How a big bet on oil went bust: Full version

(Fortune) -- In the summer of 2008, Erlend Olson thought he had finally hit the jackpot.

A bit player in semiconductors for years, the former NASA engineer had made an improbable metamorphosis into a burgeoning oil-exploration kingpin. His company, Terralliance Technologies, a secretive startup in Newport Beach, Calif., had developed an algorithm for telling petroleum engineers where to drill.

Never mind that Olson was an electrical engineer with no background in oil. He had convinced some of the world's most sophisticated investors, including Goldman Sachs (GS, Fortune 500) and Kleiner Perkins, that his unconventional approach was legit. Kleiner would go on to bet a whopping $93 million on Terralliance, a sum that may be the storied firm's largest venture investment ever.

Terralliance hadn't found much oil, but its founder and CEO was so adept at locating cash reserves that he believed he was about to close a deal that would seal his company's future -- and his fortune.

He had come to New York that August to negotiate a financing with Temasek, the sovereign wealth fund of Singapore, which Olson had been romancing for months. The price of oil had recently soared to $145 a barrel, and Temasek planned to invest $1.1 billion, valuing Terralliance at more than $4 billion.

A hulking figure with a glassy-eyed intensity, Olson had assured his investors that an infusion of this magnitude could lead quickly to a public offering worth as much as $60 billion. That would make Olson, as he wistfully recalled later, a "three-comma guy."

Olson wasn't alone in counting commas. Kleiner Perkins thought it was on the threshold of its first mega-win since Google's (GOOG, Fortune 500) IPO in 2004. Goldman Sachs, which had been betting shrewdly on plummeting housing prices, envisioned another killing. Passport Capital, a young San Francisco hedge fund, anticipated burnishing its reputation for energy investments. John Fredriksen, a Norwegian supertanker mogul who had lent Terralliance $50 million only months earlier, stood to score a quick hit.

All told, the investors had sunk nearly half-a-billion dollars into Terralliance, an astounding sum given the audacity of the company's aspirations -- and the paucity of its accomplishments.

Why experienced investors pumped so much capital into such a risky venture is just one mystery in the tale of Terralliance, a saga that has not been comprehensively told despite the high profiles of the players involved.

Kleiner Perkins, a firm that loudly promotes its most promising investments, for years didn't list Terralliance on its website and declined multiple requests to comment for this article. Despite interviews with many of the key people involved, it's also not clear what exactly Terralliance's technology purported to do, or how well its investors understood it.

What is certain is that Terralliance's gambit to become a force in oil exploration ended badly. Despite Olson's high expectations, the unraveling began during those August 2008 meetings in New York.

Before taking Temasek's cash, Kleiner and Goldman thought it was important to share concerns they had about Olson. Terralliance's globetrotting CEO may have been an oil industry neophyte, but he had spent like a Saudi prince. His shopping list ran the gamut from oil wells in Turkey and Mozambique to demilitarized Soviet fighter jets.

An auditor had raised red flags about Olson's dealings in the Congo and referred its findings to the U.S. Justice Department for potential anti-bribery-law violations. As troubling, Terralliance had yet to close its books on 2007. Two lead board members, Joe Lacob of Kleiner Perkins and Joe DiSabato of Goldman, informed Temasek's lead negotiator, Nagi Hamiyeh, that they intended to demote the charismatic but free-spending founder to chief scientist.

It was all too much for someone wielding a city-state's checkbook. Instead of signing on the dotted line, Hamiyeh returned to Singapore. In early 2009 the board fired Olson outright. By then the price of oil had cratered, Temasek's stock market holdings had collapsed, and Terralliance had all but crumbled into a heap of litigation, layoffs, and recriminations.

By the spring Kleiner Perkins was in damage-control mode on Terralliance, even as it was promoting a new thrust into the field of "green" energy. As for Olson, who was out of work and raising new funds to continue his global quest for oil, not adding a comma to his net worth was the least of his worries.

Olson didn't set out to look for oil. As the dotcom bubble was peaking in 2000, he found himself at a crossroads. Then 37, he had spent 14 years at NASA's Jet Propulsion Laboratory (JPL) in Pasadena, which runs the country's unmanned space probes.

After leaving JPL, Olson co-founded a semiconductor company in 1998 called Pivotal Technologies, where he was chief technology officer. Pivotal made chips for cable modems and Bluetooth devices, and its designs were in hot demand, enabling it to sell out to Broadcom after just two years for $605 million.

A government employee for most of his working life, Olson suddenly was wealthy. Not super-rich, mind you, but way beyond his space agency peers. "I went from making $65,000 a year to being worth millions," says Olson, who years later still affects the look of a gussied-up engineer: open-neck shirts, faded blue jeans, and black wingtips.

