From Wells to Wallets: A Beginner’s Guide to Oil and Gas Investing
Dentists and physicians spend their entire careers focused on the health and well-being of their patients (which is a good thing!). Unfortunately, most don’t think about their own financial well-being until they “have to.”
For me, that “have to” moment involved injuring my wrist while snow skiing.
After completing 8 years of training post college, getting injured never crossed my mind, much less the thought of not being able to work while in my 30s.
This was my wake up call to the fact that I was putting my family at risk by relying on my two hands to feed them.
Most of us are put on some type of 30+ year financial plan with our financial advisors once we start grinding it out in the workplace.
But what happens to that plan if you can only work 10 years or less due to some type of tragic event?
If you think that disability insurance is going to take care of you the rest of your life, think again. Unless you have multiple income streams (outside of your 9-5) that don’t involve your time then you’re going to work a long time.
Look, there’s nothing wrong with having a long career, as most of my new Passive Investor Circle members enjoy what they do for a living.
My biggest takeaway I want them to have after our 20-minute intro call is to figure out a plan to mitigate their risks in case they have to stop working for an extended period of time.
And part of that plan involves educating themselves on alternative investments that can start replacing their income now instead of later.
And one of those types of investments involves investing in oil wells. Investing in oil and gas can be a lucrative way to grow your wealth, but it’s important to understand the industry, really any industry before investing.
In this article, we’ll discuss the oil and gas industry, including the various segments, how they work together to bring oil and gas to consumers along with some of the beneficial tax deductions.
We’ll also highlight the different ways to invest in oil and gas, plus the potential risks and rewards, as well as the key factors to consider before making an investment.
As with any type of investment, it’s important to understand the basics and the different methods to investing to help minimize your risk and maximize the potential for returns.
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The Oil and Gas Industry: An Overview
Crude oil and natural gas are still two of the most important sources of energy around the world. As technology continues to improve and new opportunities open up, energy needs in the United States and abroad are growing quickly.
At the same time, we’re still seeing a lot of worry around the world that we’ll run out of oil and natural gas. This makes companies that know where to find these resources even more valuable.
Oil and gas production includes:
Exploration uses geological and geophysical tools to find new oil and gas deposits. Production uses existing oil and gas reserves. Refining is the process of turning crude oil into gasoline, diesel, and jet fuel. Finally, distribution involves transporting fuels to places such as gas stations and airports where they’re actually used.
All of these parts work together, and each step of the process builds on the one before it. For example, you have to do exploration and production before refining takes place, and refining must be done before fuel can be sold to consumers.
In laymen’s terms: crude oil, also known as petroleum, is taken out of the ground using large oil rigs and refined into various goods, including gasoline, using a number of different procedures.
The industry is also heavily regulated, and governments all over the world play a big role in making sure that oil and gas are made and sold in the right way.
Common Petroleum Uses
There are more ways than you think to use products made by the oil industry.
Many people think that oil drilling only makes gasoline, but that’s not the case. Here are just some of the things that are made from oil:
- antiseptics and toothpaste (yes, you read that correctly)
- bike tires
- life jackets
- toilet seats
- golf balls
Influence Of Supply of Oil and Demand On Oil
Currently, there’s no available alternative to petroleum, which makes our reliance on it extremely high in the energy sector. Because of this, the production of the products listed above and many others greatly depends on the supply.
As the demand continues to increase along with the limited supply, oil remains a hot commodity.
And because oil is not a renewable resource, ultimately we’ll reach a point where the supply will drastically decrease while the demand will continue to rise.
Because of this, most investors anticipate that the price of oil in the future will go up.
When the price of gasoline goes up, it means both oil prices and shareholders’ investments increase as well.
How To Invest In Oil and Gas
If you’re interested in gas and oil investment opportunities, there are several ways to get involved.
Here are some of the different opportunities available:
Buying mineral rights
Mineral rights refer to the rights to underground resources, including oil.
They give the holder ownership of the mineral resources found on a plot of land. Even though someone may control the surface rights, they have no right to explore the resources beneath the land unless they own the mineral rights.
Mineral rights can be bought at an auction, through negotiations, sealed bids, upstream oil and gas companies, brokers, or directly from the person who owns the mineral rights.
When you invest in mineral rights, you’re actually buying a portion of the gas and oil rights that are still below the surface.
A common way to handle this type of ownership is by leasing it to a gas company for development. Once the well starts producing, you can begin keeping a percentage of the revenue. This process is called a royalty interest.
