In this conversation, Michael Tanner shares his extensive experience in the oil and gas industry, focusing on investment strategies, syndications, and the importance of due diligence. He discusses the significance of understanding fee structures, track records, and the impact of tax deductions on investments. 
Tanner also highlights the current trends in the oil and gas market, particularly in relation to rising interest rates and the challenges of underwriting in a fluctuating market. He emphasizes the need for LPs to be cautious and informed when investing in oil and gas, providing insights into effective risk management and the importance of consulting services.

The Oil & Gas Gold Rush: Red Flags, Fee Tricks, and Smart Due Diligence with Michael Tanner

Pat Zingarella (00:00.982) Mike, thank you very much for joining me today. Before we jump into it, why don't we take 30 seconds? Tell us a little bit about your background and Sandstone, and then we can get into it.

Michael Tanner (00:09.104) Absolutely, Pat. I'm really excited to be on here; I appreciate the opportunity. The short version of my background is I work in oil and gas. I started out as an engineer and moved to the "dark side" of finance, as everybody tells me, about halfway through my career. I really cut my chops working in and around different oil and gas syndications which, to be honest, before I got into the business, I had no idea what a syndication was or even that oil and gas used that model. I figured it was exclusively for real estate and other alternative investments.

I found out there's a huge market of oil and gas companies that raise capital through that syndicated market. So, I really cut my chops on the finance side of the business. About four or five years ago, I broke out and started my own small oil and gas consulting firm, mainly running A&D—helping with mergers and acquisitions on the small side. Then, about three years ago, we opened up a small private oil and gas asset management company where we just invest our own private money in various oil and gas deals.

Pat Zingarella (01:10.19) Awesome. Very cool. I would love to focus on your LP background and then get more into what trends you’re seeing in the O&G space. What's interesting is—and I've said this on a bunch of podcasts—more and more LPs are bringing up oil and gas to me. In the essence of trust and transparency, what are some red flags you look out for in the O&G space when you are making these LP investments? And are there any hyper-specific points in your due diligence that you look for before you make an investment?

Michael Tanner (01:44.464) Great question. I would say to answer the first part of your question, if a sponsor can't clearly explain how they get paid, it always throws up a red flag on my end. One of the things that I've found—and I'm an industry insider, so I have a little bit of a unique perspective when I go to specifically invest in the oil and gas space—is that for non-oil and gas folks, a lot of oil and gas sponsors weaponize the fact that you don't know anything about oil and gas against you.

Meaning, they'll tell you, "We don't have any management fees," yet they're charging cost-plus. If a well costs a million dollars, they're marking that well up to $1.6 million. They say, "We don't have any fees," but it's cost-plus. They're very particular about their words. So, one of the first things I always look for in marketing material, or a PPM, or if I'm just talking with somebody who's trying to pitch me an off-market deal (which is the majority of the investments we make), I ask them: "What's your fee structure or how do you get compensated?"

If they dance around that, or if they can't clearly say, "We charge an X percent fee and we have a little bit of carried interest on the back end," or "We're charging cost-plus," if they're really coy about that stuff, to me, that's a red flag. That means they're looking to slip one by from that standpoint. A lot of people invest in oil and gas from a non-industry background because of the tax deductions. I'm sure that's how 90% of people who aren't in oil and gas get exposed to it—because of the tremendous tax benefits. And they're amazing, to be honest with you. A lot of people use those tax benefits as a way to say, "Don't look at my massive fees I'm charging; I'm saving you 50% a year on taxes."

Pat Zingarella (03:14.22) Yeah. Yep.

Michael Tanner (03:32.144) Some other big red flags I look for: track record. And track record, I would say, is not necessarily years in business. I can tell you there are companies that have been in business for 30 years that have a terrible track record, and there are companies that have been around for two years who've only done three funds who have a tremendous track record.

When I say track record, I really think about pedigree. Are you an oil and gas expert? Are you somebody who has worked in oil and gas and then decided they wanted to build a company and need financing for that? That's really how I look at it. I don't necessarily look for somebody who used to be a salesman and realized that there's this big burgeoning business of oil and gas syndications where I can sprinkle tax deductions over unwitting LPs to raise capital, charge an enormous amount of fees, and call myself Billy Bob Thornton from Landman.

