IS OIL AND GAS A PROFITABLE INVESTMENT?
Yes. Oil & gas can be a very profitable investment. After all, some of the largest companies in the world are oil and gas companies.
Investing in oil and gas can be accomplished in many ways; from purchasing stock in large public companies to participating in private, independent projects. You can invest in oil and gas exploration, refineries and service companies and you can invest through mutual funds or derivatives such as commodities futures.
All of these investment areas in oil and gas are potentially profitable. However, as an investor you should try to analyze their varying degrees of risk and reward.
One of the first factors of investing properly is trying to determine what your investment goals or objectives may be. As an example, it may be that you are looking to receive a 7 to 12 percent annual return. This type of return can be easily obtained with the purchase of stock from most of the well-known major or independent oil companies.
Or, you may be looking for a rate of return in the 20 to 50 percent range. This can be accomplished by purchasing stock in aggressive small independents or by investing with service companies expanding into new markets.
There is also potential to receive much higher rates of return – some exceed 100 percent – depending upon your ability as an investor to accept higher degrees of risk. Investing with independent operating companies on a direct participation investment is one option. This is similar to what the major companies do when they invest with each other in developing projects.
They also reduce their risk by participating with other oil companies that are located in different geographic areas. It is not uncommon for oil companies to have a specific knowledge or infrastructure in different geographic regions. By sharing in developmental costs, the companies equally reduce risk and gain potential reserves by diversifying their risk.
Yes, investing in the oil and gas industry can be very profitable. However, it is very important to have a good understanding of the type of programs, their structures, and your own level of risk. This leads us to the next question.
IS OIL AND GAS A SAFE INVESTMENT?
Yes, investing in the oil and gas industry can be a safe investment. As we eluded to earlier, one of the safest investments is to own stock in what many consider to be “blue chip” companies known as the “Majors” in oil and gas.
One incentive in investing in a “blue chip” company is that your level of risk is quite low. As a result, return levels are also fairly low. However, you will be making an investment in the oil and gas industry. If this is your main objective and you’re looking for low risk, this may be a good and safe investment. On the other side of the coin: the higher the risk, the greater the return. Again, we come back to your investment objectives.
One way our government helps address the issue of risk is that it allows companies that drill for and produce oil and gas to offset some of the cost through the use of tax deductions.
Oil and gas are natural resources that deplete through extraction. In other words, these are not renewable energy sources and our tax code has allowed a depletion allowance of up to 15 percent*. In addition to the depletion allowance, we have intangible drilling costs as well as tangible drilling costs. There can be additional tax benefits depending upon what type of category a particular project falls into.
Even though the tax benefits are very helpful in offsetting some of the risk for oil and gas, no consideration for an investment in oil and gas should be considered based on the tax benefits alone. Tax benefits are what they are – BENEFITS. These benefits are very useful, however, if it is taxes you are wanting to avoid, you would be much better off giving your money to a favorite charity.
When investing in oil and gas there are many aspects of the industry to consider before determining a safe investment. Three of the main features are:
1) Your investment acumen.
2) Investment objectives.
3) What type of investment vehicle?
1) Investment Acumen: Investment acumen means insight or judgment. In other words, as an investor you need to have the knowledge to be able to ask the right questions and understand what is the right answer. That way, you will be able to make much better investment decisions. Safe decisions to invest or who to invest with are the first prerequisite to profitable investing.
2) Investment Objectives: As we stated earlier, your investment goals, or potential returns, accompanied with the appropriate amount of risk can only be determined by you, the investor.
As an example, if you are interested in analyzing the potential loss of your investment funds, you would be much better off investing in “blue chip” major oil company stocks. However, if you could accept a larger degree of risk, or in other words, potential loss of these investment funds, you may consider investing in projects that offer a higher rate of return. This leads us into our next category.
3) Investment Vehicles: These vehicles may be stock, an investment fund, a drilling fund, private placement, commodities trading, or some combination of all of the above.
These options bring us to the next section: What ways are there to invest?
WHAT WAYS ARE THERE TO INVEST?
Major Oil Company Stock – All of the major oil companies that own the majority of reserves throughout the world are probably traded companies. As an investor interested in oil and gas, their stock can be considered one of the safest investments in oil and gas. However, as a general rule, they do not provide a high rate of return.
Medium-sized Oil and Gas Companies – Many of these are publicly traded on the New York Stock Exchange, as well as the NASDAQ and other exchanges throughout the world. Again, these stocks can offer a higher rate of return, but potentially have more risk due to the fact that most of these companies are still acquiring assets and going through a growth process.
Mutual Funds – These focus their portfolios towards the energy industry. They may own stock in the majors, stock in independents or stock in companies that provided a variety of services for the oil and gas industry. There may even be some direct participation in oil and gas development or exploration projects.
Independent Oil and Gas Companies – There are over 4,000 independent oil and gas companies located in the United States. Many of these firms offer the opportunity to invest with independent producers in industry development projects as well as exploration. These direct participation investments can utilize the full capability of the tax benefits.
Direct participation does offer a much higher rate of return and can, in most cases, have a much higher degree of risk.
One important fact to consider is that 90 percent of wells drilled on an annual basis in the United States are drilled by an independent oil company. These producers may vary in size from one-man shops to multi-level corporations.
