Oil and Gas Energy Investments

Commodity Volatility and Recent Historical Pricing (2008 – 2020)

The oil and gas industry is notorious for its boom and bust cycles, with particular commodity volatility seen in crude oil prices. Extreme price swings in oil are driven by supply and demand, subject to economic expansion and retraction, geopolitical events, environmental regulation, and the increased utilization of alternative forms of energy.

In July 2008—in the early stages of the Great Recession and ensuing bear market—West Texas Intermediate (WTI) crude oil traded for around $145 per barrel. Yet by December 2008, oil had collapsed in price, trading around $31 per barrel. By mid-2011 through mid-2014, WTI crude had recovered and was rangebound, trading for $80-100 per barrel. In September 2014, with WTI oil trading around $100, the energy sector component of the S&P 500 comprised about 15% of the entire Index’s market capitalization. Then in February 2016, WTI oil cratered in price to around $28 per barrel. Yet by September 2018, WTI oil had rebounded significantly, trading around $70 per barrel.

More recently, oil has continued to display extreme price volatility. By early 2020, WTI oil was trading above $50 per barrel. However, with the demand shock caused by the Covid-19 pandemic, further exacerbated by international factors, oil subsequently plummeted in price. In fact, on April 20, 2020, during a multi-state Covid-19 pandemic shutdown, the price of WTI oil went negative for the first time, trading at -$37.63 per barrel. To be sure, the phenomenon of negative oil prices has less to do with market reality than with how the futures market for oil functions. Due to a rapid decrease in demand for oil by April 2020, sellers of “front month” WTI oil futures contracts (for May 2020) scrambled to unload their positions to avoid the risk of taking physical delivery of oil. As a result, oil prices on the May 2020 futures contract went negative, providing a sobering reminder to the market of oil’s susceptibility to extreme volatility. Since 2020, the price of oil has continued to exhibit volatility, with WTI prices rising to over $120 per barrel in 2022, only to fall to nearly $70 per barrel by the start of 2023.

Investing in Oil and Gas - A Risky Proposition

Because of oil’s inherent volatility, as well as certain other risks addressed below, investing in the oil and gas sector carries significant risk. And with the demand for oil and gas still going strong and projected to grow in a meaningful way—in 2019 global demand for crude oil (including biofuels) totaled 100.1 million barrels per day and is projected to rise to nearly 140 million barrels per day in 2040—there is no shortage of financial products tied to the oil and gas sector.

Many stockbrokers or financial advisors may recommend an oil and gas investment. Of course, not all energy products are unsuitable investments, and depending on the investor and his or her stated investment objectives and risk profile, a prudent allocation to energy in an investment portfolio may be appropriate. However, when recommending an oil and gas investment product, a financial advisor should first seek to inform his or her client of the volatile nature of oil. Further, the broker has a duty to determine if the oil and gas investment or investment program is suitable in light of the investor’s profile and stated objectives.

In instances where an investor’s account becomes overly concentrated in oil and gas, or a financial advisor fails to disclose the degree of risk associated with a certain investment, then the broker and his or her firm may well be liable for any investment losses sustained. Furthermore, if a brokerage firm fails to conduct adequate due diligence on an oil and gas investment—in particular if the investment is not publicly traded as is the case with a private placement—then the broker dealer may be held liable for losses. If an investor suffers losses due to an unsuitable recommendation or related misconduct, the investor may pursue recovery of these losses through securities arbitration before the Financial Industry Regulatory Authority (FINRA), or in some instances, by initiating a lawsuit.

Examples of Oil and Gas Investments

MLPs

Master Limited Partnerships (MLPs) are structured as publicly traded partnerships. Accordingly, a MLP has a General Partner (GP) and the investors are Limited Partners (LPs). The GP controls the operations of the entity and the LPs, often referred to as Unitholders, have a very limited role in the operations and management of the MLP.

Many MLPs operate in the so-called “midstream” of the oil and gas sector. Midstream MLPs own, operate and maintain critical infrastructure (including pipeline, rail, barge, tanker and trucking carrier assets) to ensure delivery of crude and/or refined petroleum products to end buyers in the “downstream” of the energy market.

Still other MLPs, as well as other oil and gas drilling companies, engage in exploration and production (E&P) activity, thereby operating in the “upstream” of the oil and gas sector. In particular, upstream oil and gas investments are very risky, as E&P activity is costly (many upstream oil and gas companies, including MLPs, carry significant debt and must issue debt and/or new equity in order to sustain E&P activity) and the profitability of the company is directly impacted by oil price volatility.

While some financial advisors might recommend MLPs for their characteristic high yield and favorable tax treatment (MLPs are not taxed, instead passing-on income, expenses, and any gain to the LP, to then be treated as income), MLPs carry unique and significant risks. To begin, MLP investors have limited control and voting rights, as compared to shareholders in a traditional corporation. In addition, significant conflicts of interest exist between the sponsor of the MLP, its GP, and the LPs in their capacity as investors.

Oil and Gas Drilling Funds

As their name implies, oil and gas drilling funds operate in the upstream of the oil and gas sector. As such, the owners and operators of oil and gas drilling funds must expend capital not only to maintain ongoing drilling activity, but also to engage in expensive E&P activity in the ongoing search for new reserves. Many drilling funds are structured as limited partnerships, and these investments often carry significant risk, including the potential for conflicts of interest between the investment sponsor and the investors. For example, in certain instances, the sponsor of a drilling fund may use investor capital to drill risky wells, while at the same time drilling wells for their own account near other high-producing wells.

The up-front fees and commissions associated with drilling funds are often extremely high, in some instances as high as 15%. Such significant up-front fees create an immediate drag on investment performance. In addition, many drilling funds are offered via placement, and thus are usually offered and sold to investors as unregistered securities pursuant to Regulation D (Reg D) as promulgated by the SEC. Investing in an oil and gas drilling fund via a private placement is risky due to the illiquid nature of the investment, as the investor should be prepared to hold the investment for at least several years, if not longer. In addition, the distributions paid to investors may include both income and return of investment principal.

Direct Participation Programs

Oil and gas investments are sometimes offered through a Direct Participation Program (DPP). DPPs are pooled investment vehicles that offer investors access to a business venture’s underlying cash flows and tax benefits. DPPs are typically passive in nature and usually entail investment in real estate or the energy sector. In similar fashion to many oil and gas drilling funds, many DPPs are offered through a private placement, meaning the investment itself is illiquid and cannot readily be resold on a secondary market.

In addition to liquidity concerns, DPPs typically charge high up-front fees and, in many instances, high recurring annual fees. And it gets worse. As may be the case with investing in MLPs or drilling funds structured as limited partnerships, many DPPs involve sponsors who have significant conflicts of interest. For example, a DPP sponsor may receive a disproportionate amount of net income from the business venture, thus incentivizing the sponsor to engage in risky behavior to enhance revenue.

The attorneys at Giarrusso Law Group LLC possess considerable experience in successfully representing aggrieved investors in various complex and esoteric oil and gas investments who have lost money due to financial fraud or related misconduct. In many instances, investors may pursue claims to recover losses through securities arbitration before the Financial Industry Regulatory Authority (FINRA). Investors who wish to discuss a possible claim related to an oil or gas investment are invited to contact us by telephone at (201) 771-1115 or by email at info@gialawgroup.com for a no-cost, confidential consultation.