Oil and gas investments, although risky, have the potential for big payoffs. Cash flow from a successful well can last more than a decade, and investors can write off nearly the entire investment. Lucrative returns and tax incentives have long attracted investors to oil and gas.
Returns can range anywhere from nothing at all (or even a loss) up though very attractive returns on investment.
“Based on today’s prices, and with the right project, it is not unreasonable to see anywhere from a 5 to 1 or 10 to 1 return on your investment, if not more,” Robert Jones of broker-dealer company Lone Star Securities said.
Oil and gas investments are generally at the riskier end of the spectrum, but investors can limit the degree of risk by careful research into the geology, structure of the deal and the company involved.
One of the most attractive benefits of oil and gas investing is “the ongoing cash stream,” according to Mitch Reifel, who accepted oil investments in lieu of payment during the time he spent working in the oil industry.
After 12 years, Reifel still receives monthly “oil checks” from those investments.
“Normally when a well starts to produce and gas or oil is sold, you should see monthly revenue checks within 60 to 90 days,” Jones said.
Oil and gas investors benefit from substantial tax breaks. The intangible drilling costs, which go toward labor and other unrecoverable costs, usually make up about 60 to 65 percent of the investment and can be written off in the first year, Jones said.
The remaining 35 to 40 percent would be written off over time, Jones said. “Sometimes you can do a straight-line depreciation over seven years, and sometimes it’s done over the life of the well.”
If the well is a dry hole, the entire investment can be written off, Jones said.
In some cases, tax incentives can reduce an investor’s tax bracket, Dr. Roger Cory, president of Mammoth Resource Partners, said. The write off can be “as much as 35 plus percent against their adjusted gross income,” he said. This offers a sizeable risk hedge, where the worst case scenario is a 65 percent loss of the initial investment (provided there are no additional capital calls and the investor is in the 35 percent tax bracket).
Tax incentives are available because the government wants to encourage energy independence, Cory said. “They want to encourage U.S. citizens to drill as much as we possibly can domestically...because every single drop of oil and every NCF [normal cubic foot] of gas that comes out of a pipe is one more bit of energy that we don’t have to purchase from what now are typically countries that hate us.”
Oil and gas investments are “actually hard to find since you can’t call up Merrill Lynch and have your broker pick some up. Typically they are sold through small and mid-size oil companies and small brokers, and have quite a bit of legal paperwork,” Reifel said.
Accredited investors are preferred by most oil and gas companies. “In our industry, we really like to deal with accredited investors for the most part,” Jones said. An accredited investor is “somebody that has a million dollar net worth or has made $200,000 or more in the past three years,” he said.
Mammoth only works with accredited investors because “these are individuals that have substantive income and sufficient sophistication with which to make a decision like this,” Cory said.
Regulations do allow a certain number of non-accredited investors to participate in projects, but “they must have a full understanding of the risk and show that they’re sophisticated, meaning they have experience or have enough education and experience to prove that they understand what they’re getting into,” Jones said.
“If you’re going to do it as a non-accredited investor, I wouldn’t really look at oil and gas unless I had a personal net worth of $750,000,” Jones said. At that level, “you might want to start thinking about getting into the oil and gas. But again, I wouldn’t put more than 10 or 15 percent of my net worth into it,” he said.
“Minimum investments in this area are typically tens of thousands of dollars,” Reifel said. The investments Mammoth offers are usually available in units of about $25,000, Cory said. Larger investors can buy multiple units, and very large investors can fund entire projects, he said.
“If you are serious about doing this, make it for only a small percentage of your portfolio, and invest only if you are willing to lose it all,” Reifel said.
Hitting a dry hole is an obvious risk in oil and gas investing. To avoid that risk, Reifel recommended buying into wells that are already producing. “In this case, the biggest risk is the depletion curve (i.e., when the oil will run out), and if there are any ongoing costs to keep the oil going.”
This strategy is safer because the investor is “investing in a cash stream, and your risk is limited to oil prices, depletion curves and the cost to operate the well,” Reifel said.
However, even producing wells can be financially risky. “I had one working interest in a producing well that had more cash-calls than oil payouts, and they finally plugged the well. I lost quite a bit of money on that investment, and it was a well that was already in production,” Reifel said.
Risk levels vary depending on the geology of the area. Projects in proven areas are at lower risk than “wildcat” exploratory wells, Cory said.
In order to mitigate some of the risks, Jones recommended diversification. “If you’re going to invest in a one-well project, just invest a portion of your money where you can spread it out...within multiple projects. Because the theory is, if one well does not work, the other two wells that you invest in should overcome the dry hole.”
Some companies may accidentally damage or destroy the structure of the well in their eagerness to enhance returns, Cory said. Stimulation methods can greatly enhance the amount of oil or gas recovered, but overstimulation can destroy a well, he said.
Opportunities for companies to take advantage of investors abound, and a big risk for investors lies in “making sure that the company you’re dealing with is a legitimate company,” Jones said.
