Wall Street V. Main Street Podcast – Episode 3 – Oil and Gas Limited Partnerships

The following is a transcription of a recent episode of Wall Street vs. Main Street, a radio show hosted by the firm’s managing partner D. Daxton White.

In this episode, Mr. White talks about potential concerns with oil and gas limited partnerships, and other high commission securities products.

Producer: Welcome to Wall Street versus Main Street, a different take on the investment show with our host Dax White. Dax White is the managing partner of the White Law Group, a national securities fraud, securities arbitration and investor protection law firm with offices in Chicago Illinois and Vero Beach Florida. The White Law Group has represented hundreds of investors in FINRA arbitration claims against their brokerage firms. Here Mr. White will shine a light on some of the tricks of the brokerage industry while also providing valuable information for investors on how to successfully navigate the investor financial advisor relationship.

Dax: Welcome everyone. Thank you for joining us on Wall Street versus Main Street. I’m your host Dax White and we are again going to be trying to shine a light on the tricks of the brokerage industry based on my experience representing investors in FINRA arbitration claims against brokerage firms, and some of things that I’ve picked up over the years and things that I’ve seen in the cases that we’ve handled. Each week we’ll take on different topics. I found in the first few episodes we maybe tried to sandwich too much in there, hit too many topics, and didn’t really get into the quality that I’d like, so we’re going to focus now, just broad strokes, one topic maybe per week, a couple of tips and play it out that way and see how it goes.

This week I want to talk about what’s going on in the oil and gas market. Obviously this is something that if you follow the market, in any way, your tracking you’ve seen that oil prices have collapsed in the last six months to a year impacting virtually every aspect of the market, but certainly companies that are focused on oil and gas energy etc. and we’re not going to dive into detail in terms of the impact that it might have on your big boys, your Exxons, your Chevrons, your BPs. That’s out there and I think that information is readily accessible to people. And the reality of the show again, is the objective here is not to provide investment advice. I’m not a registered professional. I’m a securities attorney, the objective is to focus on where I think we might have financial advisors taking advantage of people based on what’s happening in the oil and gas market based on things that I’ve seen in previous cases. And in that regard I see two things that are potentially problematic.

The first which we haven’t seen yet, but I still think that it’s going to be a problem here in the future, has to do with junk-bond cases. Obviously part of the reason for the decline in oil prices has to do with America stepping up and we’ve developed the technology for shale drilling and we now are huge producers of oil again, capturing enormous market shares and frankly flooding the market with new reserves. The companies that have done that are primarily upstart shale companies who bought drilling rights either in North Dakota or Colorado or Arkansas. There are some in West Virginia or wherever they’ve found these new deposits that were inaccessible before shale technology came out. And these companies have primarily raised money by issuing debt. That debt was paying an enormous rate because frankly these are very aggressive, very high risk companies. They are hit or miss. Either we’re going to drill a well and it’s going to work out and pay great, or it’s not and the only way to incentivize people to want the debt is to pay a very high yield. That investment might be attractive to certain investors in a very low yield environment.

My concern would be the situations were maybe you’ve got a retired investor whose plan for retirement was I need a 4% return, that’s always been the industry standard, hey you can retire comfortably on 4% but in this low yield environment that’s incredibly difficult to do without risk and so the question, the discussion with the financial advisor may have been hey where can we get some yield and the concern would be an advisor who says, hey you know why don’t we buy some debt of these shale companies that are paying 9 ½% and 10 ½% very high yields.

Obviously there is a correlation between risk and return but the concern I have because I’ve seen it so many times is maybe that’s not a discussion that the broker is having with the investor. Maybe they’re saying to him, hey you know these are solid you know oil is always safe let’s invest in this and it pays this great yield. Now we’ve got oil prices that have collapsed there’s going to be an incredible difficulty on these companies to repay that debt. Maybe they are still paying it now, dipping into reserves but if prices remain at these levels I’m concerned that a lot of that debt is going to end up in default. So it really depends in terms of the weather not we will see these types of cases, it depends on who bought it. Are they Main Street?

