WV Executive

The opportunity to invest in American petroleum has been around since the first oil well was drilled in 1859 in Pennsylvania. Today, investment opportunities exist in various forms, with one type structured to offer the alluring tax advantages which this discussion will review. Petroleum investments can hold their productive assets in a variety of locations nationwide and even multi-nationally, but they all have one overriding goal in common: the pursuit of cash distributions to investors from the sale of the resource being produced.

 Many West Virginians already have some knowledge of the petroleum industry because the state has long been producing natural gas and was also a big oil producer at one time. In fact, the Appalachian Basin, a seven-state region of which West Virginia is part, is famous in geological circles for its oil and gas reserves. The basin’s oil deposits were shallow and fairly easy to find, so nearly all of the oil was taken before 1920. Oil production at Sistersville, Mannington and scores of other West Virginia boom towns of the past was amazing news at the time. Today, the small amounts of oil produced in the basin are typically a by-product of the operation of gas wells.

Natural gas was oil’s less appreciated counterpart and initially on the fringe of the basin’s early petroleum development. It was not long until the usefulness of natural gas was apparent and it became an equal object of the driller’s affection. There was plenty of it in West Virginia, as well. The state was the nation’s number one producer of natural gas from 1910 until 1925.

Contemporary drilling for natural gas in the Appalachian Basin and the other areas of proven production in America is usually called “developmental” or “in-fill.” The process is similar to filling the blank squares of a crossword puzzle. Developmental drilling makes the risk of “dry holes” slight, but occasionally such a result will occur.

Production from gas wells everywhere can last for many years. Wells drilled into deeper underground formations known as “tight sands,” for example, might be profitably produced for 30 years or more. In addition to the Appalachian Basin, Colorado has become a gas investment hot-spot lately while off-shore and deep-well Texas and Oklahoma drilling continues to be attractive to many investors.

Investing in Gas and Oil

Simply owning the stocks of any of the publicly traded companies that are involved with natural gas and oil is the most common way to invest in this business. However, another lesser-known way to participate is preferred by many professionals in wealth management. This method involves the “direct investment” into a pool of to-be-drilled wells which are usually clustered in some narrowly defined part of the United States. Such investments are typically structured to allow the costs associated with drilling the wells to flow through to the investor’s tax return.

Many advisors regard investing in oil and gas company stocks as rightly belonging in the equities category of the portfolio. Advocates of direct investment contend that it is a purer natural gas or oil investment, thus preferred for better portfolio diversification and even more for the tax planning advantages it affords.

The big tax surprise for those unfamiliar with direct investment in this asset is that direct investors typically gain a federal tax deduction of all or nearly all of the invested principal in the tax year the investment occurs. Not only may this deduction be used to reduce “Ordinary Taxable Income,” it may even be of benefit to reduce “Alternative Minimum Taxable Income,” too. Those who have dealt with this increasingly pesky tax know that deductions useable against AMT are a pleasure rarely afforded by the tax code. In contrast, the only way a common stock or mutual fund investor gets to write-off the investment is if it bombs and its shares are sold at a loss—not a happy prospect.

Because most of a direct investor’s tax benefits come at the outset of the investment, the tax savings result in a relatively quick and significant, indirect return from the investment. Consider an example of a direct investment of $10,000 with a 100 percent write-off of the investment and a federal tax bracket of 35 percent. If the investor has the ability to use the full write-off in this example, either estimated tax payments could be reduced by $3,500 or a refund of $3,500 could be expected if the taxes had been withheld earlier. In either case, this is money that could be reinvested quickly.

Financial analysts love to see a large, early return as part of an investment’s cash flow chart because it can charge the investment’s Internal Rate of Return. Internal Rate of Return (IRR) is the useful, analytical calculation that considers the time-value of money and the compounding of an investment’s various annual in-and-out cash flows, regardless of their source. To analysts and planners, it is a vital component in the study of any investment that, unlike a mutual fund or a CD, cannot provide a means for reinvestment into itself.

The quick tax deduction of up to all of the money placed into direct oil and gas investments is created through the tax code’s immediate recognition of a write-off of something called “intangible drilling costs.” Gas and oil professionals like to call these IDCs, for short.

Costs falling into the IDC category make up nearly all of the expense of creating the typical well. Drilling expenses, such as site preparation, rig costs and the expensive, high-pressure fracturing of rock formations, are among the items contributing to IDCs. There are usually more IDCs when taken as a percentage of the total investment in a shallower gas well, such as those in the Appalachian Basin, than will arise from the deeper wells drilled offshore or in Texas and Oklahoma. For the shallower gas wells, the initial write-offs typically amount to approximately 90 percent but may run up to 100 percent of the invested principal, depending on the investment’s structure.

Gas Well Investing

If approximately 90 percent or more of the cost of drilling a gas well is intangible and immediately deductible, then the good question that follows is: What happens to the remaining amount invested? Typically, most of those dollars are spent on the well’s tangible components, although some of the money may be involved in creating the investment itself. Equipment such as well casings, tanks, pump-jacks and other items that remain with the well after its completion are considered depreciable. Thus, these costs can be deducted, too. The difference with tangible expenses is that their deduction is taken over a seven-year period, not all at once.

Because wells eventually “play-out” (gas well jargon, meaning they give up all of their recoverable resources), the tax code provides for their gradual depletion. This tax allowance was created to recognize that some of the invested principal is returned with every cash distribution from the sale of a well’s product because there is a finite amount of that product. Because no one can say how long a well may produce, the tax law’s creators arbitrarily decided to presume that 15 to 25 percent of each dollar an investor receives from a direct gas well investment should not be federally taxed at all. The actual amount depends on a formula set forth in the tax code that starts with the prior year’s price of gas and moves from there to conclude with what the law calls a “percentage depletion allowance.” Although it could be higher, generally, it is 15 percent and applies to the gross revenue of the well or wells in an investment pool. In an example that assumes an investor received $1,000 in investment income in a year from a gross sales revenue of $1,300, after a 15 percent percentage depletion allowance factored in, $195 of the income is exempted from federal taxes, and $805 is taxable.