Olson was a rare twofer in the IT world: a technologist who could tell a story. "Erlend is a larger-than-life guy, and he always was," says an executive who worked with him at Pivotal. "He was the franchise. There was an engine under that hood." At Pivotal, however, Olson didn't have free rein, says this executive. "Erlend is like a nuclear reactor: If you use him properly, the guy can boil water. If you use him improperly, he can melt down the city."

Actually, finding water, not boiling it, happened to be Olson's goal. As he tells it, his parents, who had retired from positions at the top-secret Sandia National Labs in New Mexico, were missionaries in Africa and complained to him about the difficulty of drilling water wells.

NASA's projects search for signs of life on and beneath planetary surfaces, including the presence of water. Together with some other ex-JPL buddies, Olson began tinkering with publicly available satellite data of terrain near his home in Southern California. Olson also had familiarity with remote-sensing technology deployed by NASA. He had designed low-power chips crucial to running communications systems millions of miles from Earth.

The noodling by Olson and his JPL pals yielded an unexpected eureka moment. "We kept running into oilfields, which was frustrating because we were looking for water. I knew nothing about the oil business or the fossil-fuels business," says Olson, who told Fortune his story in numerous interviews over the past year at hotels and restaurants in Southern California.

As he continued to investigate tracts that encompassed some of the oldest and once most productive oilfields in the U.S., Olson made another startling discovery: "We'd notice there was no pump jack, even though we knew there was oil there."

The team spent the next couple of years modeling known oilfields and developing an algorithm to test the model's predictive power. Olson likens the experimentation to writing a program for forecasting stock market fluctuations and then testing it on historical pricing data. The next step was putting the technology to work. "We figured if we could make a treasure map of where the oil is, why not go dig the treasure ourselves?"

Olson funded operations of the new company out of his own pocket. He studied the oil and gas business and deemed it technologically timid. His approach to finding hydrocarbons went beyond the two tools most favored by the industry.

One is seismography, the bouncing of sound waves off structures beneath the ground in the hunt for what geophysicists call anomalies -- abrupt changes in the substructure that suggest that worthless dirt may have given way to valuable minerals. The other is geology, or the analysis of rocks to see whether their makeup suggests the presence of something worth drilling for.

Olson's approach was to test for a series of indicators in the ground -- an example is electrical activity that can be detected remotely -- that when combined with massive computer files would yield accurate probability studies on the chances of finding oil. The mapping technique was a first step, to be followed by the industry's standard geophysical practices.

Whether it was real science or high-tech dowsing, Olson used his findings to pitch investors. Kleiner's Lacob and Goldman's DiSabato invested a total of $45 million in 2004 and 2005. (DiSabato had profitably invested in Pivotal.)

Kleiner and Goldman opened all kinds of doors. Olson was introduced to the respected oil executive Joe Foster, founder and former CEO of Newfield Exploration and a banking client of Goldman's in the 1990s. Terralliance "had Kleiner Perkins and Goldman behind it," says Foster. "They told me about this, and I said it sounds too good to be true."

Nevertheless, in the Continental Airlines lounge at the Houston airport, Foster met with Olson. "Erlend sort of knocked my socks off. It didn't make sense to me that you could acquire that kind of data with a satellite. But I left the meeting saying, 'Shit, I'd better think about this.'" Foster joined Terralliance's board in 2005.

Excitement about a sure-fire way to find oil -- and all sorts of other valuable things -- isn't new, of course. "The real story, to boil it down, is as old as mankind: a charismatic individual with a compelling story you just want to believe," says Foster, who says he lost several hundred thousand dollars of his own money in Terralliance. "My whole career I've been interested in alternative exploration tools. By force of personality, [Olson] convinced a lot of people. There's a real psychological story there. This was beyond numbers and contours."

Investors wanted proof, so Terralliance began mapping small projects and then drilling for oil and gas. Success was relative. The company's maps accurately indicated oil was present in previously active oil basins -- albeit in places previous drillers hadn't explored -- in locations including Oklahoma and Alberta.

Though not a huge surprise, these finds helped Terralliance make the case for bigger projects. The company raised an additional $248 million in mid-2006, with new investors including Ithmar Capital, a private equity firm in Dubai.

Olson was the fundraiser-in-chief as well as head negotiator for the drilling leases he was signing around the world. At one point Terralliance claimed to be drilling for oil or negotiating rights to explore for it on four continents, including eight African countries. An oilfield in eastern Turkey produced some oil, though it turned out not to be commercially viable when oil prices dropped. An expensive well in Mozambique turned up all but dry. Many of Terralliance's other proposed projects never broke ground.

