Earn High Potential Profits with Oil and Gas Investments!

Although some people invest in oil or natural gas for income tax reasons, most people investing in oil or natural gas do so because they believe they will make a profit. This belief is often based on simple rules of supply and demand. The supply of oil is limited while the demand for oil has the potential to increase.

A limited supply and an increase in demand generally means an increase in the price and hopefully an increased profit for the persons owning the supply. In the United States, and most other nations, oil is the principal resource that fuels the economy. The reason for this is simple: nearly everything consumers have or do is in some way related to oil. Gas for the family car, plastic bottles and containers, and petroleum jelly are only a few of the products created from oil.

As free market economies continue to spread and flourish around the world, the demand for oil and natural gas will almost certainly increase. This increase in demand will ultimately result in higher oil prices. As the price of oil increases, oil and natural gas investments will become even more profitable.

Oil reserves, like gold, can increase in value even while sitting in the ground. Thus, participation with companies that find significant amounts of oil or gas reserves will generally result in a healthy profit for the investor.

As noted above, some investors like oil and gas because it may generate federal income tax benefits. Although tax benefits alone may not be the best reason to invest in oil or natural gas, the benefits generated may allow investors to take advantage of other tax benefits from which they would normally be precluded.

Several developments make petroleum an attractive opportunity right now:

        Increasing world energy demand. Third world countries are industrializing at previously
            unimaginable rates without means of creating their own energy production.

  The last down cycle left the industry with "lean and mean" proven survivors.

  Much improved financial returns due to technological breakthroughs that significantly enhance reserves and lower finding costs.

  Availability of favorable high-quality prospects for private investors.

  The need for additional investment capital in the industry has created an opportunity for the private investor once reserved for larger energy companies and investment bankers.

Oil and gas investments can add balance to and serve as a hedge for "stock or mutual fund heavy" portfolios. If you compare oil prices to stock prices, now is the best time in the last 38 years to invest directly at the well head.  As an example, in 1970 the cost of 1000 barrels of oil divided by the S&P 500 index gave an oil/stock exchange rate of 34.51. Ten years later, with oil prices at all time highs, the exchange rate had soared to 159.03. However, by mid 1998 the ratio had plummeted to 12.38.  Oil is at the highest value it has been in 38 years when compared to the stock market. The old adage of "buy low and sell high" has never been more true than today. Although oil and gas is one of the most volatile of all investment categories, it is also one of the most negatively correlated to the stock market.  Because returns from direct oil investment generally move up as returns from stocks move down, private investors couldn't find a better hedge than hydrocarbon.

  Is Oil and Gas a Profitable Investment?

An investment in oil or natural gas has the potential to be very profitable. After all, some of the world's wealthiest individuals and companies made their fortunes in oil or natural gas. The type or form of the oil or natural gas investment directly effects the investment's potential risk and potential reward.

An oil or natural gas investment may take many different forms; from stock in a major oil and gas company to participation in private, independent projects. Investments may be made within particular segments of the industry as well. For instance, investments may be made in oil and gas exploration, refineries, or service companies.

All of these oil related investment alternatives are potentially profitable. However, as with any investment, certain rules of risk versus reward must first be assessed.

The following is a summary of some of the differing types of investments available in the oil or natural gas industry and a general assessment of the investment's risk:

  Major Oil Company Stock

This investment is probably one of the safest investments in oil and gas. Most of the major oil companies are traded over a public stock exchange and are subject to strict governmental regulation regarding the nature of any public offering. Because an investment in companies of this sort is relatively safe, the rate of return is relatively limited.

  Medium-sized Oil and Natural Gas Companies

Many medium-sized companies are also traded over a public stock exchange. Again, these companies are subject to strict federal regulation regarding their public offerings, but may offer a higher rate of return than the major oil company stock. Naturally, the stock of a medium-sized company will carry more risk and thus carries a greater risk of loss.  

  Mutual Funds

Energy based mutual funds will often purchase stocks from several of the major oil companies and occasionally from medium-sized companies. Furthermore, they may purchase stocks from particular segments such as exploration or well service companies. Because they purchase stock from several companies, the risk is lowered, as is the upside potential. However, some of the more aggressive funds may directly participate in oil and gas exploration programs. These funds carry a significantly higher amount of risk as compared to those funds that focus on stocks of the major oil companies.

