D.O.G on Oilpods

WARNING: VERY LONG POST

For those thinking about Oilpods, here is some information that may prove useful.
1. Oilpods is a project of OL&M, Business International Pte Ltd, a company registered in Singapore. OL&M's website is: http://www.oilpods.com.

2. OL&M sells shares in oil and gas production leases, known as "working interests" in industry jargon.

3. Investors in working interests buy a percentage of all current and future oil and gas revenues for a particular project. An upfront payment is made, in exchange for a revenue stream tied to the sale of oil and gas from that particular project.

4. Revenue stops when that project's oil and gas is exhausted or uneconomic to extract. If the upfront payment is less than the NPV of the future oil and gas revenues, a profit is made. A loss is made if the converse is true.

5. The working interests are sold to OL&M by Powder River Basin Gas Corp, a company quoted under the code "PRVB" on the OTC BB in the US. OL&M in turn sells these working interests to investors. The websites for PRVB and the OTC BB are: http://www.powderrivergascorp.com http://www.otcbb.com

6. PRVB's business has 2 arms: a. Purchase of marginal / non-producing oilfields with the aim of increasing or restarting production; and b. Sale of 25% working interests in the above oilfields to generate working capital.

7. PRVB currently owns working interests on about 8,000 acres of land, in either 100% or 75% proportions.

8. According to the Form 10-K (available at the OTC BB website) filed with the SEC, for the year ended 31 Dec 2005, PRVB booked revenue of US$4,643,965 and net income of US$699,335.

9. The revenue breakdown was US$622,882 in oil and gas revenues, and US$4,021,083 from the sale of working interests.

10. The commission paid to outside investors of the working interests was US$482,500.

Some lay analysis:
PRVB sells working interests to OL&M, which then sells them to investors. Investors' funds flow to OL&M, which passes a portion of the funds to PRVB, which in turn books these as revenue.

As PRVB develops the oilfields and sells oil and gas, a portion of the revenues are paid out to OL&M, which in turn pays the investors. Therefore, the investors' income streams are dependent on the oil and gas production at the PRVB fields where they own a working interest.

However, we can see that PRVB sold only US$622,882 of oil and gas. Since it only sells 25% working interests and retains a 75% stake, the commissions paid to investors in the working interests should be at most 25% of oil and gas revenues i.e. US$155,720.50. However, the actual commissions paid were US$482,500. The extra US$326,779.50 paid out appears to simply be a return of capital.

In other words, it seems that PRVB may actually be operating an elaborate Ponzi scheme. For as long as it can sell working interests, it can generate cashflow, from which previous investors can be paid, regardless of whether it is actually selling any oil or gas.

Evidence:
FY05 administrative expenses were US$1,181,374, and lease operating costs were US$258,662. These expenditures supported the production and sale of oil and gas, yet the company only sold US$622,882 of oil and gas. The story is the same for FY04: adminstrative expenses of US$513,854 and lease operating expenses of US$97,025 were used to generate US$248,328 in oil and gas sales.

Clearly, the current cost structure of PRVB makes it impossible to actually earn any profits from selling oil and gas. It is deriving all its "profits" from selling working interests. These working interests appear to be overpriced with respect to the value of the oil and gas they appear to be producing. It is possible that PRVB is deliberately misrepresenting the true value of the recoverable oil and gas i.e. fraud may be occuring.

Implications:

So, back to Oilpods. If someone was to invest with OL&M, he would be buying a working interest directly from OL&M and indirectly from PRVB, and his future cashflow would ultimately depend on the sale of oil and gas from the corresponding field being operated by PRVB.

As shown above, the cashflow being paid out is coming from other new investors purchasing working interests as well as from the sale of oil and gas. For as long as PRVB can find new investors, current investors will be able to receive an income stream.

If, however, PRVB is unable to continuously sell additional working interests, based on its current cost structure, its oil and gas revenues alone will not suffice to pay the investors their due commissions. PRVB will then default on its payments to OL&M.

If OL&M is not able or willing to make good the payments out of its own pocket, it too will default. The investors can then choose to either write off their investment, or sue OL&M for misrepresentation, fraud, etc. Of course, their legal choices may be limited by any waivers that they signed when purchasing the investment in the beginning.

