Investing in alternatives has the potential to offer portfolio diversification, tax-advantages, improvement of risk and return profile, and potentially sustained income. Private oil and gas alternative investments are one asset class that accredited investors invest in that can – depending on the structure and the outcome – offer some or all of the above advantages. There are important characteristics for investors to look for when analyzing alternative investments in the energy industry.
The U.S is now the largest producer of oil in the world. In 2018, the U.S. accounted for an 18% share of the world’s total production of oil. The boom in production has led domestic sponsors to increase the number of private oil and gas offerings. Sponsors have created opportunities for experienced investors to gain access to the oil and gas industry through a multitude of deal structures.
Experienced investors look for turnkey arrangements when measuring oil and gas investment structures. In private markets, oil and gas investments may be structured as direct investments in working interests, direct investments in royalties, or drilling partnerships.
Direct Investment in Working Interests
Also known as “operational interests”, direct investments in working interest typically are investments into oil and gas drilling operations. Investors can buy percentage ownership of the drilling operation, thus granting them a form of a lease with the ability to participate in the drilling operations. Investors are liable for any on-going costs associated with exploration, drilling, and production. Similarly, investors can fully participate in the profits from a successful well.
The income generated from “working interests” is eligible for certain tax deductions as this income is treated as self-employment income. Working interests are not passive unless they are owned under an entity that limits liability. These investments are illiquid and have high exploration risks.
Direct Investment in Royalties
Royalty investors are entitled to a portion of the resource – oil or gas – or revenues produced from the sale of the oil or gas. Investors can purchase royalties from private landowners. Typically, private landowners are smaller firms that own the oil field and hold developable resources. They may lack adequate financing to turn the resources into the production phase.
A company or an individual that owns royalty interest is not forced to pay the operational costs needed to produce the resources, unlike owners of a “working interest”. Royalty investors face limited liability as they only bare the cost of their initial investment. These are illiquid investments that are not exposed to exploration risk since the exploration costs do not fall on investors.
Experienced investors also may invest in drilling partnerships. These entities are typically structured similar to a limited partnership. Investors can attain passive income since they do not participate in the operations of the well.
Drilling partnership investors can qualify for first-year federal income tax deductions ranging from 85% to 100% of their initial investment. This tax deduction is associated with intangible drilling costs, which are expenses that carry no salvageable value and are necessary for the drilling and preparing of oil and gas wells, such as labor and fuel. Investors may face the functional allocation of tangible and intangible drilling costs based upon each drilling program. These investments are typically illiquid and pose high exploration risks.
When investors are measuring oil and gas alternative investments, it is important to analyze the Authority for Expenditure (AFE) document. This budgetary document is prepared by the operator of the well and specifies expenses associated with the drilling of the well.
Furthermore, it may be important for most investors to search for turnkey financial arrangements with drilling contractors or sponsors. A Turnkey arrangement is when the drilling contractors assume full responsibility for the wellbore to some predetermined milestone. The operator of the well will owe nothing to the drilling contractor until the milestone is reached. The contractor bears a great amount of risk and eliminates the liability for cost overruns on the investor.
As with any alternative investment, investing in oil and gas can come with substantial risks. These risks include–but are not limited to–illiquidity, commodity price volatility risk, elimination of dividend payments, or the potential of an oil spill.
Although private placements carry substantial risks, the potential upside returns for investors participating in the oil and gas are often commensurate with the added risk. These high-risk production and exploration-based investments can be suitable for accredited investors that seek investments with higher earning potential.
Oil and gas investments can also serve as tax-advantaged investment vehicles, with high ROI potential, long-term passive income generation, and portfolio diversification benefits.
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