  Independent Oil and Natural Gas Companies

There are literally thousands of independent oil and gas companies located throughout the United States. Many companies offer the opportunity to invest directly in exploration programs. These so-called "direct participation programs" are generally offered to wealthier individuals or closely-held businesses in what is often referred to as a "private placement." Participants in direct participation programs are allowed several tax benefits as well as the potential for high rates of return. However, the risks associated with programs such as these are high and the investor could lose the entire investment.

  Drilling Funds

Most drilling funds can be broken down into two general categories: (1) Exploration Drilling and, (2) Developmental Drilling. Exploration Drilling is generally described as the search for oil or natural gas more than a mile away from any existing production and presents more risk than developmental drilling. Developmental Drilling is generally described as the search for oil or natural gas with wells designed to define or extend a proven field or existing production.

  Lease Acquisition Funds

This type of fund generally retains a royalty for accumulating the leases that it will sell or farmout to an operating company. These funds are often used for acquiring oil and gas leases in conjunction with an oil or gas exploration prospect. This type of fund can be risky depending on the lease location and the terms of the fund. If the leased acreage ultimately lies in an area that presents strong exploratory potential, the profit potential is significant.

  Commodities Trading

As previously noted, oil and gas stocks are traded on public exchanges throughout the world. As opposed to trading stocks, commodities traders deal with contracts for the purchase of the actual commodity, in this case either oil or natural gas. There are several grades of oil and natural gas traded on these markets. Obviously, the more pure the oil or gas (i.e., not containing trace elements of sulfur, nitrogen, or other elements that must be refined out of the oil or gas) the higher the market price. Speculation as to the price of oil or gas can be very risky due in part to the external factors (such as OPEC) that affect the oil and gas market.

  Summary

These are a few of the more common types of oil or natural gas investments. Because of the complexity of each type of investment, potential investors should properly analyze each investment vehicle to determine whether the particular investment meets the investor's personal criteria.

In any event, if investing in oil or natural gas, it is important to devote the time necessary to understand the company, fund, and/or direct participation program being considered. Furthermore, novice investors should consider seeking the assistance of a professional adviser.

  What are the Tax Benefits of Direct Participation
Oil and Gas Investing?

Direct participation oil and gas investments generate several tax benefits. These benefits range from relatively large up-front deductions for intangible drilling costs (IDC) to tax credits for the development of certain tight formations. Most deductions are generated from non-salvageable equipment or services conducted during the drilling, testing, or completion of the well.  

The following is a summary of some of the more common tax benefits generated by oil or natural gas investments.  

  Intangible Drilling Cost (IDC)

When a well is drilled, there are several expenses that may be immediately deducted. In general, these expenses are deductible because they offer no salvage value if the well is subsequently declared to be dry. These expenses may include labor, rig time, drilling mud, and other expenses.

IDCs generally represent from 40 to 60 percent of the total cost of the well. In a direct participation program, if the investor invested before the drilling operations are conducted, the investor's proportionate share of the intangible expenses can generally be deducted. The deduction is generally taken in the year in which the intangible activity occurred, however the accounting method adopted may affect the deduction period.

  Intangible Completion Costs

Intangible costs are also incurred when a well is completed. As with intangible drilling costs, these costs are generally related to labor and other materials used during the completion that cannot be salvaged. These are treated the same as intangible drilling costs (i.e., they are generally deductible in the year incurred). The costs generally account for approximately 10 to 15 percent of the overall cost of the well.

  Depreciation

As opposed to materials and services that offer no salvage value, equipment used in the completion and production of a well is generally salvageable. Because these items are salvageable, they are generally depreciated over a seven-year period. The method of depreciation is referred to as the Modified Accelerated Cost Recovery system (MACRS-pronounced like the word "acres').

Equipment subject to depreciation includes pumping units, tanks, well casing, well head equipment, and any other physical equipment that can be salvaged if the well is subsequently abandoned. The cost for the equipment as well as certain other tangible completion expenses generally accounts for 25 to 40 percent of the well's total cost.