That’s the title of the show, Wall Street versus Main Street. Is it Main Street investors who are being sold this by their financial advisor? Because this is how it works in the world, they try to sell it to institutions first because frankly institutional investors are going to invest hundreds of millions of dollars, so if you want to raise a hundred million dollars and you only have to go to one person that’s much easier. But if that doesn’t work they move down the line and the last person they go to is Main Street. Last thing they do is go to brokerage firms and say, hey we need to sell our product. They’ll incentivize them to do it, hey we know it might be a tough sell why don’t we increase your commission to do it. And so that’s what isn’t clear to me at this point is who bought that debt. But if it’s little old ladies who are retired and needed income for retirement those were incredibly inappropriate investments, particularly if it’s any kind of high concentration. And so I have concerns that as long as oil prices remain at these levels that we may see some situations where Main Street investors get burned.
One other area where I’m relatively confident there are going to be cases, because we handled them in the past, have to do with oil and gas limited partnerships. We’ve seen a number of these cases over the years. These are incredibly high-risk investments. Usually they are sold talking about a track record, “hey look how great this has done in the past.” There will be, in the fine print, some language that says you know prior track record is not indicative of future success. But the broker glosses over this and says look at this huge return this company has had. The problem is of course, is in the past oil prices were higher than they are now. So if you’re buying an oil and gas LP, and you bought it two years ago when gas prices were north of hundred dollars, and they drilled, the well took about six months to a year to get going, now they’re drilling, and every gallon of oil they pull out of the ground they’re losing money on. They’ve got fixed costs on infrastructure. They were banking on, in particular, shale. Shale is more expensive than it is to drill for oil without using that technology. They’ve got enormous costs involved and my concern is, again we’ve seen these cases these.

These types of limited partnerships have been around for a long time. Our clients were buying these in the “03 to 2008 time period. Those cases are still ongoing but for the most part they’ve played out. What I’m concerned about are the people who bought in 2010, 2012 thinking this is a five year investment. But if you bought it when oil was at that low at those levels it probably looked pretty good and again if they are basing it on prior track record it could look good. But what we’ve seen in a number of cases is that brokers gloss over the risks of these types of investments. The sponsors we’ve seen, and this is not an indictment on the sponsors, but we’ve seen these products mis-sold by financial advisors: REEF oil and gas, Atlas, Mewbourne, Noble Royalties, Ridgewood Energy. These are some of the players in this limited partnership space, and again, these are products that are sold by brokerage firms, they’re regulation D private placement, so they are exempt by the SEC from certain filing requirements and there are parameters on how they can be sold. You have to have a certain, you got to be an accredited investor generally, so you have to have a certain net worth or her certain income.

The problem that we’ve seen is that most retired Americans are going to qualify but that doesn’t mean they’re necessarily…The reason for accreditation was to establish this baseline of who’s, who is going to have the requisite knowledge and investment experience to really be able to evaluate these deals on their own. When they said okay let’s make it $1 million back in the 60’s that was a lot of money, if you had $1 million you probably were really sophisticated. That’s no longer the case. We have so many clients, they live in California two teachers making $60,000 year, they bought their house, and four years ago they sold it when they retired and now their house is worth $1.2 million. Suddenly they’re millionaires. That doesn’t mean they can evaluate these types of deals. That’s where the financial advisor comes and they’ve got to make sure they’re making investment recommendations that are appropriate. You can’t just go off the baseline, oh you’re accredited okay it’s suitable for you. You have to make sure that the investment makes sense so those are some things that I’m concerned about as we see oil prices tanking. Who are these investments being sold to? Because if oil prices stay at these levels I’m concerned that those deals don’t work out the way the investors hoped.

The other problems with the investments just in general have to do with how they’re structured. It’s very advantageous to brokerage firms, very high commissions. Again, they got to incentivize the brokerage firm to sell them and if they’re down to the level of mainstream they can’t just go and find another energy company that wants to drill a well, or if it were on the level of okay let’s go find mom-and-pop investors, then they have to pay these brokers something to sell it in and usually it’s on the very high end of the spectrum for these oil and gas limited partnerships. So those are things I’m concerned about.

We’ve got a few questions on point, Cindy why don’t you hit with the first one please.

Cindy: So I bought an oil and gas limited partnership a few years ago. At first it paid great but now the payments have dropped dramatically. Should I be concerned?

Dax: Maybe. Probably yes, generally speaking these oil gas limited partnerships the payout is, it looks like a bell curve. It starts out exceedingly slow, that’s while they’re drilling the wells. So they’re not pumping any gas out of the ground yet, it’s all costs so they’re not paying out anything. Then you see a huge spike as we drill it hopefully, unless it’s a dry well, but now we’re drilling the well and pumping out gas and you see a big big spike in it and then that eventually starts to peter out. That’s where the bell curve comes in because at some point, it will go to zero of course because the well will be dry, so if your investment has reached that point where it started to peter out it’s not likely to go back up. Once it peters out that’s sort of it because it’s not magic in the ground. If the well is dry its dry. So yes, that’s something that would certainly be a concern and frankly the reason we see these things has to do with the costs involved.

