Originally published on Dec. 16, 2014
By Adam Weinstein
As recently reported in Reuters, Atlas Energy LP (NYSE:ATLS) has marketed itself to investors as a way to get into the U.S. energy boom, by contributing at least $25,000 in a private placement partnership that will drill for oil and gas in states such as Texas, Ohio, Oklahoma and Pennsylvania and share in revenues generated from the wells. Atlas Resources LLC, a subsidiary of the energy group, has filed documents with the SEC for Atlas Resources Series 34-2014 LP stating that it seeks to raise as much as $300 million by Dec. 31 of 2014. The deal sounds good when pitched: participate in investments where advances in drilling technology have turned previously inaccessible reservoirs of fossil fuels into potentially viable prospects and to boot Atlas will invest up to $145 million of its own capital alongside investors. Through this method and similar deals, oil and gas projects have issued nearly 4,000 private placements since 2008 seeking to raise as much as $122 billion.
But before you take the plunge, a review of Atlas’s offering memorandum reveals some red flags and given Atlas’ past failure rate, investors should think twice. First, up to $45 million of the money raised will be paid to Atlas affiliate Anthem Securities that will then be turned over to as commissions to broker-dealers who pitch the deal to investors. Up to $39 million more will be used to buy drilling leases from another affiliate. Think investors will get a fair price on the leases when Atlas controls both sides of the deal? More conflicts ahead as Atlas-affiliated suppliers may also get up to $53 million for buying drilling and transport equipment. Next, an additional $8 million of Atlas’s investment is a 15 percent markup on estimated equipment costs. Finally, Atlas will pay itself nearly $52 million in various other fees and markups.
In sum, at least 40% of Atlas’s $145 million investment alongside mom and pop goes right back to the company. In addition, Atlas’ profits don’t stop there, when the venture starts generating revenue Atlas is entitled to 33% before accounting for those payments and markups. In the end, not much of a risk at all for Atlas.
Atlas isn’t alone in this type of arrangement. When it comes to oil and gas private placements they tend to be structured so that the house always wins. Just like Wall Street likes it. And since Atlas has issued dozens of private placements similar to Atlas Resources Series 34-2014 LP, the company now has its marketing down to a science that includes: typical charges of between 15 to 20 percent in upfront fees from investors, while paying brokers an additional 10 percent of the total offering in sales commissions. Investors only get to see 65-70% of their capital actually put to work on oil and gas projects.
An analysis by Reuters shows how oil and gas projects have more in common with running profitable casinos than investments. Reuters found that in slightly more than half of 43 private placements Atlas issued over the past three decades investors lost money or just broke even. While investors lost in more than half of the deals in 29 or 67% of those deals, Atlas actually out-performed their own investors.
Till now we explored how the house seems more likely to win on these deals over investors. But beyond the inherent risks with speculating on oil and gas and unknown oil deposits, most investors don’t realize the deals are often unfair to investors. In a normal speculative investment, as the investment risk goes up, the investor demands greater rewards to compensate for the additional risk. However, with oil and gas private placements the risks are sky high and the rewards simply don’t match up.
In order to counter this criticism, issuers say that the tax benefits of their deals - where the investor can write off more than 90 percent of their initial outlay the year they make it - help defray the risk and increase the value proposition. First, the same tax advantage claims are often nominal compared to the principal risk of loss of the investment as seen by Puerto Rican investors in the UBS Bond Funds who have now seen their investments decline by 50% or more in some cases. Second, oftentimes brokers sell oil and gas investments indiscriminately to the young and old who have lower incomes and cannot take advantage of the tax benefits.
In fact, of the 28 people interviewed by Reuters who invested in deals from Atlas, Reef Oil & Gas Partners, Discovery Resources & Development LLC, and Black Diamond Energy Inc. 17 were retirees who had low tax burdens when the product was recommended to them.
By now you may be asking, how do these deals even get issued? First, the private placement market is very opaque. Issuers are only required to file a statement to exempt the security from registration and a few other details about the investment. Second, investors rely upon the brokerage industry’s due diligence on each issue they sell to ensure its suitability for investors. But many brokers use outside due-diligence firms that may be paid by the issuer, a conflict of interest, when evaluating deals. Indeed, some of the largest securities frauds in the private placement space have been the result of reliance on third-party due diligence.
Finally, brokers pitch oil and gas projects to investors as a way to generate monthly income and an alternative to traditional stocks and bonds. Given the recent collapse of the oil market it is likely that many of the oil and gas investments issued in recent years will end up unprofitable.