  Depletion Allowance

After a well is drilled and is producing, the owners of the production are allowed to shelter some of the gross income from the well through a depletion deduction. Two types of depletion are available-cost and statutory (statutory depletion is often referred to as percentage depletion). Cost depletion is calculated based upon the relationship between current production as a percentage of total recoverable reserves.

The other type of depletion available (called either statutory or percentage depletion) is subject to several qualification requirements and limitations. This deduction will generally shelter 15 percent of the well's annual production from tax. For so-called "stripper" production (generally a well producing 15 bbls or less per day), the depletion percentage can be up to 20%. For 1998 and 1999 the depletion allowance earned from stripper wells can be used to offset income from other sources (i.e., from wages, rent, interest, etc).

  Tax Credits

As an incentive to operators and investors to attempt alternative methods of recovery, Congress has enacted several tax credits relating to oil or natural gas production. The enhanced oil recovery credit is available for certain project costs incurred to enhance a well's oil or natural gas production. The credit is up to 15% of the costs incurred to enhance the production. The nonconventional source fuel credit provides a $3.00 per boe (barrel of oil equivalent) credit for certain production from so-called qualified fuels. Included in the list of qualified fuels is oil shale, tight formation gas, and certain synthetic fuels produced from coal.

  Alternative Minimum Tax

Historically, the tax benefits from oil or natural gas production presented the potential for taxation under the alternative minimum tax (AMT) regime. In the early 1990's, Congress provided some relief for so-called "independent producers". An independent producer is an individual or company with production of 1,000 bbls per day or less. Although there is still a potential for AMT for excess IDCs, percentage (or statutory) depletion is no longer a preference item.

  Lease Operating Expense

These costs include the cost of day-to-day activity at the well site as well as the costs involved with the re-entry and rework of a producing well. These costs are generally deductible in the year incurred without any alternative minimum tax consequences.

  Conclusion

As can be seen from this discussion, the tax benefits from a direct participation investment are considerable. Of the benefits provided, the immediate deduction of the intangible drilling costs (IDC) is generally considered the most significant. By taking this up-front deduction, the investor's risk capital is effectively subsidized by the government through the reduction in the investor's federal (and possibly state) income tax. Investors considering a direct participation investment in oil or natural gas should seek the counsel of their tax adviser

  How Has Technology Changed the Industry?

Two of the key differences between the 1980's and the energy business of the 1990's is 3-dimensional seismic & horizontal drilling. Quite simply put, 3-D seismic has added to the oil industry what cat scans added to medicine. It gives operators a way to get a computer generated blue-print of what is under the ground just like a doctor can look at the inside of your body without using a knife.

"Chevron and Shell in particular have come out in public and stated that 3-D seismic completely revolutionized the way they do business." Oil and Gas Investor-June, 1993.

Jerry Box, Oryx Energy's senior VP for worldwide exploration and production said,

"3-D can see through rocks and identify prospects, reducing discovery and delineation well numbers." World Oil-1994.

The domestic energy outlook of the 90's has seen dramatic change from the past. A market, once dominated by major oil companies and large banks, is now seeing more private capital and smaller specialized companies poised to take advantage of greater-than-ever opportunity. With the glut of quality technologically-driven prospects available today, it is becoming a buyers market thus more deals chasing money.

Three-dimensional seismic has created a unique opportunity for the private investor. A few short years ago, the technology of the times allowed one productive well for every ten drilled in undiscovered areas. Three-D enables us to be successful six or seven times for the same money, therefore many more quality projects needing funding than ever before. Banks today are loaning money on 3-D seismic survey. Each dollar spent on the surveys needs about four dollars to drill the acreage or a 4 to 1 ratio.

Thus, with six or seven times more projects available to develop, and each project needing four times the survey money spent for development, the opportunity created puts the private investor in the enviable position of being offered the high quality prospect once reserved for the oil "fraternity of good ole boys".