Olson decided that Terralliance needed to make its own maps rather than rely on purchased satellite data. So the company bought an airplane and a helicopter, each fitted with custom-designed sensors. For Olson, this "low and slow" approach was a half-measure. He craved the "high and fast" capability of U-2 spy planes that NASA uses for research.

U-2s aren't available for commercial use, however, so Olson arranged to buy two surplus Sukhoi SU-27 "Flanker" fighter jets, stars of the Cold War-era Soviet air force, from the Ukrainian government. Terralliance paid $22 million for the pair of jets, as well as more than $4 million for an option to purchase two others.

Olson says the planes cost more than conventional, slower aircraft but are more effective because they can cover more ground. "It was like a NASA platform but better," he says. "I got the blue-collar version of the U2."

By 2007, Terralliance was running out of cash, despite having raised nearly $300 million in less than three years. Olson is unapologetic about the outlays. "We spent like NASA during the Apollo program, and we were on our way to the moon as well," he says.

Stephen Buscher, an oil industry investment banker, relocated from Russia at the end of the year to become Terralliance's chief financial officer. He marveled at Olson's persuasive powers. "It's unbelievable how easy it was to sell that story with Erlend manning the PowerPoint," says Buscher, who signed on to take Terralliance public and has since left the company.

One PowerPoint obtained by Fortune sheds light on Olson's technique. In an October 2007 presentation to Kleiner's partners, he proclaimed Terralliance a "Revolution in Oil and Gas Exploration." He declared that the company had 500 million acres in "oily places" under its control, more than Exxon Mobil, a claim that seems to have encompassed everything from partnership agreements to discussions with governments.

Olson had no doubt that if Terralliance could just raise more money, it had "all the projects necessary to be as valuable" within five years as Occidental Petroleum. Oxy, a decades-old oil company, was worth more than $60 billion.

There was never a shortage of potential investors willing to listen to Olson's pitch. In early 2008, Temasek emerged as the most enthusiastic. The Singaporean fund had begun a major thrust in oil acquisitions, forming a special subsidiary, Orchard Energy, as its petroleum vehicle.

Temasek dispatched consultants to study Terralliance's technology, as well as its petroleum assets. In the meantime Terralliance needed funding to keep the drill bits turning. Through Goldman connections again, it met Passport Capital, whose founder, John Burbank, had been a top-performing U.S. hedge fund manager in 2007. Passport agreed to lend Terralliance $150 million -- a bridge loan -- with the expectation that the loan would be repaid in a matter of months.

To share the risk, Passport offered a third of its Terralliance loan to an investment firm in London called Franklin Enterprises. Franklin is a private investment arm of Norway's John Fredriksen, CEO of Frontline, a major oil tanker operator.

Passport told Franklin about a company code-named Project Sunshine, whose backers included the original investors in Google and which promised to be the "Google of the oil and gas industry," according to a lawsuit Franklin later filed against Passport. The pitch worked; Franklin invested in March.

How Terralliance was spending its capital became a central sticking point. The company hired a chief accounting officer named Howard Selzer, who had worked at Enron in its dark days.

Selzer hired PricewaterhouseCoopers, and together they became a thorn in the side of the CEO. Olson hadn't kept particularly good records in the early years of the company. Accounting for travel expenses was notably weak, and Selzer eventually identified $4.4 million of expenses Olson owed the company.

The auditors also had a devil of a time accounting for the business uses of all the company's property. A warehouse near Pasadena was supposed to contain aircraft parts but upon investigation was full of earthmoving equipment as well as a masterfully crafted baby crib. Olson had a side business in real estate development, and his wife had recently given birth to their first child. Olson -- who says the facility was Terralliance's original headquarters and that he had permission to store his belongings there -- personally sublet the warehouse from the company.

The auditors also accused him of making questionable payments to government officials in the Congo, where Terralliance had signed a drilling concession, and referred the matter to the U.S. Justice Department. (No one involved is aware of any actions taken in the case by Justice, which declined to comment. Olson also declined to comment on this.)

By then, board members -- in particular Kleiner's Lacob and Goldman's DiSabato -- had had enough of Olson. But there was a catch. He was the main point of contact with Temasek, and he also told Terralliance's story better than anyone else.

In an effort to remove his authority but keep him onboard, the board demoted Olson in September 2008 to chief scientist. The next month, when the auditors finally closed the books on 2007, they noted that Terralliance "renounced the concession interest" in the Congo, and that the "former officer" who negotiated it, Olson, "no longer had the authority to legally bind the company."

