Investing in Oil and Gas

Energy Exploration and Development

Excerpted from Guide to Understanding Direct Investments

By Virginia B. Morris and Kenneth M. Morris. Published 2005 by Lightbulb Press, Inc.

You do not need cowboy boots and a 10-gallon hat to invest in oil and gas wells. invest_oil_01

You can invest directly in energy exploration through a partnership that puts money into petroleum or natural gas drilling projects. Like other direct investments, an energy partnership invests in hard assets rather than shares of a corporation that is drilling for oil and gas.

In addition, assuming the venture is successful; the partnership provides income over an extended period that reflects the market price of the oil or gas that the wells produce.

THE ENERGY BUSINESS

There are two types of energy partnership programs—developmental and exploratory. Developmental drilling is done close to existing, productive sites, which means that new wells have a good likelihood of being productive as well.

Exploratory drilling, on the other hand, seeks oil and gas in new, untapped areas. That means there is a higher risk that more of the wells will be dry.

Because there is enormous political and economic pressure to increase the amount of oil and gas produced in the United States, Congress provides major federal tax advantages to encourage investment in domestic drilling of both types. The primary benefits are the intangible drilling cost (IDC) write-off, which offsets regular income, and the depletion allowance. This deduction reduces the investment income on which you owe tax.

INTANGIBLE DRILLING COSTS

Intangible drilling costs (Ms) are costs related to opening a well, including fuel, trucking, wages, drilling supplies, and whatever else is needed, except the actual drilling equipment. These costs are concentrated in the first year of a project, and the deduction may offset income up to your entire capital contribution to the partnership during that period.

From its beginnings, the energy industry has depended on not only entrepreneurship, but also knowledgeable investors. This one-time deduction may make direct energy investments especially appealing if you've received a lump sum such as a pension distribution, proceeds from selling your business, or profits from exercising stock options—that would other wise be taxable in the year you join the energy partnership.

An additional advantage is that the IDC deduction can also offset up to 40% of alternative minimum tax (AMT) income if you fall into that tax category.

A LIMITED RESOURCE

Because oil or gas wells draw on natural resources and will eventually be exhausted, Congress provides another tax incentive to encourage you to invest the depletion allowance. You can take this allowance as long as the wells are productive to offset your tax liability on
income you receive from oil or gas sales. In addition, depending on the way an energy DPI is structured, you may be able to take a depreciation allowance for tangible drilling costs, such as equipment, against any income you receive.

THE NATURE OF PARTNERSHIPS

Partnerships are organized in two tiers— general partners, who are responsible for running the business, and limited partners, who provide investment capital but have no personal liability for the decisions the partnership makes or any debts it might incur.

When you make a direct investment in a natural gas drilling partnership, for example, you generally invest as a general partner. The reason is that only general partners can write off intangible drilling costs against ordinary income, not just against passive investment income.

Then after a year as a general partner, you will be converted to the status of limited partner.

You will want to discuss how this two-step process
works with your financial and legal advisers to be
sure you understand the benefits and the potential
risks.

ENERGY INCOME

Three factors affect the regular income distributions you receive from oil and gas direct investments:

           Production volume

           Market price

         Operating expenses

The more a group of wells produces, the more income the partnership generates, and the greater your potential income. However, oil prices tend to fluctuate dramatically because the bulk of US oil is imported from OPEC countries, which may expand or restrict production in response to economic or political events.

Natural gas partnerships, on the other hand, are less affected by international politics, since US, wells supply much of the gas consumed within its borders. As a result, natural gas prices tend to be influenced more by demand than by problems in the supply chain. And because utility

Companies use clean-burning natural gas to fuel their electricity production, energy researchers believe demand for natural gas will continue to grow in the next two decades.

THE IMPACT ON YOUR PORTFOLIO

Energy investment programs can help diversify your portfolio and provide a long term, partially sheltered revenue stream despite the potential risks they pose as an asset subclass. Since they are non-traded, long-term investments, their returns aren't correlated to stock and bond market returns and their value isn't affected by securities' market pressures.

One consequence is that energy DPP income may outpace returns on more traditional investments in adverse economic cycles. For example, natural gas and oil prices tend to increase with inflation, making income from the investment an ideal hedge against rising prices. Similarly, because demand for energy tends to be non-cyclical, you generally continue to receive gas and oil income during recessions.

TERMS OF INVESTMENT

Although some energy direct investments have seven-to-ten year terms, it is not unusual for these investments to be open-ended. A well produces oil or gas on a diminishing basis over a period of time, but its duration can only he estimated. When the well stops producing, the income stream of the investment ends too. So there is no single event that results in a final cash distribution or capital gain.