Investment Consult

October 21, 2005

Pumping up returns with oil and gas

Sometimes a client will say, "Lew, I've got a well-diversified portfolio, but what else can I invest in?"

Sometimes I suggest a direct interest in an oil and gas drilling company, typically through a limited partnership. This is different from buying stock in an oil company or shares of an energy sector mutual fund.

The way you make money through this kind of arrangement is very different from investing in stocks or funds, however. If and when the partnership starts paying money to investors, each quarterly check includes a return of your principal as well as an amount of interest or profit. I've seen cases in which the investor's entire principal is returned in about three years, and the interest payments after that are sheer profit. For example, eight years ago one of my clients invested in Five States Energy, a Dallas-based oil and gas investment company and has earned 200 percent since then. Another client's investment in the same company has returned 175 percent since 2001. Over the last four quarters, these two clients have earned 38 percent and 41 percent, respectively.

In fact, some investors get back as many as three times their original investment over time. But of course, if everything were so smooth and rosy, oil and gas partnerships would be as popular as real estate. They're not.

Some partnerships don't pan out. The company engineers believe they've done thorough research, but after sinking money into exploration and drilling, they find no oil, or at least not enough to pump economically. Or, the oil runs out sooner than company officials expected, or other complications occur, such as having to drill deeper to maximize output.

Oil prices themselves are another risk factor. If prices decline, the partnership doesn't make the profits it needs to cover its costs. Right now, oil's more than $60 a barrel. If the price falls by $20, chances are you'll lose part of your money. Over the past five years, oil has ranged from about $17 to $67 a barrel.

Because of this volatility, you shouldn't invest in an oil and gas partnership unless you're willing to park your money for a minimum of seven to 10 years. Prices could fall if China, a major consumer of oil, were to announce a slowdown in its economy. The same thing could happen if the US announces an end to the insurgency in Iraq. Nevertheless, a steep drop could be preceded by further leaps in oil prices. Goldman Sachs, for one, says prices could soar to over $100 a barrel within the next couple of years.

That's why if you're looking at stakes in oil and gas partnerships, I'd recommend creating a portfolio of them, not owning just one. You might buy into four or five, putting in from $25,000 to $100,000, or more, in each one. At any rate, I wouldn't advise keeping more than 10 percent of your total portfolio in these investments.