Memoirs of a Money Manager: TEXAS CHECKERS

This memoir is really not about Texas or checkers, although as you will discover, both played a role. These events took place between 1979 and 1983. At that time inflation was soaring and the prices of oil and natural gas were strong. Marginal income tax rates were very high and congress intentionally provided numerous tax loopholes to encourage various enterprises. One of these incentive programs was for drilling oil and natural gas wells. Lest the reader get too sanctimonious about these incentives I would like you to think more recently of sugar, tobacco, ethanol or cash for clunkers. Congress thrives today, as it did then, on doling out taxpayers’ money to reward its friends, punish its enemies and gather up votes. This combination of high marginal income tax rates, high and rising prices for oil and natural gas, and tax incentives spawned a whole industry on Wall Street creating partnerships to invest in oil and gas.

During these years, I needed a little tax shelter for my ordinary income and decided to educate myself in the business of the drilling partnerships being offered by the major Wall Street firms. What a mistake! I foolishly thought that my skill in analyzing financial statements, macroeconomic trends, commodity prices and foreign exchange would easily translate into selecting investments in oil and gas.

How complicated could it be? I started my analysis by meeting several brokers and getting copies of prospectuses, both old and new, of oil and gas partnerships. I gathered data on the success and failures of various groups of promoters by comparing results, returns, tax effects, and expenses. I found only one common denominator across all the deals: the expenses were huge. Wall Street firms and the oil and gas promoters were charging very high fees.

At this time, my dad lived in Texas, having moved there in 1965. He was a self-employed small businessman and had no specific knowledge of or serious connections to the oil and gas business. He did, however, provide one great insight that I should have heeded. “Son,” he said, “Do you really think that a good oil or gas prospect ever gets out of Houston, Dallas or Fort Worth? If the promoters have to take the deal to New York to raise money it is either too risky or no good.” Now why didn’t I think of that? My father’s comment made sense: the best deals are funded by locals. Since then, I have used this same simple logic many times in other situations. Another classic example: if a technology venture deal has to leave Silicon Valley to find investors, one best be very cautious.

So, how to become a local? Not possible. Nevertheless, on my next trip to Texas to visit my Dad, I set up several meetings with oil and gas promoters. In total, I interviewed over fifteen promoters. Each meeting included one or more geologists and various financial folks. To be blunt, I was too small an investor for most of them. I ended up performing due diligence on three or four firms, checking references and talking to their investors, accounting firms and banks. I found two firms that seemed honest, had a reasonable track record and would take my money. I should have walked away right then, but I trundled on. I now had a considerable amount of time invested in learning about this potential investment opportunity and was reluctant to back out.

I decided to invest in a joint venture in specific wells. This arrangement was not a partnership and I felt more comfortable without the partnership overhead. I could invest in wells one at a time, so it also allowed me to get my feet wet slowly, so to speak. As luck would have it, the first well, an oil well, was a winner. Not a gusher, mind you, but productive enough that I earned my money back very fast and reaped the tax advantages. It did not occur to me at the time to ask, “hey guys, let’s drill another well right next to that one.” The reason I did not, I later pretended to myself, is that I was deep into another well, this one a gas well. It too was a winner, although without the tax advantages it would not have been a very good return. I was getting hooked; it was like Las Vegas. And so it went. I had some winners and some losers, but considering the tax advantages, I was doing a lot better than the big brokerage firm oil and gas partnerships because my expenses were lower.

One day I received a call from one of the firms I was doing business with saying they had a unique opportunity to acquire several hundred acres of gas-bearing property. This property was not in Texas, but the geology was good. It was, they told me, “tight sands” and most likely held gas. Even better, they said, drilling the wells would be inexpensive because the gas-bearing sand was not too far beneath the surface. They had optioned the acreage and were “…letting me in on the opportunity because I had been such a good partner.” They might as well have been offering to sell me the Brooklyn Bridge, but I was flattered. Dumb. Where was my head? I do not know what I was thinking, but my head was probably in the gas-bearing sand. What made the deal even more attractive was that I did not have to commit to all the wells; it was another one-at-a-time proposition.

They came to New York to go over the details with me; of course they had paper work I had to sign. In all they had an option on two parcels of 640 acres each with 40-acre spacing for each well. They had a map showing a “checker board,” with the wells to be drilled on the “red” sections of the board. It made sense to me that they were spreading the bets across the whole 640 acres in a logical fashion. I liked it. I signed up as an investor, or should I say “partner.” I thought I knew how to play checkers, and I did. What I had not counted on was that this was Texas checkers.

