Oil and Gas Chapter 24 Tools & Techniques of Investment Planning Copyright 2007, The National...

Oil and Gas Chapter 24Tools & Techniques of

Investment Planning

Copyright 2007, The National Underwriter Company 1

What is it?

• Exploration for and production of oil and natural gas involves:– A high degree or risk– Large amounts of capital– A great deal of technical expertise– Incredible potential rewards

• The combined efforts and capital of many groups of individuals are necessary to achieve profitable exploration and production, including:– Corporations (including S Corporations)– Trusts– General and limited partnerships– Joint ventures


Investment Planning


What is it?

• Four basic types of oil and gas investments:– Exploratory drilling

• The search for oil or gas in new areas

– Development• The search for oil or gas near previous successful wells

– Income • Investment in the production of oil or gas reserves already located

and drilled

– Diversified• A combination of the first three


Investment Planning


When is the use of this tool indicated?

• When the investor is in a high income tax bracket and in need of a tax shelter

• When an investor desires additional diversification of his/her investment portfolio – Into an asset class that is not positively correlated with equity and

bond markets

• When the investor is psychologically willing and able to take relatively high risks in return for possible large rewards

• When the investor desires a completely passive role– He/she does not wish to be actively involved in the operation of the

investment.


Investment Planning


Advantages

• Tax Advantages: Result in both high front-end deductions (often exceeding 60% of the initial investment) and a continuing deferral of tax.– A deduction is allowed for the depletion of the oil or gas reserves

in the ground, of which there is two types:• Percentage depletion

– Allows for a deduction of a specified percentage of the gross income derived from the property (after reduction for any rents or royalties the investor must pay with respect to that property)

• Cost depletion– Bases the deduction on proration of the investor’s basis in the property

between the number of oil or gas units sold during the year and the number of estimated units remaining

– (Investor’s Basis / Barrels of Oil Remaining) x Barrels Sold During the Taxable Year


Investment Planning


Advantages

• Tax Advantages– Intangible Drilling Costs (IDC) incurred in exploratory and

development programs are deductible.– Investors may elect to take an “enhanced oil recovery credit” in

lieu of deductions for depreciable property and IDCs• Equal to 15% of the investor’s qualified enhanced oil recovery costs

for certain projects begun after December 31, 1990• As a component of the general business credit, it is subject to the

applicable general limitations and carryback and carryforward rules– The interest expenses on funds borrowed to finance the

investment are deductible, subject to applicable limitations.– Losses are currently tax deductible, subject to the “passive

activity” limitations• Except so-called “working interests” in oil and gas properties


Investment Planning


Advantages

• Tax Advantages– The investor has the potential to receive long-term capital gain treatment

upon the sale of his or her interest– If an investor has purchased an interest in the form of a limited

partnership unit, participants can agree to divide up income, deductions, and credits in a manner disproportionate to their ownership interest

• The investment required is relatively small when compared with the potential profit.

• Since most investors are limited partners in the oil and gas venture, their liability is limited to the extent of:– Their capital contributions to the partnership.– Any contributions investors contractually agree to make in the future.– Any partnership debts the investors agree to guaranty in order to

leverage their tax benefits.


Investment Planning


Disadvantages

• An investor in oil and gas assumes an extremely high degree of risk if the investment is in exploratory drilling.– An investor may lose 100% of capital.

• Only one out of ten “wildcat” wells is successful– By participating in only developmental or income drilling, the

degree of risk can be reduced.– Many wells never produce reserves of sufficient quantity to

enable a recovery of drilling costs.• Many advisors recommend that an investor split the total investment

among two or three types of drilling programs.– Risk of mismanagement and/or fraud is high.

• Most investors do not live near enough to the drilling site to constantly inspect operations or monitor costs.


Investment Planning


Disadvantages

• The tax advantages are offset by the “at risk” and “passive loss” rules.– The current deductibility of “losses” is limited to the amount that

the investor stands to lose in the economic sense.• “At risk”: The actual investment in the property plus the amount of

partnership debt incurred that the investor may personally be called upon to repay.

• To the extent the investor may not deduct the loss in the current tax year, the excess may be carried over indefinitely.

– “Passive activity” loss limitations apply.– Investments in oil and gas may be subject to the alternative

minimum tax because of preference items.• Does not apply to “independent producers”


Investment Planning


Disadvantages

• The “time line” of the investment varies, but is often long term.– 3 to 5 years

• The value of an investor’s interest can quickly drop due to the volatility of energy prices

• The value of an investor’s interest can drop in the long run due to:– Conservation efforts– New technology– Alternative energy sources


Investment Planning


Tax Implications

• The investor may hope to achieve three results:– A deduction for intangible drilling costs– A deduction for percentage depletion– A credit for enhanced oil recovery costs

• The investor’s tax benefits may be reduced by:– The limitations on the depletion deduction– The “at risk” and “passive loss” rules– For certain producers and royalty holders, the impact of the

alternative minimum tax


Investment Planning


Alternatives

• “Exotic” tax shelters are very high risk with possible high return.– Leasing “masters” for stamps, recordings, and lithographs– Movie deals– Cattle feeding programs

• Certain rental real estate investments– Based on the potential tax shelter– Appropriate for upper-middle to high-income investors who are

able to take significant risks– Less risky than oil and gas


Investment Planning


Where and How do I get it?

