The risk was acceptable for the size of the potential return. He also found an honest oilman who explained the risks and the costs.
The problem with those big direct investment deals is that they make money from your investment. Their success is guaranteed as soon as you write the check. Here’s the real kicker – they can find oil every time and you won’t make a cent from the investment.
How can that be? Let’s do the math.
Say you invest $100,000 along with five others. The well comes in at 25 barrels per day, which grosses $1,000. First, you pay the fees - say $200. Then split the net eight ways... the six investors, the company, and the landowner. You’re making about $100 per day.
You would earn, pretax, about $36,500 per year. You won’t get back your initial investment for about three years, assuming the well even runs that long. If it doesn’t remain a producing well, you don’t make a dime on the investment.
But the company can crow about the discovery and say its investors made 30% on their investments!
I’m appalled that professional financial advisors push programs that haven’t made their investors a cent. Don’t be dazzled by your broker’s misleading numbers. Ask about a drill partnership’s track record. It won’t tell you much about the current project, but it will tell you whether its program management has the knack.
Good investing,
Matt Badiali

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