A few weeks after the signing, they called and said that they expected to “spud” the hole and start drilling as soon as the ground thawed. Right after receiving this call I jumped on a subway to go to lunch with a friend of mine who worked in Wall Street. We had agreed to meet at a restaurant near Washington Square because he was taking a class at NYU. It was a beautiful New York City spring day and, after lunch, we took a walk around the square. The chess players were out in full force and my friend, a player, quickly got into a game. I am not a chess player, so I bid my friend farewell.

Since it was such a beautiful day I decided to walk back to my office in midtown. As I walked, my mind wandered from the oil deal, to the stock market, to interest rates, to oil prices, to chess. My brain just kept coming back to those red and black squares; checkers, like my oil deal, only played on half the squares.

And then it hit me. I was at Union Square; I practically ran into the subway, grabbed the local train to 33^rd street and hustled to my office. I scooped up the file on the latest gas deal and looked for the answer to the question that had been nagging at my brain ever since I stood and watched my friend start his game of chess. Did I have the right to drill on all the 40 acres squares in the checker board, or only the red or black? The answer was a little vague; I definitely had the right to drill on the red, but the black squares were not discussed.

I pick up the phone and dialed. “Gregg,” I said, “when did you say you were going to start drilling?” “About three weeks, give or take,” he replied. “Say Gregg,” I asked, “I was just looking over the paperwork and was wondering, suppose we drill up all the 40 acre red squares in your drilling plan checkerboard. And further, suppose all the wells are producers. When would we start to drill on the black squares?” There was silence; not a peep. “Gregg, are you there? Gregg?” Finally, he said, “I believe if you check our agreement you only have rights to the red squares.” “Yes, yes,” I replied. “That is why I am calling. It seems to me that since I am taking the upfront risk to drill on the red squares, I should have the opportunity to invest my money in the lower-risk adjacent wells.” Once again, I was blessed with silence. Finally, he said, “That is not how we do business. We never sell those rights.” I only invested in the one well I was committed to. It was a marginal well. It was the last well I ever participated in.

This memoir about my misadventures in oil and gas drilling partnerships and joint ventures contains many lessons. The facts are as I remember them, but names and places are changed. The first lesson is the advice from my father. When the promoters come looking for your money, ask yourself why you are so special. Great oil and gas prospects probably can find plenty of knowledgeable investors in the local, in this case Texas, market. This axiom is also generally true of technology ventures from Silicon Valley, real estate deals from anywhere and perhaps hedge funds. Buyers and investors beware.

Second, look for the existence of or lack of continuation rights. In this case, it was the other 40 acre parcels. What happened here was if the field proved to be successful by drilling on half the squares with the investors’ money, then the promoters would be able to take the proven field to the bank and drill up the other 40 acre parcels with less risk; they reaped all the reward without having to share it or take much upfront risk.

This concept of letting the investors take all or most of the upfront risk and not collect on the second round is pervasive. In real estate the developer may own a “black acre” and a “white acre” and sell you a share in the development of the black acre, which, if successful, makes his exclusive ownership of the white acre much more valuable. In movie deals ask who has the rights to foreign distribution, video sales, and sequels. If you plan on investing in Broadway plays or movie deals make sure you have a very knowledgeable entertainment lawyer.

In hedge funds, the fee schedule is asymmetrical; if the returns are positive the manager collects a performance fee. If the fund returns are negative, the fund manager only shares in the loss to the extent he is invested in the fund. This is why it is important to make sure the hedge fund managers are heavily invested in the same fund you are. If the fund has a high water mark, then the fund manager does not collect a performance fee until your capital account exceeds its previous high. Hedge fund managers sometimes do not have high water marks, or they close the fund and encourage you to invest in a new fund where you no longer have the protection of a high water mark.

Another lesson is to always do your homework and hope for the best but plan for the worst when examining potential investment opportunities. Try hard to look for the holes. What is missing? If the deal is successful, what is the next step? How do you cash out? Does the success of the venture generate additional opportunities? Does failure create opportunities?

Finally, every investor should remember the purpose and job of Wall Street is to raise capital for their clients. If you are not a client, you are a target. Stock brokers and investment bankers play an important role in the capital-raising necessary to support new and existing business ventures. Their goal is to raise that capital on the most favorable terms to their clients. If your accountant, lawyer, broker or money manager tries to sell you products, be sure to take off the rose colored glasses. Good luck.