• “Co-Ownership” Arrangement– Acquisition of a fractional, undivided working interest in a co-

owned oil or gas property– Investors participate in every item of income and expense

attributable to the operation in accordance with their fractional ownership interest

– Each co-owner signs an operating agreement that names one of the co-owners as the “operator” of each property

– Considered a partnership for tax purposes


Investment Planning



• “Co-Ownership” Arrangement – Advantages and Disadvantages

• A co-owner’s interest is more transferable than a partnership interest.

• A co-owner’s interest also has a greater collateral value.

• A co-owner is not restricted by tax elections made by the partnership.

• There is a significantly broader level of risk.

• A larger investment of funds, time, and effort is required.

• Co-owners cannot allocate costs with the same flexibility as limited partners.


Investment Planning



• Limited Partnership– Preferred by most investors due to the limited liability– “Sharing Arrangement”

• Agreement by which revenues and costs are shared by partners

• Typically, capital costs are allocated to the general partners and tax deductible expenditures are allocated to the limited partners.

– Sharing arrangements typically fall into four categories


Investment Planning



• Limited Partnership– Four categories:

• Functional Allocation of Costs (Tangible-Intangible Allocation)– The general partner participates in revenues from the beginning of

the venture.– The percentage of that participation is decided by agreement among

the partners– Maximizes the tax deductions of the limited partners

» Limited partners pay costs that are deductible when incurred, while the general partner pays costs that must be capitalized.

– Limited partners bear the full cost of drilling unproductive wells and the majority of the cost of drilling productive wells.


Investment Planning



• Limited Partnership –• Promoted interest

– The general partner arranges to participate in revenues in excess of his participation in costs.

• Carried interest– Limited partners “carry” the general partner with respect to costs.– The general partner participates in revenues from the beginning of

the venture while paying a relatively minimal share of costs.» His income interest will typically increase a few more percentage points

once the limited partners have recovered their investment from their share of production.

• Reversionary interest– The general partner receives a small percentage of the revenues and

pays only a small portion of the costs until the limited partners have recouped their investment from revenues.


Investment Planning


What fees or other costs are involved?

• Sales commissions• Management fees

– Sometimes given exotic names such as “drilling overseeing fees”

• Broker–dealer fees• Loan origination fees and points


Investment Planning


What fees or other costs are involved?

• Guarantee fees– Generally paid to the general partner for such commitments as

providing a guaranteed minimum cash flow from the investment

• Other “syndication” fees– Paid to promoters or syndicators

• These fees will generally range from 13% to 20% of the equity invested by limited partners.


Investment Planning


How do I select the best of its type?

• Compare the “track records” of the sponsors– Top rating

• Established program: one that has been in business at least 7 or 8 years

• A history of consistently returning the investors’ capital

– Lower rating• A program that has been in business for 4 to 6 years• Limited partners have received a return of at least 20% of their

original investment

– Lowest rating• A program that has been in business for less than 4 years.• Should typically be considered only by investors with an ultra high

risk taking propensity.


Investment Planning



• Determine the sponsor’s success ratio– Compare wells completed and producing to wells drilled– Examine the location of the drilling– Examine the amount of oil lifted from the ground and the cost

of doing so• Measured on a “per well” basis


Investment Planning



• Use “time value of money” measurements in the analysis process– Examine how quickly investors’ money was returned

• As well as the amount of each payment

– The financial advisor should consider alternative drilling programs.

• As well as alternative investments, other than oil and gas

• Ascertain the location of the wells to be drilled.– The reliability of past history is directly proportionate to the

location of the wells to be drilled.


Investment Planning



• Measure one sponsor’s financial participation against another’s.– Give top grade to the sponsor with the greatest identity of interest

with the limited partners.• Identity of interest is reflected in a greater commitment of money and

a larger share of the cost.– Give preference to sponsors who are in the business of finding oil

or gas rather than to those who are in the business of just drilling wells.

– Give higher marks to sponsors who contribute land they already own to the oil or gas partnership at their cost.

• The sponsor should not have the right to pick and choose which acreage will be drilled for its own account.

• Compare the cost/return ratios


Investment Planning


Where can I find out more about it?

• Tax Facts on Investments – Published annually by The National Underwriting Company

• Money in the Ground• Taxation of Investments

Oil and Gas Chapter 24 Tools & Techniques of Investment Planning Copyright 2007, The National...

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