How to Know which Oil and Gas Investment to Pursue

Rising oil prices have made energy investments more attractive than ever...but what's the best way to cash in on this sector? There are several ways to approach this, but which is right for you?

Instructions

Difficulty: Moderately Challenging

Things You’ll Need:

• A tax advisor
• An experienced geologist and/or petroleum engineer
• Perhaps an attorney to draw up a working agreement

Getting Started

1. Oil and gas investors must determine first whether they would be better off simply investing in a mutual fund or UIT that invests in energy rather than through any kind of direct participation. The former route has less risk, but also lower returns. The latter option has greater risk, greater returns and a series of unique tax incentives not found elsewhere.
2. If direct participation is desired, then the next choice is whether to pursue a working interest, partnership or royalty arrangement. Of course, royalties can only be paid to landowners-so if this is what you desire, then contact your real estate agent about buying some land that has producing oil wells on it.
3. If you would rather just stick to investing directly in oil and gas without owning the land, then you will have to decide whether to buy shares of a partnership or else obtain part or all of the working interest of an oil or gas project.
4. If you decide to invest in a partnership, you may have to prove that you are an accredited investor, meaning that you have a net worth of at least $1 million or income of at least $250,000 a year. You will receive a K-1 form at the end of the year detailing your share of the partnership's income and expenses.
5. If you decide instead to invest in the working interest of a project, remember that any income you receive will be considered earned income, so you will need to pay self-employment tax on any amount you receive that is below the Social Security wage base.
6. A working interest investment usually involves partnering with an engineer or geologist that is able to actually drill and/or rework a project so that it becomes profitable. Working interests involve paying monthly expenses, such as pumping fees, electric fees, and other maintenance that is required to keep the project running.
7. However, virtually all expenses associated with drilling and running an oil or gas project are tax-deductible, either in the year they are incurred or over a seven-year depreciation schedule. Furthermore, all income realized from a working interest in a partnership is 15% tax-free off the top from the depletion allowance.
8. But one must be careful when entering into a working interest arrangement, because the investor can be liable for mistakes made by the engineer or pumper if there is an accident. This type of investment is also not regulated directly by the SEC like a partnership is.
9. Here is an example of a working interest arrangement: An investor partners with a petroleum engineer, who finds a project for $250,000 that he feels he can rework to produce 10 barrels of oil per day for another $100,000.
10. The investor supplies the $350,000 of necessary investment income, and the engineer gets to work. The four wells are stimulated and reworked, and the project soon begins to produce 10 barrels per day. At $80 per barrel, this is gross income of $800 per day, or $288,000 per year.
11. But, of course, royalties and severance taxes must be subtracted before computing return on capital. The Net Revenue Interest of this project is 81.25%, which means that 18.75% of the gross revenue is paid to the landowner (18.75% of $288,000 is $54,000.)
12. Each state also assesses a severance tax on any resource that is extracted from the ground. For this example, we'll assume that the severance tax is 7.5%. 7.5% of $234,000 is $17,550. This leaves the net production of this project after royalties and taxes at about $215,000.
13. Finally, the net revenue is split 75/25 between the investor and the engineer, who did not contribute the capital but is doing all the work. This gives the investor about $160,000 a year in schedule C income and the engineer about $55,000.
14. The monthly expenses needed to run the project are split 75/25 as well, with the investor of course paying the larger portion. Both the investor and the engineer can deduct all of the expenses on their taxes, as well as take the depletion allowance against their income.

Tips & Warnings

• Many of the good projects available in the oil and gas sector will not be widely advertised. Talk to a petroleum engineer to see if he or she knows of anything good that is available.
• Oil and gas investments contain types of risk not found in conventional investments. Due diligence is always necessary in order to protect yourself.