As usual, YMMV. The analysis above is based on public information only. It may be flawed and is not conclusive. IMHO anyone interested in Oilpods should visit the 3 websites (OL&M, OTC BB, PRVB) and do some reading, so that they can make an informed choice

D.O.G Investment Lessons

1. When fundamentals deteriorate, sell NOW.

I wish I'd listened to myself in 2008. I would have ended 2008 with a lot more money! By the time 2009 rolled around the fundamentals were pretty much at the bottom. So it would have been time to start buying instead.For 2009 there wasn't much more deterioration in fundamentals so I was a net buyer.

2. The market leader is not always a good investment.

The market leaders in finance and property e.g. DBS, Capitaland and Capitamall Trust were also the ones who did rights issues. These were severely dilutive to existing shareholders. Those who managed to pick up excess rights ended up doing very well, but since their profits were at the expense of the original shareholders I think it speaks poorly of the company management to have given so much wealth away.I did much better with companies who were not market leaders but had outstanding balance sheets. No rights issues, no business risk, and many of them doubled anyway.I will continue to ignore "market leaders" in favour of what the financial statements tell me.

3. AGMs and EGMs are a valuable source of information.

I made it to a few AGMs and again, it was good to read the body language of the management and see how they answered shareholders' questions. In one case where I sat in as an observer, the management gave a reason for not paying dividends. I went home and counterchecked, and concluded the excuse was nonsense. I stayed away, and later in the year the company's results took a significant turn for the worse.I also made appointments to visit a few companies, and called some others. All very useful, and sufficient to seal the buy/don't buy decision.I continue to believe it is vital to meet management every chance you get.

4. The margin of safety must be sufficient.

A hard lesson here. I took an unnecessary 25% loss on a large holding because I thought a low price was sufficent to compensate for a so-so business. Nope. As it turns out, if I'd held on and sold later the strong market would have rescued me. But I was proven right about the business: fundamentals declined in the quarters after I sold out.

5. Beware companies in cyclical industries.

No kidding. The business decline for cyclicals like steel, airlines and shipping (both container and bulk) was not funny. Since I was on the sidelines here it was not painful, merely interesting.On the other hand, the buyout of SPC pointed to the importance of understanding replacement value. SPC couldn't be easily replaced, so even in the worst of times it had a value. Maybe this will be useful in future when looking at steel mills. But aircraft and ships are fungible assets so replacement value doesn't hold here.Property is also cyclical, and here I did well with the replacement/liquidation value method.

6. Dividends are important.

All hail the almighty dividend! Cash is indeed king. Dividend yield was a great screening tool in 2009. From the list of high-yielders, I bought the strongest balance sheets. Many yielded 10% and some over 15%. Low risk, high return. Best deal I'd seen in years.

7. Keep some spare investment ammunition.

I started 2009 with 47% in cash so it was a blessing to be able to invest on the way down (into March). If I'd been fully invested I would have been unable to take advantage of the fantastic prices.As prices went up I began to sell. I think it is good to keep some spare cashavailable at all times. You never know when you'll find something good.

8. Watch out for changes in the core business

None of the companies I followed had significant changes to their businesses. Only those who were floundering were trying to buy new businesses. Environmentally-friendly businesses like water treatment, waste treatment, solar energy etc seemed rather popular. Maybe that's where the next bubble will be.

9. Watch the gross profit margin

I looked into many companies and concluded that companies with a long-term trend of declining gross margins were headed for mediocrity. Declining gross margins point to severe competition as well as lack of pricing power. Good for customers, bad for shareholdes. Given the many bargains available I decided to reserve my money for companies that had demonstrated pricing power. At least those will have a fighting chance against the secular background trend of inflation.

D.O.G on REITS

There is a sinister reason why Management are paid in units which I learnt in Wallstraits. Quoted from D.O.G

That depends on who the REIT manager is. For REITs where the managers were originally the asset owners i.e. virtually all the S-REITs, the owners have basically already divested their real estate at a good price in the REIT IPO. Any remaining stake is a call option, and it continues to pay out cash. So these ex-owners are having their cake and eating it - they sold most of their stake, and now they are slowly clawing it back via payment in units.

One analogy might be - I sell you a house for cash, and I manage the tenants for you. Instead of sharing in the rental, I am paid in shares of the house. So each quarter I own a few more bricks in the house. Given enough time, ownership of the house will revert to me. All this while, I get more and more cash from my increasing ownership of the house. So the net effect is that I get cash upfront from selling you the house, then I get paid to wait while the house reverts back to me. Nice deal for me, not so nice for you.

For REIT managers who were not the original owners of the REIT assets, payment in units does increase alignment of interest. However, if they then sell the units for cash (see: ARA Asset Management), alignment of interest is eroded.