Oil and Gas Investing: How to Profit from High Oil Prices

“Fill’er up.” Those three words hurt a lot more than they used to. Gas prices are near their highest levels ever, and real gas prices – those adjusted for inflation – have reached levels not seen since the Iranian Hostage Crisis, back in 1979. And with conflict looming between the United States and Iran, gas prices could go a lot higher.

High gas prices can spill over into the rest of the economy. Companies with large truck fleets, for example, can feel the pinch at the pump, and respond with layoffs, workers respond to greater insecurity by spending less – manufacturers, already stung by higher energy costs at the factory, cut back on production as demand suffers, laying off more workers, and the cycle begins anew. Indeed, oil shocks have contributed to several recessions over the years, including 1991, 1981-1982, and the deep recession of 1974-1975, which came on the heels of an OPEC boycott.

So what’s an investor to do?

One way to protect your portfolio, and hedge yourself against higher oil prices, is to invest in the oil and gas itself. Or more precisely, an investor may take a position in companies that engage in prospecting, drilling, and extracting of oil or natural gas, or in the real estate speculators believe may contain it.

Oil and gas investments come in four basic varieties:

âÂ?¢ Exploratory drilling – the speculative search for oil and gas reserves in wholly unproven areas.

âÂ?¢ Development – companies which seek to expand available reserves by exploring near previously successful oil wells.

âÂ?¢ Income – companies which invest in extracting known reserves of oil or gas in areas which have already been successfully drilled.

âÂ?¢ Diviersified – companies which engage in all of the above activities.

What to watch out for

If you do choose to get involved in oil and gas investments, be prepared for a wild ride. If you invest in exploratory drilling especially, you can lose every dime you invest. You can lose even more if you employ leverage, or borrow money, in order to make the investment. Only one out of every ten speculative, or “wildcat” wells, is successful. But one successful well can pay for itself dozens of times over. Which explains why the Beverly Hillbillies could afford that nice mansion!

You can decrease your risk substantially, of course, by investing in proven wells, which can generate a reasonable income off of your initial investment. This is risky, too, since wells can dry out sooner than expected, or the price of oil could decrease, taking your income level with it.

Note: If you have a diversified portfolio of investments, this needn’t be the end of the world – if oil prices drop, the fortunes of many other companies are likely to improve, along with their stock prices – a testament to the beauty of diversification!

You’ve also got to look out for shills and shysters. Oil and Gas investments have attracted legions of fraudulent salespeople seeking to bilk people out of their money. Often they employ “boiler room” tactics, employing telephone cold-calling and high-pressure sales tactics, preying on inexperienced, naÃ?¯ve, or greedy investors.

How can you spot crooks?

Be alert for these ready telltale signs of unscrupulous brokers:

âÂ?¢ If someone tells you “this investment can’t miss,” he’s lying. All of them can miss.

âÂ?¢ If he tells you this investment is only available to “a few lucky, specially selected investors,” it’s only because he’s specially selected you as a sucker.

âÂ?¢ If he tells you that gas or oil prices are “guaranteed” to reach a certain level by a certain date, we can guarantee you he’s a fool or a liar. Neither deserves your money.

� If he pushes you to buy over the phone, put the phone back on the receiver. Never buy without doing your own research and due diligence first. Read the prospectus. Genuine businessmen welcome that scrutiny, and can wait for your money.

Advantages of oil and gas investing

Besides the potential for strong profits (along with the attendant risks of speculative investments), oil and gas investing carry a number of important tax advantages – and for this reason are popular with people in high tax brackets searching for deductions and shelters.

Among these deductions:

âÂ?¢ Depletion of reserves. Investors are generally entitled to take a tax deduction to account for the depletion of underground oil or gas reserves. There are two methods of depletion – percentage depletionÃ?¬, and cost depletion. Your tax professional can help you decide which method is best for your situation. Either method can potentially result in deductions of up to 100% of the income from the investment – which can potentially result in tax-free income (subject, of course, to alternative minimum tax rules).

âÂ?¢ Intangible Drilling Costs (IDCs). Many of the capital outlays associated with drilling have little or no salvage value. Because of this, they depreciate almost immediately. Developers are generally permitted to deduct 100% of intangible drilling costs in the year in which they are incurred, rather than depreciate them over a period of years, as they would with most industrial outlays under the MACRS (modified accelerated cost recovery system) rules. (Note: This deduction is often attacked by some members of congress, who argue that IDC deductions are a sham designed to generate a “paper loss.” Investors must weigh the risk of a change in tax rules concerning IDCs, should the political situation change.

� Favorable tax treatment. Sales of oil and gas interests held longer than one year are generally treated as capital gains, and receive favorable tax treatment.

âÂ?¢ Current deductibility of losses. Losses are currently deductible, but subject to “passive activity” limitations. Specifically, losses must be matched against gains from other passive activities. Only $3,000 of losses can be applied against an investor’s ordinary income. But unused losses can be carried forward indefinitely – an important tax advantage, especially when it comes time to sell the investment, or when the investment eventually becomes profitable. Unused losses can be applied against profits from passive activities in future years, creating a tax deduction.

Important note: Almost all oil and gas investments are “passive activities” for investors, unless the investor is actively involved in the management of the project. The IRS limits deductions available from passive activities. It is critical to consult a qualified tax advisor to discuss at-risk and passive-loss rules before investing in oil and gas projects.

What costs will I pay?

Generally, you can expect to pay sales commissions, fees to your broker, management fees (designed to defray the ongoing expenses of managing the development project day-to-day), and in some circumstances a “guarantee fee,” for which the general partner in charge of the project may commit to providing a certain agreed upon minimum cash flow. You’ll also pay loan origination fees and points on any money borrowed. Fees can range from 13% to 20% of the amount invested.

You may also be expected to put up additional capital as needed to extract resources from the ground, over time. This is normal and expected for many investments. But you should be prepared for it going in, and have other money available if needed, or required by the terms of the limited partnership.

How do I choose them?

There’s no substitute for doing your own research. Look for experienced developers with long track records of success, ideally, a decade or longer, and a history of delivering the fruits of those successes to investors.

Find out the developer’s “success ratio.” What’s the historic percentage of successful drills for that developer? Remember to compare that success ratio against other projects in the same area. Well-explored areas will have higher rates of success than new areas.

Look for an alignment of interest. Developers should make money the same way investors do: Finding oil and gas. Avoid contracts which guarantee the general partner money just for drilling.

Don’t go it alone.

Generally, you’ll get involved in an oil or gas investment as a limited partner. The general partner runs the business – the limited partner supplies the capital. The good news is that your potential liability as a limited partner is limited to the amount you invest. The bad news, is that you will be subject to some complicated income tax rules concerning partnerships, passive activity limitations, at risk rules, and a host of other complex tax and planning issues. It’s important to go in with good team of advisors.

Let your financial advisor work the numbers for you, paying particular attention to return on investment. Let your CPA look at the tax consequences of the transaction. And let your attorney look over the terms of the partnership agreement before you sign or send money.

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