Pat Zingarella (04:09.742) Sure.

Pat Zingarella (04:29.314) Yeah.

Michael Tanner (04:30.384) Which is truly how some of it is. It's more pedigree than track record per se. I could go through a litany of examples of people using 30 years in business to mask the fact that they haven't necessarily had the greatest track record, whereas people who have been in business for less than two years but have done multiple successful micro-funds are successful because they come from a pedigree of understanding the oil and gas business.

Pat Zingarella (05:00.558) Very, very interesting. This is an area that I don't know much about. I hear people talk about "wells" and then "mineral rights." Is there a difference between those, or what should people be looking for when investing in this asset class? Should they be focusing on people drilling? I don't even know if that's the right question.

Michael Tanner (05:04.21) Mm-hmm.

Michael Tanner (05:28.39) No, it's a great question. It all comes back to what you are looking to get out of the investment. For me, being an oil and gas insider, my primary motivation is cash flow—cash flow plus some sort of multiple or return on my investment over a nice timeframe. If somebody is hard-selling me tax deductions, okay—yes, I have a tax problem on some level in my business, but that's not my primary motivation.

The reason I bring up tax deductions is because that's the main reason people get introduced to oil and gas. This is important, so I'm going to explain it real quick. The tax deduction in oil and gas comes into play through what's known as the Intangible Drilling Cost (IDC) deduction. It basically means anything intangible in drilling a new oil and gas well—labor, rig time, anything that is non-salvageable—you can 100% write that off. As the oil and gas operator, if you have investors or general partners, that can flow back to the LPs.

It generally works out that when you drill a new well, about 80% of the costs qualify for this IDC deduction, which means you could theoretically write off up to 80% of the investment. When people hear "tax deductions," they think they’re drilling oil and gas wells. That is one way people can invest: finding a project in the process of drilling wells.

When I was an engineer, the fancy term was "reservoir engineering," which is the science of predicting how much an individual well is going to produce. It's a science, and honestly, it's also a little bit of an art. In your first two years, you’re just hoping you’re working at a big company where someone with a lot more experience can say, "Interesting, I like that, but here’s what you forgot."

It also varies by region. If you're investing in the Permian Basin, evaluating that well is different than, for example, a large investment I have in a shallow vertical company an hour and a half away from here. Those are 1,900-foot wells that produce 10 to 15 barrels a day. That doesn't sound sexy, but at the end of the day, the alpha is in how much it costs to drill versus how much you produce. I try not to make crude real estate analogies; like you with oil and gas, I know nothing about real estate. I know just enough to be deadly—enough that I’ve been burned on two short-term rentals, but that's beside the point.

Pat Zingarella (08:22.136) Yeah.

Pat Zingarella (08:33.175) Yeah.

Michael Tanner (08:37.948) So, if you're interested in a tax deduction, you’d invest in a well being drilled—either via a fund where the fund owns the well or directly, which is called buying "working interest" (or "non-operated working interest" for passive investors). You’re buying equity in an individual well. If I buy 5% of this oil well, I'm entitled to 5% of the revenues, but I'm also responsible for 5% of the operating expenditures (OPEX). Assuming the revenue is greater than the OPEX, you make the net there.

Mineral rights are different because there's no drilling involved. You actually own the minerals. To take a step back: if you and I are an oil and gas company and we want to go drill a well outside my apartment, we don’t own the land or the minerals underneath. We have to lease those minerals from the owner. The owner might lease us 75% of the minerals and retain a 25% interest.

If a well costs a million dollars, we pay that to drill it. If a million dollars of revenue comes off the well in the first year, we are only entitled to $750,000. The mineral owner gets $250,000, and we owe 100% of the expenses. If the expenses were $250,000, we’ve netted $500,000 of profit to share with the other working interests. The mineral owners are the true owners of the minerals underneath. In a mineral rights deal, you’re buying from that owner and you are entitled to a percentage of the top-line revenue—it could be a 20% or 25% interest.

