Without a doubt, the oil and gas sector had a wild year in 2020. A perfect storm of collapsing prices and demand was brought on by circumstances
The pandemic devastated demand around the same time that Saudi Arabia and Russia engaged in a price competition to determine who could go the lowest. From a peak of $63.27 per barrel (WTI) in January, prices gradually decreased to $20, $19, and $18. Then, on April 20, the unexpected occurred: oil futures plunged to a low of -$37 per barrel before ultimately rebounding.
A CNBC headline said, “A barrel of oil is cheaper than the cost of beer.” Companies were unable to give oil free because demand had fallen so low. Instead, producers were paying expensive tanker fees to temporarily “park” their oil.
Investing in Oil and Gas: A Guide
The ideal way to be exposed to oil and gas wouldn’t be on the stock market, right?
Most likely not. Significant financial incentives are provided for investments in order to encourage the nation toward energy independence. This means that drilling expenses in the oil and gas sector, including labor and equipment, are up to 100% tax deductible. Investments in the oil and gas industry are a great way to reduce income or gains from other sources. For many, oil is a highly wise investment because of this!
Stocks would be our least preferred method of investing in oil and gas out of the various options. Let’s examine three possibilities and some benefits and drawbacks of each for oil and gas investment:
Mutual Funds and Stocks
ETFs, mutual funds, large- or small-cap stocks may all fall under this category. Since the majority of gains are reinvested, stocks only offer modest upside for shareholders. Oil spills and other unfavorable headlines can also have a negative effect on large firms and their stock values.
On the plus side, the diversification of the companies in an oil and gas mutual fund or ETF provides some risk protection. Additionally, if you don’t have a large sum of money to invest, the stock market can be your only choice.
Sadly, shareholders won’t benefit from a key advantage of direct investment: tax write-offs!
Programs for Equity Direct Participation
The most lucrative approach for the majority of investors to engage in oil and gas is through an equity investment or Direct Participation Project (DPP). A DPP is a non-traded pooled investment that runs over a number of years and gives investors access to the cash flow and tax advantages of an energy business. (Investors may also be aware of real estate DPPs, which function similarly and, like oil and gas DPPs, can take part in 1031 tax swaps.)
Usually, a DPP provides funding for numerous wells of oil and gas production. The tax write-off, which may equal up to 85% of the investment, is the investor’s benefit in the first year. Investors start to get a monthly dividend once the drilling is finished, which usually happens after the first 12 months. Depending on how well the drilling goes, the returns could range from being very modest to being extremely profitable. A tax exemption applies to 15% of this income, while the remaining 85% is considered ordinary income. Consult with your tax advisor.
The well package is normally sold to a bigger oil company after around 5 years. The returns are then recognized as capital gains, and the sale’s profit is split proportionately among the investors.
Diversification of asset classes, huge profit potentials, and large tax benefits are benefits of direct investments in oil and gas. Through the use of multi-well packages and skilled operators, risk can be somewhat reduced. Investors, though, need to be aware of the drawbacks. Investments in the oil and gas industry are speculative and illiquid. Returns can be substantial, but they can also be negligible. Oil prices have an effect on profitability. Additionally, accredited investors are the only ones permitted to invest in DPPs.
Leases for Mineral Rights
This is a private lending arrangement that works like a bridging loan for real estate rather than an investment in oil and gas per se. Investors receive returns that have been contractually agreed upon and can produce monthly cash flow. The typical investment horizon is one to three years. Mineral rights leases need lump sum payments to be made.
Listen to Kim Butler’s podcast “Investing in Mineral Rights” to learn more about mineral rights leases.
