The Independent Market Observer

7/22/13 – More About Things Not to Invest In

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jul 22, 2013 9:49:12 AM

and tagged Economics Lessons

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I was going to touch on China and the U.S. markets today, but something happened over the weekend that’s such a good illustration of the points I made on Friday that I have to talk about it first.

Saturday afternoon, my dad forwarded me an investment offer he had received from an oil and gas sponsor in Kentucky. They wanted to sell him a 1/64-of-1-percent interest in oil and gas wells there for $2,500, for which they believed he could receive a payout of about 90 percent of his initial investment in year one.

Not only would he get a 90-percent payout for his $2,500 in the first year, but he’d also have the opportunity to invest a lot more—but he had to hurry because it was a limited-time offer.

I’ve seen these kinds of deals before, of course, but it was different having my dad forward it. Because of that, and because it was a great example of what I wrote about on Friday, I decided to do a bit of digging.

First, I looked at the oil and gas company’s website. Interestingly, there was no information—none—on the program my dad had been offered. There were also few specifics on the programs that were discussed, which involved buying leasing interest from property owners, buying residual interests, or drilling new wells on a lease that the company did not appear to own, based on the information on the website.

I also visited the website of the Kentucky Oil & Gas Association, but the company name wasn’t listed there. Actually, three separate companies were mentioned in the information my dad received, none of which were listed on the site.

The offer materials also included a letter from a local personal injury attorney, stating that he had reviewed his client’s purchase agreement (I discovered he was a personal injury attorney on the lawyer’s own website); sample agreements from yet other companies; and an assortment of articles from various sources that had little or nothing to do with the deal in question.

For all I know, this could be a legitimate offer, but the signs sure don’t suggest that. And yet, even as I researched it, I found myself trying to find reasons the deal was real. That 90-percent payout in year one sure looked good.

Per Friday’s post, this is a superficially attractive offer in an industry that’s currently fashionable. Much of the supporting material is from credible sources about the very real oil and gas revolution here in the U.S. The inclusion of actual facts from credible sources bolsters the perceived reliability of the other claims.

Let’s look at the questions from Friday as a way to frame the overall evaluation of the investment. First, do we understand it? As for the opportunity itself, the answer is yes; at this point, fracking and oil/gas extraction are pretty well understood. As for the structure of the deal and the underlying assets, however, the answer is definitely no. The information provided doesn’t answer any of my questions. I also don’t understand the company itself, who is involved, and how everything works. These are deal breakers.

The next question is, does this make sense? Looking at the proposed economics, the answer again is no. Consider the 90-percent payout in year one. Nothing is mentioned for year two and after. If we are to assume that 90 percent continues (which is implied but nowhere stated), then the company has no need of retail investors, as hedge funds will be beating a path to its door. The 90-percent payout won’t continue—it can’t—and the fact that the company is pushing an uneconomic proposition that doesn’t make sense makes me question everything else.

Moving on to question 3, we have no idea what the valuation levels are because we don’t know what the investment is or what the underlying assets are. The offer materials attempt to finesse this by calculating revenue based on assumed prices and production levels, but, without information on costs, this is meaningless.

Question 4 is probably a pass, as things really do appear to be different this time—the fracking revolution seems to be proven at this point. Question 5 (how this might blow up) has almost too many answers.

In the end, this looks very much like a Ponzi scheme to me. The limited-time offer; the proposition that you put in a little money, get paid some back, and then invest a lot more; the attempt to piggyback off a real industry. I could be wrong—I don’t know the company and haven’t done the due diligence needed for a definitive judgment—but the signs are certainly there.

Which brings me to my final point. Part of what we do here at Commonwealth is exactly the due diligence I didn’t do on this deal. We look at companies and products in detail, review their legal and regulatory backup, and evaluate the reasonableness of the products and their promises. Many poor products aren’t criminal, they’re just lousy investments, and it is our job to screen them out. If I were to take it to the next step for this deal, for example, we’d start by getting actual legal information on the company and the assets; then move on to its legal and accounting firms, banks, and so on; and then dig into regulatory matters—and this is all before we even start on the product itself.

We don’t always get it right, of course, but we do manage to protect our advisors and their investors from the really bad stuff and much of the bad stuff. Any investor should do the same type of work when looking at a potential investment. It’s a lot of effort, but it’s necessary for pretty much any investment.

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