Again when you’re talking about these types of investments, were selling to Main Street now, these aren’t usually the best wells. The best wells get bought by Exxon and BP and we’ve seen a number of times. I’ve seen arbitration hearings where you’re asking the sponsor of one of these oil and gas companies, “Why are you doing this deal”? The answer is all the money they make regardless of whether or not the well works out. But it says right there in the prospectus or the private placement memorandum that, hey Exxon passed on this deal, but we think with our technology that we can make it work. To me it’s laughable because obviously Exxon is the gold standard and if they can’t make it work what makes the smaller oil and gas companies think that they can? The answer is they don’t care, they’re going to make money regardless and unfortunately the ones that take the lumps are Main Street investors who were relying on financial advisors that told him, hey these things have a great track record. They pay great. So yes, long answer, if your investment stopped paying or started to peter out that is definitely a problem. What’s our second question?

Cindy: The second question is I bought an oil and gas LP because of the income my broker told me that I would get and because he said it was safe. I read the prospectus though, and it discloses all kinds of risks. Which is right? Maybe they just have to say that.

Dax: I hear this one a lot. Usually at a hearing or in a mediation where the client says I read through it and I know it says all sorts of risks in there but I asked the broker about he said don’t worry about it, that’s just some lawyer who has to say that. That’s not accurate. these are exceptionally high risk investments and those risks that are disclosed in the private placement memorandum are in there for a reason. It’s because they’re very risky investments. There are number of times where they drill a well and there’s no oil. So if your financial advisor is telling you that the net is absolutely inaccurate and you need to ask some follow-up questions and make sure that you guys can get on the same page. Now these investments, every investment has a time and place and maybe you’re looking for an exceptionally high yield. You’re willing to take those risks and that’s fine. But what we’re concerned about, and where we would typically get involved, is where you have an investor who frankly doesn’t have a level of sophistication to evaluate the deal. Can’t read a private placement memorandum and understand it, and they’re relying on their broker. If your broker is telling you “oh don’t worry about that,” that’s just boilerplate. That is wrong.

So I think that’s all the time we have are questions. If you have a question, please feel free to send us a request to our website at WallStreetVMainStreet.com and we will try to get to those in a future episode.

Cindy: We’re back with Wall Street versus Main Street with your host Dax White

Dax: Thank you. Welcome back. The second thing I wanted to hit on was to sort of, again the objective of the show is to provide information so that you’ve got, try to even the playing field a little bit when you’re having dealings with your financial advisor. I would say 99.9% of the cases that we work on are situations where the financial advisor was maximizing his commissions at the expense of the client. Because the rule, as much as I’d like it to be a fiduciary duty standard where they have to make recommendations that are in your best interest, the reality is, at least as the law stands right now, their requirement is only to make a recommendation that is suitable for you. Suitability has to do with your income and your investment objectives and your net worth and your investment experience but the reality is there can be a whole spectrum of investments that might be suitable for you but maybe the one that’s in your best interest is this low-cost ETF versus this very extremely upfront costs whatever it is. So typically when we’re involved that’s what happened, is that you’ve got a financial advisor who, he’ll argue the investment was suitable but what he was really doing was putting his own interest first or her own interest first and recommending a product that was better for them in terms of compensation. So what I thought I’d touch on today was what are the investments that pay the most so that you can be on the lookout if your broker is steering almost exclusively these products you can say, “hey why are we talking about these investments why are you only recommending these, what else is there,” because what I have found is that generally speaking there’s always a lower-cost alternative. There are great companies like Vanguard who put out low-cost ETFs set up a .1% Let’s say they are trying to track the S&P, that cost basis is enormous if your alternative is a mutual fund that’s trying to same basic thing but your upfront load is 4%. It is exceedingly difficult regardless of who the fund manager is to outperform a S&P ETF with a .1% basis versus an upfront load of 4%. They are already 4% behind the eight ball so not only do they have to track it but now they have to beat the market by 4% and that’s exceedingly difficult for any money manager, particularly insistently. So that’s why cost is so important with these investments and we’ve got some resources on our website Wall Street V Main Street that touch on that point because there is a lot of great studies out there but you’ll find that if you were to track the progress of your portfolio over the history of your life. Let’s say you are 30-year-old investor, you’re putting aside $10,000 year. If you look at how your portfolio will perform if your cost basis is less than 1% versus 2 or 3% you’ll find that the results are enormous. You can have the same performance, let’s say on average 8%. Same performance but you could have hundreds of thousands of dollars of difference in terms of where your portfolio will be at the end. 35 years later when it’s time to retire if you’ve been paying out too much money. So that’s why commissions are so significant and that’s why it’s important to ask the question. It’s easy for investors to say well it’s only 50 basis points or .5% more, that adds up. Compound interest is a big deal. There are a lot of studies out there that talk about it. The more you can keep in your pocket and let that grow the better.