Both have pros and cons. If you're drilling a new well, you know they're actually going to drill. One thing to know about oil and gas is every single well declines over time. It's why one of the tax deductions is called "depletion"—you’re depleting the reservoir. The most amount of oil you'll get is in the first six months, and it'll slowly decline from there. The difference between minerals and wells comes down to: do you like control? On minerals, you can't control if we drill or not. If we decide not to drill for two years, the mineral owner gets no revenue. But if it does get drilled, the owner is entitled to a cost-free royalty on the top-line revenue. On the well side, we can control the timeline, so the opportunity for revenue goes up, but there’s more risk because no one truly knows what a well will produce.

Pat Zingarella (12:27.202) That's really, really interesting. You can see the passion coming out of you on this. For people getting into oil and gas from real estate, what are you seeing in terms of trends or opportunity flow compared to two or three years ago? For example, in the multifamily space, cash-flowing deals are tight right now because of interest rates. Are any trends like that happening in the O&G world?

Michael Tanner (13:08.562) I think you hit the nail on the head. The reason oil and gas has become such a big topic within the real estate community over the past four or five years is exactly what you pointed to: interest rates. At the end of 2021 into 2022, when rates started going up, what were oil prices? Oil and gas prices drive returns. If oil goes to $100, I’m going to be a millionaire.

As interest rates began to creep up and it became harder to underwrite multifamily deals, oil was at $75, $80, or $85, which is an attractive price for underwriting. It unlocks a lot of areas that we could drill. We aren't running out of oil and gas; we're running out of oil and gas that we can drill at $60. If oil goes to $100, there's plenty of oil.

There was this arbitrage opportunity between real estate deals becoming harder to underwrite and oil and gas having extremely attractive cash flow metrics due to high prices. When you layer in the tax deductions—which in my opinion are superior to real estate—there’s no better tax-efficient vehicle that also provides cash flow. That’s where the shift really happened.

Now, oil prices have dipped a little bit. I think a lot of these funds or projects that haven't seen the test of time are struggling. I've been in the business 12 years—which is not that long—but I've seen four downturns. It's a cyclical business. A lot of funds got spun up in 2021 or 2022 because they saw this arbitrage opportunity, and now they’re dealing with their first downturn. They got into projects that worked at $80 oil but didn't stress-test their models for $65 oil. Trust me, there are still profitable wells to drill, but Exxon and Chevron own all of them. They aren't necessarily going to be available to us. If you’re an industry insider, you sometimes get passed deals in the core Midland Basin that don't reach the open market, but a lot of deals in the drilling space are becoming harder to underwrite at these prices.

Pat Zingarella (17:02.04) So, diving more into that, when an LP is shifting from real estate into oil and gas, what should they look for to effectively protect themselves from an underwriting standpoint in that scenario? How often do downturns happen and how much does economic policy impact this?

Michael Tanner (17:42.386) First, if the PPM or summary deck doesn't have a slide showing "sensitivity economics," that's a red flag. If they haven't stress-tested the model down to $50 or $55 oil and they’re only giving you one scenario at $70, that’s a problem. We both know prices won't stay exactly at $70.

I have a lot of friends and family who ask me to look at deals, and that’s a service we do at Sandstone: consultations where we read the PPM and give non-biased thoughts. If I knew exactly where oil prices were going, I’d be on a beach in St. Barts right now because I would have gambled all my money in futures. I don't know where prices are going, so if you aren't giving me a view of different price points, that red-flags it for me.

In real estate, you're generally getting a fixed interest rate, so you don't necessarily need to vary that. But oil is volatile. My big thing is making sure they’ve underwritten at multiple prices. Also, don’t over-allocate. No more than 5% to 10% should be allocated toward one investment. Don't overexpose yourself to something you don't necessarily know about. If you're looking to place $500,000 of capital, $50,000 is a great number for oil and gas. Don't let yourself get talked into $300,000. These sponsors will always have new deals. If this one works out, they’ll be more than happy to have you invest again. Make sure you can stomach the returns at $50 or $55 oil; if you can, go for it, because the upside if prices go up is tremendous.