Drilling Funds – In the early 1980s, many of the small independent companies that were publicly held provided funds that specifically targeted drilling projects.
Most drilling funds can be broken down into two general categories: 1.) Exploration Drilling and 2.) Developmental Drilling.
Exploration Drilling is described as the search for oil or gas more than a mile away from any existing or proven economic oil or gas wells.
Developmental Drilling is typically categorized as wells designed to define or extend a proven field or existing production. This can be a step-out project to define the productive limits of a reservoir or can be considered in-field (or in-fill) drilling of a pattern of wells. It can be used in a waterflood development. Some types of horizontal drilling are considered developmental due to the fact that the drilling operations are being conducted in known reservoirs, thereby reducing the risk. Developmental drilling offers the highest profit potential of any oil and gas area, as well as significantly lowering the risk.
Commodities Trading – Oil and gas are traded on a daily basis in different exchanges throughout the world. Oil is the commodity that is most commonly referred to as West Texas Intermediate. This commodity is traded on a daily basis in contract increments of 5,000 barrels. Even though you are investing in the oil and gas industry, or one of the products of the industry, you would be described as a speculator.
Basically, what you are speculating, is whether or not the price for a certain commodity will move up or down. Speculating in oil and gas commodities can be a very volatile and turbulent market. As an investor, one should keep in mind that you are speculating in price movement and not the actual ownership of that commodity. Commodity trading has an extremely high degree of risk.
Royalty Funds – Generally speaking, a royalty fund is when royalty interests are being bought, sold and held by the funds sponsors. In nearly all leasing situations, once a lease has been developed, it provides a revenue stream. A portion of the revenue stream is set aside for royalty which generally amounts to 12.5 percent and overriding royalty and/or carried working interest of 2 to 5 percent.
In a royalty fund the objective of the fund is to generate its revenue from royalties that are held from different producing fields throughout the country. The main feature to owning a percentage of a royalty fund is that the royalty owner (or interest owner) pays no percentage of operating or developmental costs associated with the production of the oil or gas. Royalty programs generally offer a low risk factor along with a relatively low return. However, their main feature is that these types of programs last for many years.
HOW TO ASSESS A POTENTIAL OIL & GAS INVESTMENT?
Understanding or assessing potential really starts with a two phase process:
1) The company that will be sponsoring the program.
2) The property that the company will be developing or acquiring.
The Company
One area of the due diligence to focus on is “Prior Activities.”
Basically, this will summarize the programs the firm or company has drilled in the past and how they have fared. Prior activities will cover when the offer commenced, the amount of the offering, the minimum size of units, the method of offering (private or public), the number of wells in the project and the type of wells (development, waterflood, exploration). It will also cover the net revenue, and the frequency of payments (monthly, quarterly, dry hole).
The projects should then be summarized by lease name and a yearly account of the gross revenue, operating expenses, net revenue and cumulative barrels. You should be able to determine an average return on revenue as well as a total return on investment. I have found that these numbers can and will provide you with a fairly accurate track record of the types of projects that this company has developed.
The Property
There are many ways to evaluate drilling proposals or acquisitions of producing assets. Generally, the sponsor will provide you with a geological report or engineering report discussing the potential of these reserves.
Unless you have a proper understanding of geology and/or engineering your best course of action may be to consult with an energy analyst or advisor that is knowledgeable about the company and/or projects you are considering. Quite frankly, the hardest part about determining whether an oil and gas project will be successful is trying to locate the specific benefits of the project through the terminology the geologist or engineer is using for a given area.
The best way to evaluate an oil project is to try to determine how successful the other wells that were drilled in the area were. What we are really looking for is a history of wells that have been drilled in a given area and what type of reserves have been recovered. This should serve as a benchmark in determining the probability of success in this project. In most drilling proposals or geological reports, what has been produced in the past will give a summary or probability of what might be expected in the future or throughout the drilling process.
Analyzing geological and engineering reports is a process that should be undertaken by someone with the proper investment acumen as well as understanding of geology and engineering. The best description of this individual would probably be an energy analyst. However, with a little common sense and time devoted to research and understanding, a non-industry individual should be able to determine the proper investment scenario.
Again, we come back to the question of how we assess the potential of an oil and gas investment. The two phases that I referred to in the preceding section are only a cursory review. There are many aspects of an oil and gas project that need to be addressed. Some of these are sharing arrangements, deal terms, liabilities, market for product, transportation, further development and many other subjects.
WHAT ARE THE TAX BENEFITS OF OIL AND GAS INVESTING?
Intangible Drilling Cost (deductible in full) In the process of drilling a well, there are certain expenses incurred that have no salvage value. They may be labor, drilling expenses, testing, etc. These expenses generally represent from 40 to 60 percent of the total cost of the well. The investor’s proportionate share of these intangible expenses can be deducted as a cost of operation in the year in which they were incurred.
Intangible Completion Costs These are treated the same as intangible drilling costs. These are approximately 10 to 15 percent of the cost of the well.
Depreciation Equipment used in the completion and production of a well – pumping units, tanks, well casing and any other physical equipment – is depreciated over a seven-year life under the new Modified Accelerated Cost Recovery System (MACRS).
Tangible Completion Expenses These usually represent 25 to 40 percent of the total cost of the well.
Depletion Allowance 15% percent of the gross annual income from the production of a well is tax free revenue.