So let’s talk about the ones that are exceedingly high commission. So again if your broker is consistently pushing these products, that can be a red flag for you. One of the higher commission products is hedge funds. We are going to talk about those in next week’s episode because again this is Wall Street V Main Street, I think hedge funds, there’s a time and place for every investment but hedge funds, it’s really tough to justify for Main Street investors, at least in my view, particularly you know again little mom-and-pop retirees who probably have no business in a hedge fund. Part of it has to do with commissions, part of it has to do with evaluating risk. But the commissions are often between 8 and 10% to the sales agent who’s getting paid to recommend a particular hedge fund.

The next one, and we just talked about these, oil and gas limited partnerships. But there are other types, there are equipment leasing funds, there are all manner and types of private placements, but private placements generally pay between 5 and 10% and it’s often on that high-end range. So again that’s a huge incentive for the broker versus an ETF that pays .1% that’s expense ratio, and now you’ve got a broker who can make between 8 and 10% or 5 and 10%.

The next one is non-traded REITs. Non-traded REITs are a real estate investment trust. It’s a real estate investment structured similar to a mutual fund but those things often pay up to 7%. Huge commission. Again, most financial advisors who do the models and assets under management and will take 1% annually of the assets they’re managing. Compare that to a 7% upfront fee. That’s enormous.
Next one is variable annuities. That’s a high commission product anywhere between 3 and 7%, usually in the 3 to 4% range. You know there’s a time and place for annuities, for sure, but the problem I see is when the objective is just an equities portfolio and the broker says okay we can do that in the subaccounts. Yes you can, but you could just buy mutual funds, stocks, bonds, equities, ETF’s, whatever, without paying 3 to 7% for annuities. So with annuities please, make sure there’s an insurance component reason why you wanted that because the commissions are high.

Next one, mutual funds, anywhere between 2 and 5%, usually they’re on the lower end. The problem with mutual funds is when they’re flipping mutual funds. Usually you’ll see them recommend one and a year later recommend another one. That can be problematic certainly from a commission standpoint because they are usually upfront load fees and here they are, they get paid again. That upfront load is okay if you hold it for 20 years, you paid 4% one time and you sit on it. But it’s not good if you’re flipping them so that’s something to be on the lookout for.

Close end fund, same sort of range, similar products, same problems. If they’re flipping close end fund that’s a problem. Managed futures will pay a high percentage. They’re also very complex investments so they have their own issues. Structured products that brokerage firms will create, principal protected notes, and you know tracking this index and whatever, there’s a variety of them. But those usually pay the brokerage firms a high percentage. The last one I’ve got here is unit investment trusts, also called UITs. And those usually pay upwards of 3%. So those are some of the products, again investments, they all their time and place, and if your broker is saying “hey I really think this unit investment trusts is great for you.” and it’s 10% of your portfolio that’s probably not a huge red flag. But if every recommendation they’re making is one of these on this list that’s a red flag. Because those are all the highest commission products and the question is why. Why are we only getting these recommendations and why am I not hearing from you on these and you better like the answers or make sure that you’re okay with the recommendations that you’re getting.

So that’s been this week’s show of Wall Street versus Main Street. Again each week we’re going to try to shine the light on the brokerage industry and talk about some of the things that we’ve seen in our experience. Things to look out for. Next week’s show, we are going to discuss hedge funds and we’ve got Peter Phillips coming in. He’s a hedge fund professional having worked for Blackrock and Blackstone. He’s going to give his take on, he’s usually dealing with institutional investors but what are the concerns when we were talking hedge funds for Main Street investors. So if that interests you, please tune in and if you have questions or you just want some of the information I’ve talked about, head to our website at WallStreetversusMainStreet.com . Lots of resources there on a lot of topics we’ve talked about, commissions, and how that impacts the performance of your portfolio. We’ve also got information on there about modern portfolio theory and a lot of things that would be of significance when you’re talking about your relationship with your broker. You know asking those questions, having those resources in front of you and see what their responses are.

Producer: You’ve been listening to Wall Street versus Main Street. The views expressed by the participants of this program are their own and do not represent the views of and not endorsed by the White Law Group, its officers, directors, employees, agents, representatives, shareholders, none of its subsidiaries, none of the content should be considered legal advice and as always consult a lawyer.

This transcription has been created by Dragon Software. There may be grammatical or translation errors. For clarification, listen to Episode 3 .