Crowdfunding: New Sources Of Capital For Independents

In the business world significant news does not always appear in headlines, yet it makes a profound impact. The oil and gas industry embodies a prime example. Even though extraordinary technological advancements have occurred in E&P and operating efficiency over the last few years, another key development has actually flown under the radar. Simultaneous with the technology explosion is the global revolution in the financial industry, also enabled by technology and aptly named Financial Technology or FINTECH.

Comprising several different components such as mobile payments, money transfers, consumer loans, asset management and capital acquisition, one component of the FINTECH revolution is particularly advantageous to the oil and gas industry: access to capital. Recent changes by the U.S. Securities and Exchange Commission (SEC) in May 2016 created an entirely new addition to the capital stack. This action opened the door to new sources of capital directly applicable to independents and small operators in the oil and gas industry never before available. The phenomenon, equity-based crowdfunding, represents one of the biggest changes in SEC regulations in more than 80 years, and the oil and gas industry is just now waking up to the possibilities for new growth capital.

How the game is played

The SEC passed new rules, along with amendments to existing rules, on Oct. 30, 2015, that were destined to have a profound impact on the future of the U.S. capital markets. These rules had previously been under consideration and deliberation by Congress for four-plus years under “Title III of the JOBS Act,” also known as Regulation Crowdfunding. That is the operative term for oil and gas executives. These new rules and amendments were intended to permit companies to offer and sell securities through crowdfunding to a much wider definition of investors than previously possible.

The basic idea behind crowdfunding is to raise money through relatively small contributions from a large number of people, combining the best of microfinance and crowdsourcing. These new Regulation Crowdfunding rules had two primary purposes: 1) to assist in the capitalization of startup and emerging growth companies, thereby creating jobs and stimulating the economy; and 2) to provide investment opportunities, with appropriate protections, for a new class of unaccredited investors. These rules officially took effect May 16, 2016, for technology companies via web-based portals, which had met all of the SEC criteria for offering investments under these rules.

Because equity-based crowdfunding is breaking new ground in the U.S. and the oil and gas industry, industry independents might understandably have apprehensions. Statistics abroad are considerably more reassuring. While equity-based crowdfunding is relatively new in the U.S., it was a $34 billion global business in 2015, ($17.2 billion in the U.S. alone) and was projected by many analysts to surpass venture capital by year-end 2016. It also is projected to grow by as much as 20% per annum worldwide over the next few years. Bluntly speaking, equity-based crowdfunding is a major development that, for no valid reason, has gone relatively unnoticed by most of the U.S. population and the oil and gas industry.

Ironically, Regulation Crowdfunding was not originally imagined by its primary author and sponsor, Rep. Patrick McHenry (R-North Carolina), a member of the House Financial Services Committee, as an effective financial tool for the oil and gas industry. Rather, his stated purpose was “to foster relationships between investors and entrepreneurs,” specifically “to permit crowdfunding issuances that offer an equity stake [securities] to investors.” This includes any industry where capital is required and jobs can be created.

How Regulation Crowdfunding benefits operators

Of all of the industries where equity-crowdfunding is being introduced, the oil and gas industry, specifically the E&P sector, is uniquely and perhaps even ideally suited. The caveat is that operators need to separate their thinking about “rewards-based crowdfunding,” typically to raise money to build a prototype or create public awareness, from “equity-crowdfunding,” with its multiple features and benefits to fund a potentially viable company. For the independent oil and gas company, Regulation Crowdfunding provides:

• Access to new, never-before-available capital from a new investor class—the “crowd.” This crowd is largely composed of unaccredited investors; however, the numbers are huge;
• Relatively low cost of capital compared to other options;
• Maximum flexibility in project planning with a combination of capital sources that include the crowd with other capital sources;
• Perpetual funding from the crowd for entire oil and gas field development where success begets success and crowd participation momentum builds with achievement of expected results;
• National and (with SEC and anti-money laundering banking compliance) international exposure to operators’ projects and development programs; and
• Crowd investor communication and management as one aggregated group through web-based portals.

Unprecedented investor opportunity

At the same time, benefits are not exclusively limited to operators since the individual investors become part of an investment opportunity that was previously beyond their reach. By virtue of SEC actions, the new crowd investor Regulation Crowdfunding through approved portals provides:

• An opportunity to invest directly in oil and gas projects, not merely public stock in oil and gas companies;

• An opportunity to invest in different levels of risk vs. reward and estimated return-on-investment profiles:
  • De-risked completion-only projects where the investor gets a “free look” at the electric logs (and perhaps tests) prior to investing;
  • Low-risk recompletion projects where production improvements are attainable from zones previously identified with openhole logs, cased-hole logs and/or offset production;
  • Low- to medium-risk projects in proven fields with identified resources, extensive geology and infill wells in known formations; and
  • Higher risk exploration where geology and reserves are less well known yet early indications are for excellent potential and high returns.
• Assuming project success, recurring revenues from working-interest ownership for years in the future;
• Generally higher returns on investment than other investment classes previously available to the crowd; and
• The opportunity to participate in an industry that has historically been closed to the general public.

Challenges and outlook

Of course, the brave new world of Regulation Crowdfunding is not without its challenges. In the original bipartisan bill (Title III of the JOBS Act) several restrictions were introduced to limit risk and exposure for unaccredited investors. Some of these also reduced the intended purpose of the original bill. As a result, McHenry acted swiftly and decisively by introducing H.R.4855 (aka Fix Crowdfunding Act) in mid-2016 to “fix” the original limitations and thereby increase the effectiveness of Regulation Crowdfunding for small business and the crowd investor. H.R.4855 passed the House side of the 114th Congress (2015/2016) by a vote of 394-4 in favor. It was sent to the Senate July 6, 2016, where it currently awaits action. This will likely be taken up and passed by the 115th Congress in 2017.

Despite the initial challenges in Regulation Crowdfunding, the future for the industry and its application for oil and gas is very promising. This optimism is not a surprise given so many upsides in terms of the benefits to operators and to the investors who are providing the valuable capital often unavailable to many small project sponsors, producers and operators in the past.