Bill Weidner, managing director of Cosco Capital Management, an Avon, Conn., investment bank specializing in energy, says that through the early to mid-1990s, “companies bought properties assuming things would go up and down, but would always revert to a mean of $18 a barrel. They had good discipline and made money.” Now, with supply-and-demand trends pushing prices skyward, conventional wisdom embraces a new, higher mean. Even so, he says, companies reportedly are resisting using the latest highs to crunch their numbers. “Companies are probably building their business models on $28 a barrel now. I’m comfortable with $28.”

New private equity funds that focus on small oil and natural gas companies are springing up daily, while existing funds are getting bigger.

To help investors hedge their bets, fund managers are encouraging companies to place long-term contracts that lock in a price slightly above what they need to break even. “We don’t want to take significant commodity price risk,” VanLoh says. “We’re trying to back guys who have a systematic way of building a business that will make money in all cycles.”

While the arguments in favor of restraint and consistent returns are sound, few deny the role sky-high oil prices have played in attracting investors and increasing returns. Most experts did not expect prices to go as high as they have, or as quickly, leaving some cautious about the long view. “The risk and reward balance has changed from a few years ago, from positive to neutral,” says William Quinn, a managing director with Natural Gas Partners in Dallas, which closed its seventh fund in March 2003 and manages more than $1.5 billion. “There is probably more room for prices to go down than up.”

While that may be so, would-be energy investors should consider that overall demand is expected to remain high. In July, the International Energy Association in Paris estimated that global oil demand will grow by 2.9 percent this year, the biggest increase since 1980. It expects that pace to slow next year, but only to 2.2 percent.

Questions to Ask Your Private Wealth Advisor About Oil and Gas Ventures 1. How have leading E&P funds performed relative to the rest of my portfolio? 2. Of those funds requiring a 10-year commitment, which are best positioned to succeed in the long term? 3. How do management fees compare among leading oil and gas funds? 4. How quickly have the energy funds under consideration grown over the past three years? 5. Given current Treasury rates, would MLPs or bonds make a better investment?

In the meantime, domestic supplies continue to become scarcer and international supplies have the clouds of terrorism and political uncertainty hanging over them. “A portion of the premium that we’re seeing in prices is unrest,” Quinn maintains. “Something as simple as Tom Ridge saying that there could be an attack in the United States in the near term riles markets.” Some fund managers argue that the potent combination of strong demand and international unrest will keep prices high. Both factors are, however, unpredictable. If India and China, where oil consumption has soared, see their economic growth stall as suddenly as it did for other Asian tigers in the late 1990s, demand growth would fall quickly.

The Long View
Ultimately, even investors who are bullish on energy should hold out for management teams that take a restrained, long-term view. “You want to ask about their historical rates of return, the consistency of returns and the size of deals completed, and you want to see how those things have evolved,” Weidner says.

“I would especially look at the track record through different price cycles for oil,” adds John Farber, a cofounder of Lime Rock Partners.

It is also important to understand the types of companies in which a firm prefers to invest. Companies that buy proven reserves at the best prices will have more modest, but reliable, returns. Firms that focus on finding new streams here or abroad take on more risk, but the payoffs can be bigger if explorations are successful.

Firms such as Lime Rock and First Reserve seek security in diversification—they also invest in pipelines and oilfield services. Service companies transport, store and process oil and gas or rent field equipment. Their rates remain stable because they make money from the volume of oil pumped, not the price at which it is traded. Farber cautions, however, that if prices go down and there is less interest in drilling, some of these companies might see their volumes decrease.

Recently, fund managers have been under pressure to increase the size of their funds. Farber advises investors to examine how quickly prospective funds have recently grown, and by how much. “At some point it will fundamentally change your investment style,” he says. “If you grow aggressively without a strategic reason, that’s troublesome.”

In some ways, oil and gas funds are similar to other private equity plays. Investment minimums are usually $5 million, and most funds state they have a few affluent individuals investing alongside their institutional clients. VanLoh notes that some of his investment bank clients are investing money they have pooled together for their private banking customers. According to Glen Hill, a vice president of alternative investments at JP Morgan Private Bank in New York, it is reasonable to expect returns of 20 to 25 percent, with most of this return coming the last five years of the fund. Annual management fees are typically 1.5 percent, plus 20 percent of the profits.

Investment advisors and fund mangers alike recommend limiting energy investments to 2 to 3 percent of our assets— 4 percent for those of us who may be particularly bullish on oil. Edmonds counts himself among that group, at least until the headlines tell a different story. “You have a combination of higher price levels, calculated decisions on how to get the best overall returns and a better understanding of how to use technology to get the most out of the oil patch,” he says. “The private equity guys can sink their teeth into those things.”

Additional Information
Energy Alternatives: The Master Limited Partnership