“There are companies out there that can talk a wonderful game” but are not properly licensed with the NASD or SEC, Cory said.
Scams can take many forms. For example, Cory said, a company may lie to investors and say the well hit, then request more funding to cover costs. During that period, the company may even send a check or two as evidence that the well hit.
That money may very well be taken from the investor’s original investment and sent in order to increase the investor’s confidence such that they will agree to pay a later fee.
“The world is replete with stories of drilling companies drilling multiple drills in an area and hitting one big well, and then stating that that well was their own well, but this dry hole over here is the one that we drilled for you. There was absolutely no indicator ahead of time of which one was going to be theirs,” Cory said.
“You want to watch out for anybody touting, overselling a project, making it sound too good to be true. If you ever hear somebody call, tell you about an oil deal, and they’re saying that they’ve already hit the well, they’ve drilled the well, they just need you to pay some money to complete the well and then you’ll get an interest, that’s I would say almost every time a scam,” Jones said.
In order to find legitimate companies, investors can look for broker-dealers that are registered with the NASD or SEC and can research the company’s track record.
“The first thing I would do is make sure you’re dealing with a registered broker-dealer as a selling agent,” Jones said. “Go with a registered firm.”
“The registered firms have a complete disclosure requirement that we have to follow. They are going to be audited by the Securities Exchange Commission, they’re going to be audited by the National Association of Securities Dealers and the state securities boards,” he said. Investors can check up on specific broker-dealers on the NASD or SEC websites.
Reifel recommended dealing “with people you know or have a long track record in the business.”
Every potential oil and gas investor should analyze the prospective opportunity, the company and the individual representing the product, Cory said. “You should know why you’re investing with us and why you’re investing in gas and why you’re investing in this particular project.”
Each of the parties involved should be easy to research and investigate, Cory said. “If you cannot find that ease of information, then that is a really good signal to hold back until you’ve been able to.”
“One big part of advice that I would have for any investor out there to keep from being involved in a scam would be to demand full disclosure. Ask for everything in writing,” Daniel Northcutt, chief operations officer for Mammoth, said.
Registered broker-dealers are required to send out a private placement memorandum, or PPM, which includes the details on the project and deal. The broker-dealer is responsible for completing due diligence on the projects.
As a broker-dealer, Lone Star Securities “looks at projects from issuers. And we do the due diligence on the projects to see that they own what they say they own. That you do own the leases and have authority to sell those projects and that the geology makes sense. And then we put those together as a selling agent and sell those to investors,” Jones said.
“We look at the projects, make sure...they have all their operations in order...and typically just make sure the deal is put together properly,” he said.
Potential investors “need to know how to read a private placement memorandum, and they need to know how to break down the numbers” in order to determine how much oil or gas must be produced to break even, Jones said.
History and future of oil and gas
“Oil is a very, very exciting area...it could be considered a very sexy area of the energy business,” Cory said.
Oil is more valuable than natural gas and less expensive to access. “Gas is much more expensive...typically, you’re drilling much deeper,” Cory said. The fact that oil wells also contain natural gas is another bonus for oil investors.
However, U.S. oil production has declined every year since 1971 due to a dwindling supply, Cory said. “So while oil is very exciting and sexy and people understand that, natural gas is the up and coming energy now.”
Oil companies and the U.S. government are aware that their mission is to “take energy out of the ground, and this is a depleting commodity that the government has viewed can no longer practically speaking be replaced,” Cory said.
Therefore, the more successful an energy company is, the less success it will have in the future, he said. Many mergers recently have occurred as a “direct result to the oil companies’ knowledge that they just don’t have the fields anymore,” he said.
The industry is estimated at $33 trillion, Cory said. “So we’re stuck with the energy business for a long time....If you sink the energy business, the gas and oil industry on the planet, you have sunk the globe....There is nothing to replace $33 trillion. That is by far the largest industry ever known in the history of man.”
PROS AND CONS OF OIL AND GAS INVESTMENTS
- Potential Returns Projected returns of five to 10 times the initial investment are common. Although risky, oil and gas can be highly profitable.
- Tax Deductions Up to 65 percent of costs can be written off in the first year. For high earning investors, this can provide significant current tax savings and partial investment protection in the ability to write off losses.
- Rapid Results Checks can begin within 60 to 90 days of a well hitting, a rapid pace for an investment offering such high projected returns.
- Drilling a Dry Hole In oil drilling, as in real estate, it’s all about location, location, location. If the hole comes up dry, the investor will lose their entire investment (but can write off 100 percent of costs).
- Price Volatility The profitability of oil and gas projects depend on the market prices of oil and gas. Volatile price swings are common and can dramatically impact the profitability of a project.
- Scams or Bad Company Management Scams and schemes to take advantage of investors abound, so investors must ensure they fully understand any contracts or agreements. Success relies greatly on the management of the company, so in depth due diligence on the companies involved is a must.
Thanks to Robert Jones of Lone Star Securities for his input on benefits and risks.