In light of @racheladhe awesome work published today: Exposing Climate Threats From an Empire of Dying Gas Wells (bloomberg.com), I wanted to share the original piece I put together in Q2 ‘19 on the infamous Diversified Energy and their bargain gain on purchase scheme. I have not updated since 2019, but needless to say the scheme became larger. Diversified Energy survived the downturn thanks to a volumetric production payment securitization via a German reinsurance firm. Assets acquired in the scheme where securitized, unitized, traunched, syndicated, and distributed to financial institutions across Europe. These financial institutions took security over scheme assets, are on the chain of title, and thus liable for the asset retirement obligations. Environmentalists can sleep well at night knowing the ECB is ultimately liable and infinitely capable of funding this disaster. Enjoy.
‘We had the opportunity to analyze his toenails and the bronzing of his feet before we ever saw the balance sheet, though the reflection in the orange tint of his sunglasses resting atop his highlighted hair tips were a beguiling distraction. It’s not often that a Tampa real estate broker takes control of an Alaskan oil company headquartered in Tennessee, but in the American Shale Revolution stranger things did happen. Future investor meetings would be hosted by the newly hired Vice President of Investor Relations who relinquished her career as a lingerie model for a robust warrant package and a shared address with the Chief Financial Officer at the company’s Laguna Beach mansion. CEO Scott Boruff had left his brokerage firm, GunnAllen, as it was being investigated and subsequently shut down by authorities for running a three hundred and fifty million-dollar Ponzi scheme, and married into a Tennessee Oil family with a penny stock listing. Through that listing in 2009, he acquired PER’s Alaskan assets and associated decommissioning liabilities for two and a quarter million, but only after multiple failed bankruptcy auctions, as bids of seven and eight million dollars failed to close. The Chief Operating Officer interviewed reservoir auditors until he found one willing to use his own internal cost estimates which were ninety percent below prior actuals. The prior reservoir auditor refused to put its “name on a report that implies value exists where it likely does not.” The CFO having no prior oil and gas accounting experience double counted a hundred and ten million in infrastructure assets on top of the already inflated report. In the reported quarter, Miller Energy would pioneer the use of ‘Gain on Bargain Purchase’ accounting standards to mark their $2.25m purchase to $480m and record net income of $270m, a figure KPMG would later regret negligently blessing. Shares vaulted a thousand percent and a margin loan secured against their value funded the equity for a mortgage on the famed 37,000 square foot Villa Collina (See Appendix).
A New York Stock Exchange listing, six preferred equity offerings, and a Wells Notice later Miller Energy filed for bankruptcy and its executives are under continued insider trading investigation. Its auditors and financiers having settled with regulatory bodies now face class action suits. There were several unique factors that allowed for ‘Gain on Bargain Purchase’ accounting fraud this outlandish to occur. The incredible distance between financial executives, operating executives, and investors played a key role. The lack of material oil and gas experience at key internal financial posts as the Chief Financial Officer reviewed his own work as a board member on the Audit Committee. The reliance on internal estimates for critical assumptions determining operating and decommissioning costs for the creation of a third-party reserve audit. The continual issuance of high yield equity instruments to new investors to finance distributions to current investors. Diversified Energy, the largest operator of wells in the Marcellus has transformed the accounting standards Miller Energy pioneered into a ten figure multi-continent enterprise. The size and scope of their decommissioning liabilities is unparallel in U.S. history and has journalists and environmental regulators wondering if they are too big to fail.
Diversified Energy was a penny stock that uplisted to the London Exchange in 2017. Headquartered in Birmingham, Alabama, Diversified Energy has made thirteen acquisitions operating over sixty-thousand conventional wells across six states covering almost eight million acres of land. The sixty-thousand wells represent 420,000 Mcfe of natural gas or trickling just 7 Mcfe per well per day. In reality, tens of thousands are already dry holes and the ‘cheap’ purchase price was represented via the operating costs and decommissioning liability which were subsequently reduced ninety percent with internal estimates. Any back of the envelope math would suggest this is a multi-billion cash environmental liability. Diversified Energy has no competitive advantage in decommissioning. They only just started the process after being served by regulators at the Department of Environmental Protection in Pennsylvania. Their employees and operations come from the company’s they have acquired as they had no material operating business prior to the acquisitions.
The assets were acquired in competitively marketed transactions some from the largest independent operators in the United States including Anadarko and EQT. They embody the winners curse and their purchase established the firmest estimate of fair value. After every acquisition the company uses ‘Gains on Bargain Purchase’ accounting to mark up the assets on their balance sheet representing the vast majority, if not all, of their operating income in every calendar year. Rather than using a ‘one-time’ gain as Miller Energy did, the acquisitions are often subsequently marked higher and higher as management’s internal estimates of Fair Value ever increase. They improve an actuarial assumption in almost every calendar year. Last year they doubled the expected life of their wells which are now expected to produce for almost a hundred years. They pay a nine percent dividend they don’t ‘Earn’ except by this accounting methodology which they fund by issuing equity to new investors. The internal director of revenue accounting that oversaw the beginning of the ‘Bargain’ program had no oil and gas experience, left shortly after the IPO, and now works at a local BBQ joint in Alabama. Neither the CEO or the Chairman ever had Oil and Gas experience before forming ‘Short D’. The current Finance Director had no oil and gas experience and the current CFO has never held a CFO position previously, and until very recently reviewed his own work as a board member on the Audit Committee. The structure and process of the audit is such that the UK and U.S entities are considered separate entities with separate audits and in the most recent financial filing their auditor highlighted acquisition accounting and gain on bargain purchase as key risks to their audit. While assets passed impairment examination, given the collapse of natural gas and natural gas liquids, the inflated balance sheet will have a difficult time getting past subsequent audits.
Appendix
Too big to fail: How one gas company can leave a mark on Pennsylvania | Pittsburgh Post-Gazette
Villa Collina Purchase Funded via Margin Loan and ‘Gain on Bargain Purchase’