Investing in stocks, ETFs and mutual funds
One of the quickest and easiest ways to start investing in oil and gas with little money is with the stock market.
- mutual funds
- exchange-traded funds (ETF)
When you buy stock in a company, you own a piece of that company. This is no different when it comes to the oil and gas industry. Investing in oil stocks and gas stocks can help you make money as they continue to grow and add to their operations.
It’s best to buy stocks when their prices are low and sell them when crude oil or natural gas prices go up.
An exchange-traded fund (ETF) is another way that you can invest but it’s closely tied to the price of oil. They’re like regular stocks in that you can buy and sell them, but your investment is spread out among many different stocks.
They’re made up of contracts, stocks, or futures that track the price of oil.
A mutual fund or ETF that invests in oil and gas spreads the risk over several different companies. And if you don’t have a large lump sum to invest, the stock market may be your only choice.
Unfortunately, as a shareholder, you won’t get the significant tax benefits, which is one of the best things about investing directly (more about that below).
Direct Participation Programs (DPP)
When it comes to investing in oil and gas, equity investments or direct participation programs (DPP) could be considered the most lucrative option for those who want to invest directly in oil exploration and production.
A direct participation program is a non-traded pooled investment that functions over a several-year time frame allowing investors to take advantage of:
- Potentially high ROI
- Diversification of portfolio
- Tremendous tax incentives
- Long-term passive income generation
This program is divided into two categories:
- working interest ownership
- limited partnership ownership
Working interest ownership
This is a way to invest that was originally used to fund oil drilling projects in the early 1920s. In this channel, you own a piece of the oil well.
And because of this, your risks and responsibilities are higher than in a limited partnership.
Limited partnership ownership
This type of partnership started in the early 1970s. This type of ownership is different than working interest ownership in that it uses working capital to give the general partners more power.
Typically, this type of ownership can deliver a high ROI, as the working interests get wrapped together and investors incur the backend and management costs.
It’s common for a DPP to finance the drilling of several oil and gas wells at once. The investor can potentially deduct upwards of 85% of their initial investment from their taxes in the first year (check with your CPA, as this is NOT to be taken as tax advice).
When drilling is completed, after the first year or so, investors typically start receiving a monthly dividend.
Depending on how well the drilling goes, the returns can range from modest to very large.
Most of the time, the well package is sold to a larger oil company after about five years. The profit from the sale is then split among the investors based on how much they put in, and the returns are considered capital gains.
Types of DPPs
There are a few different kinds of DPPs including:
- Developmental Drilling Program: this is the most common type of DPP as it involves looking for new oil in proven areas
- Exploratory Drilling Program: has the highest risk as it involves looking for new oil in new areas not already proven
- Working Interest Program: this program involves currently producing wells
- Rework Program: this is just as it sounds, reworking or improving low-producing wells
Direct participation programs have two major advantages:
- Cash flow – most pay out almost immediately on a monthly basis; good source of passive income
- Tax advantages (see below for further explanation)
The nature of oil and gas investments makes them illiquid and more prone to speculation. Returns have the potential to be significant; nevertheless, they may also be nonexistent.
Oil prices have an impact on profitability, and only accredited investors (aka qualified investors) are eligible to make investments in direct participation programs (DPPs).
If you want to know why you should become an accredited investor, then check out this video:
Tax Benefits of Oil and Gas Investing
*Check with your CPA about any tax benefits before considering and oil and gas investment.
Intangible drilling, which accounts for 80% of investments, can typically be deducted from earnings. These intangibles include things like:
Usually, between 60-80% of the overall cost of oil drilling goes toward these expenses.
For instance, investors would receive a deduction of $187,500 if drilling a well cost $250,000 and 75% of the cost was deemed intangible. These expenses are subtracted annually.
Moreover, deductions are made as soon as drilling starts, regardless of whether the well strikes oil or produces any. As “tax preference items,” intangible drilling costs are exempt from the Alternative Minimum Tax under the 1992 Tax Act.
Also, 20% of investments are regarded as tangible drilling costs. The value of drilling equipment is directly correlated with tangible expenses. Each year, these expenses are also subtracted. If they were incurred in the first year, they can also be deducted. Normally, 100% of these costs are deducted in the year of the investment.
Businesses may deduct the cost of equipment purchased or funded during the tax year under Section 179 of the IRS tax law. Also, there’s a “depletion deduction” which allows for a tax exemption of 10% of oil and gas gross income.