With so much turmoil, it's no wonder that Singapore's Temasek hit the pause button on its investment in August 2008. Fredriksen's Franklin Enterprises also caught wind of the controversy and asked Passport for its money back. Passport rejected the request, and in October, Franklin filed suit against Passport, charging the San Francisco firm with misleading it about the nature of Terralliance's management and finances. (In a court filing Passport denied the allegations.)

The Soviet fighter jets seemed a flamboyant purchase; some people involved with the company even doubted their existence. Whether or not they were a good idea, the planes were real. The same month that the auditors completed their work and Fredriksen sued Passport, the jets arrived unassembled at a commercial hangar in Rockford, Ill. The planes remain there and are for sale for $5 million apiece.

According to Pride Aircraft, which is marketing the planes, the twin fighter jets were "painted in the standard Russian air-superiority blue/gray camouflage scheme by the Ukrainian overhaul facility" that outfitted them for commercial use. The SU-27s never flew a mission for Terralliance.

In the year since Erlend Olson had told the Kleiner Perkins partners that his company could soon be worth $60 billion, the world had become a different place -- for Terralliance, for Wall Street, and for so many others. Terralliance's senior executives made a last-ditch effort to woo Temasek in November 2008. The deal team watched Barack Obama's acceptance speech from a Temasek conference room in Singapore. By this time, though, the price of oil had fallen to $60 a barrel, and Temasek formally walked away in December.

Kleiner Perkins moved swiftly in 2009 to try to salvage its investment. John Doerr, Kleiner's most prominent partner, hadn't previously been actively involved with Terralliance, but he began attending board meetings. He hired as executive chairman a longtime confidant, Mike Long. Doerr flew to London to meet with Franklin in the hope of resolving the litigation with Passport. He enlisted computing pioneer and Kleiner partner Bill Joy to evaluate Terralliance's technology.

In May, Terralliance announced new funding, which amounted to a restructuring of the company that severely diluted the stakes of existing investors. Kleiner, Goldman, Passport, and others invested an additional $54.2 million, $30.5 million of which ultimately went to Franklin. An additional $7 million was promised by the end of 2010 to Franklin, which dropped its suit against Passport.

With Olson gone -- he was fired as an employee in March and left the board in May -- Terralliance abandoned its wildcatting dreams. The investors still believe there's something to the mapping technology. So instead of buying drilling rights, today the company -- renamed TTI Exploration -- is charting plots on a project basis for clients.

Last July, Terralliance filed suit against Olson for misappropriation of trade secrets, alleging that he had failed to return documents belonging to the company and had started a new venture based on Terralliance's intellectual property.

There has been no activity in the suit since then because TTI doesn't know where Olson is and can't serve him with court papers, says TTI lawyer David Schindler of the Silicon Valley office of Latham & Watkins. Olson calls the company's claims baseless and says the lawyers shouldn't have any trouble serving him: "My wife doesn't seem to have any trouble finding me."

Of the many unanswered questions in the strange story of Terralliance, two stand out: Was there ever anything to the technology, and how could such seasoned financiers have invested so much money with so little control over it and in an industry with which they were so unfamiliar?

Given that Olson never patented the technology and otherwise wouldn't document it for his own investors, it's problematic for any outsider to judge it. He certainly believes that it works, and he says that consultants from Temasek's Orchard Energy blessed it.

That claim can't be verified because Temasek declined to comment for this article. Joe Foster, the former board member, says he still doesn't know whether the technology worked. "The way I came to look at this was as a very good reconnaissance tool," he says. "It would tell you where to do more work -- or to get the hell out."

Kleiner Perkins certainly believed. "They perceive themselves to be great venture capital investors and capable of taking substantive risks," says Foster. "I spent an afternoon with Kleiner. They were sold. They didn't necessarily have any technical background for this, but they had hired consultants. I had plenty of technical capability, and I got sucked right in too."

Kleiner Perkins declined to comment on Terralliance, citing the ongoing, if inactive, litigation against Olson. So did Goldman and Passport. Franklin Enterprises did not respond to requests for comment. Kleiner partner Joe Lacob, who exited the board last year, said in an e-mail: "Clearly, the economic upheaval of late 2008 and early 2009 dictated business-model changes for many, many companies. [Terralliance], through the efforts of many, has successfully navigated those waters and emerged, arguably, stronger than ever."

As for Erlend Olson, he has formed a new venture and has been spending his time in airplanes again, particularly between California and Africa. He still burns with the same intensity. But where once he searched for water, then for oil, now he's looking for validation.

--Reporter associate: Doris Burke