Pat Zingarella (20:31.712) Very cool. You mentioned the consultative service for LPs. When you conduct these, besides the sensitivity numbers, what are the common mistakes you see people making when underwriting these deals?

Michael Tanner (21:11.596) We could talk for hours about this. Because I'm in oil and gas, I can look up where these wells are being drilled. I rebuild their models from scratch. It takes a day or two turnaround. I look at where they’re drilling and check all the wells around them.

Most of these PPMs are 400 pages long—that’s another red flag to me. I’ve actually been messing around with Gemini by uploading a PDF and asking it to search for ten specific things. AI is going to expose a lot of these thousand-page PPMs. If I can't recreate the economics using the information in your PPM, you're being too vague. You should tell me exactly where you're drilling.

If there's new drilling and no other wells around it, I'm going to apply a much higher risk factor. We call this "risked economics." If there’s production all around you, the risk factor might only be 5% to 10%. If there’s no production within five miles, the risk factor might be 50% or 60%. We apply that risk factor to the prediction, and if we still like the results, then it’s a worthwhile investment.

Another thing I look for is self-dealing. Often, the sponsors aren't the operators. I go check who the operators are, and half the time, the sponsor owns the operating company but hasn't made that clear. They say, "We don't charge management fees," but they’re charging a contract operator fee. It's like a property management company owned by the sponsor. If they're buying leases from a third-party entity the sponsor also owns, they’re just buying a property from themselves—how do I know they aren't marking it up?

Finally, I’m skeptical of "blind pools" where they say, "We’re going to go buy assets, but we don't know which ones yet." Now you have to evaluate the evaluators. I’ve done blind pools where the sponsors have a tremendous pedigree of sourcing deals for private equity, and they’ve been successful. I'm in one right now that's excellent. So, don't necessarily avoid them, but understand that your mindset should shift from evaluating the deal to evaluating the evaluators.

Pat Zingarella (25:42.772) Awesome. We’re headed toward the end of the call. I like to ask everyone the same question: What part of passive investing in oil and gas needs to die?

Michael Tanner (26:00.722) The Facebook ad. I'm not against them, but 95% of the oil and gas ads I see on Instagram and Facebook are way too sensationalized. If you get hit with a Facebook ad for oil and gas, risk those economics by 50%. There are a lot of great companies out there that don't need to run a Facebook ad to get attention. The best way to hear about oil and gas is through a friend, or an investor community like yours, Pat. The best opportunities are sourced by word of mouth because people love to talk about successful investments. If you get a Facebook ad, you probably won't become Billy Bob Thornton from Landman. There’s a very small chance.

Pat Zingarella (27:14.808) Good stuff. I'd love to hear a little bit more about Sandstone and how to get in contact with you.

Michael Tanner (27:31.41) We are not a GP. We have a private asset management company that invests our own profits from Sandstone Group, which is a unique business model. We do about three to five deals a year. Sandstone Group is a boutique consulting firm dealing in finance, acquisitions, and divestitures. We work with variety of clients—syndicated and privately held—to help them with all sorts of stuff.

We have a large due-diligence business for LPs. If you’re looking to invest $50,000, we have a very cheap package for a quick run-through. If you’re looking to allocate $1 million to $5 million, I recommend paying for deeper due diligence. We work with geologists and a full team that evaluates the deal just like we would if we were buying the company ourselves. If any oil and gas sponsors are listening: if you can't tell me what your fees are, or if I see you on a Facebook ad, it’s going to be tough to get me.

Pat Zingarella (29:07.426) And how do people get in contact with you?

Michael Tanner (29:09.874) You can find me on LinkedIn (Michael Tanner) or go to sandstone-group.com. That pesky dash kills me, but we don't quite have sandstonegroup.com yet! I also have a YouTube channel and a podcast. I'm pretty easy to find.

Pat Zingarella (29:30.414) Great stuff. Mike, thank you so much for joining me. I really enjoyed this episode.

Michael Tanner (29:36.24) Absolutely, Pat. Thanks very much.