Today's virtual E & P (Exploration and Production) Companies rely on their cash flow just like individuals, They can't reinvest the dollars spent on project generation without drilling wells to recoup their investment. Thus the quicker they can turn over their exploration dollars, the more projects they can invest into and the more dramatic the compounding effect is on their investment.

The other key difference in technology is horizontal drilling. Horizontal drilling like 3-D seismic is most effective in areas where oil and gas has previously been discovered, produced, and then thought depleted. It is not uncommon for horizontal drilling to enhance recovery rates 50 to 500% along with production rates into the thousands of bbls of oil per day.

Although the horizontal drilling concept is not new to the industry, the perfection of the technology is. Horizontal drilling has been going on since the 30's. From the 30's through around 1960 about 100 horizontal wells were drilled with an average horizontal extension of 50 feet. Most wells floundered because of mechanical problems and high cost.

Then in the summer of 1989 in the Austin chalk formation in south Texas a mini boom started taking place. Oryx and Exxon had been experimenting with horizontal drilling prior to that time. The play really skyrocketed when Oryx announced it's Heitz # 1 well in Zavala County, Texas tested at 3,262 BOPD and 2.2 MCFGPD and the EB Jones had flowed over 2,000 BOPD.

By December 1989 a full-fledged oil boom had overtaken south Texas ignited even further by the announcement of the Leta Glasscock # 10, a discovery made by independent oil man named C.C. Winn. He re-entered a well producing 185 BO per month, drilled out about 2,600 horizontally and Bingo! Winn brought in a well with an initial test of 5,492 BOPD.

These highly successful horizontal completions of various Austin Chalk wells by Oryx, C.C. Winn and other major players demonstrated that given the right combination of reservoirs and locations, horizontal drilling could yield very profitable, prolific wells.

In summary, improvements in horizontal drilling methods and equipment along with substantial cost reductions to drill over the last five years make horizontal drilling more attractive than ever. In the United Stated alone there are nearly 700 fields that would qualify as horizontal candidates. Few have been examined for horizontal drilling potential, thus leaving tremendous opportunity in the near future for new discoveries.

   How do I Assess a Potential Oil or Natural Gas Investment?

Assessing a potential oil or natural gas investment should begin with an assessment of the parties involved and with the property to be drilled. Integrity in the company's management and operations is essential to any decision. Thus, a close examination of the individuals managing the company is essential. Potential investors should ask questions about the company as well as the company's management, staff, and track record.

If investing as a partner with another nonoperating party, potential investors should determine what the nonoperator is adding in value. For example, does the nonoperating company turnkey the prospect thus relieving the investor from cost overruns? Does the nonoperating company furnish insurance in case of accidents or environmental spills? Does the company allow the investor to take part in major decisions concerning the investor's interests? If the answer to any of these questions is no, the investor should determine just what is being added.

When starting to assess a property, most investors will begin with a geological report or summary detailing the reasons for the proposed drill. Most certainly, the company will provide the investor with the report or summary upon the investor's request. Hopefully, the report will be written in a manner that is easy to understand. If not, the investor may need to seek the counsel of a trained geologist or petroleum engineer.

Generally speaking, the best way to evaluate an oil or natural gas prospect is by analyzing the success or failure of other wells drilled within the prospect's immediate area. This analysis might focus upon each well's history including when it was drilled, to what depth it was drilled, from what depth it is producing, and how much the well produced. Additional analysis may focus upon the characteristics of the producing formation and the likelihood of that formation extending to the proposed drill site.

These factors should be determined as soon as possible to "weed-out' prospects that show potential from prospects that don't. Once this initial level of analysis is complete, the investor should take steps to gather any other available information.

If available, other data such as geophysical information (i.e., seismic data), the possibility of water saturation, and the manner in which any saltwater would disposed should be considered. Although seismic data may not be available, information regarding the possibility of saltwater and the proposed steps to be taken to dispose of the saltwater should be considered before the well is drilled.

If anything, the above paragraph should indicate how complex such an analysis could be. Thus, the ability to assess the property should be another issue to consider when assessing the company proposing the well. Does the company have the personnel to conduct an adequate analysis? If not, does the company contract professional personnel to conduct the analysis? These questions should be answered before the investor decides to participate in any oil and gas investment.