Why is the federal government so generous? It is simply because we are in serious need of homegrown energy. Production of natural gas in America falls far short of the domestic demand. That is a long-time, disturbing issue for American lawmakers. In fact, back in 1986, when Congress was overhauling the tax code, nearly every well-loved tax shelter was cut off at the knees. But the tax advantages of investing in natural gas and oil drilling pools were left largely undisturbed.

Governmental concern about capital sources for gas and oil investing is as real today as it was then. The thinking goes: If enough benefit is derived by the investing public, that public will provide the capital required to bring on new production. Not wanting to take any chances with precious gas and oil production, lawmakers saw to it that tax savings would remain an important part of the total return equation for such investments.

Look Before Leaping

While a natural gas direct investment’s income from tax savings can enhance the return, for the investment to overachieve it must produce noteworthy, ongoing income to add to its cash flow from tax savings. Thus, the analysis of competing investment opportunities in this category requires care. Finding companies willing to accept investors into drilling pools is not difficult. Figuring out the right entities to invest with is another matter altogether.

In order to increase the probability of long-term, respectable cash flow from the sale of produced gas, one needs to look for the opportunity to participate with drilling and production companies capable of skillfully creating the wells and then properly operating them and marketing their product efficiently over a long period. Those companies must also have the ability to access pipelines without restriction so that the production can be smoothly moved to the consumer.

In analyzing one’s options, a close look at the background of the principals involved and the company itself is a must. Not only should there be an authentic, laudable, long-term track record for the company, the same should exist for the individuals who provide its current leadership. Audited financials should show the company in acceptable fiscal shape, and the business structure and relationships involved should be as free from conflicts of interest as possible.

Companies that are raising capital through the securities community, which is typical, are required by strict law to prepare a prospectus or an offering memorandum that explains all aspects of the investment. The investment may be publicly registered or a private placement. While federal and state securities regulators offer no opinion on the quality of any investment, securities laws exist, in part, to demand that all relevant details and material facts, such as assorted risks, costs, prior performance history, managements’ background and so forth be disclosed. This is a significant advantage for potential investors and their advisors, because these laws are firm in mandating comprehensive disclosure. An advisor suggesting such an investment should be expected to provide this sort of disclosure and be experienced and authoritative in his personal knowledge of the subject.

As with nearly all investments, there is an assortment of risks unique to the specific asset category itself. In natural gas, these include market price fluctuations for the product as it is produced and sold; management’s possible conflicts of interest (If you participate, your pool’s wells would not be the only ones the sponsor operates.); dry holes; weak production and so forth. In properly prepared securities offering documents, the various risks will be reviewed in detail. Potential investors should read the risk sections carefully and get questions fully answered.

Direct investment is not for everyone. One reason is that there is no ongoing public market for this sort of investment, and there is no likelihood of such a market arising. If one needs to cash-out, there may not be a buyer in the wings. Accordingly, this type of investment is best suited to the investor who can foresee no need to sell the asset in the first place.

Another concern for some is that there is limited diversity in direct investing when compared to an investment in the common stocks of huge, publicly traded companies. Multinationals that drill and operate wells dwarf these direct investment pools and can spread their risks across a large number of wells, accordingly.

To attain more diversity, most professionals in wealth management who use the direct gas investments for their clients prefer annual, systematic investing. This is similar in principle to the popular “dollar-cost-averaging” method often used with mutual funds. The plan calls for an investment each year into a new program, gaining an appropriate amount of tax shelter for the then-current tax year while further extending the combined portfolio into more and more wells for added diversification.

In order to receive the tax blessings these investments offer, investors typically participate in a business structure that begins with the investors classified as general partners and then converts them to limited partners after the wells are drilled. The risks associated with being a general partner, even for a short period and along with many others, must therefore be considered. Fortunately, the code allows a company to fully indemnify investors, provide insurance without limit for the investors’ protection and pledge all of the company’s assets to protect investors further. Thus, managing around this risk brings us back to the need to be certain that one is considering only drilling and production companies with an acceptable financial strength and protection capability and only those that take the three steps pointed out above to protect their investors.

Although routinely utilized by many planners, investments of this type have had fairly limited visibility during the last dozen years. But with natural gas prices hitting very high levels this year, a greater awareness of drilling programs can be expected to occur. That increases the level of another risk factor—the overpricing of wells and other excessive mark-ups. In the industry this is known as “over-promoting.” In prior gas booms, price gouging of unsuspecting investors and unsophisticated advisors has been common, so caution is in order. Remember, if a well-pool investor significantly overpays, and gas prices drop sharply later, as they may, the recovery of the investment, let alone the attainment of an acceptable return, becomes more difficult to achieve.

So, in the end, who should consider these investments? Wealth planners knowledgeable in this asset category use the strategy in a variety of situations. Foremost of those is the systematic, annual investment by the routinely high-income wage earner. But, one-time taxable events, such as an exercise of stock options, the sale of a family business or a lump-sum pension distribution can result in large income tax liabilities that could be successfully addressed by this method while seeking to create a long-term stream of income.

A Case Study

For a look at how this works, consider the impact of a typical natural gas direct investment on the portfolio of Dr. William Collins, a former vice president of West Virginia University, and his wife Karen, also retired. The Collins have long been aware of the impact of taxation on their total investment returns over time. As part of their financial strategy during the last 20 years, a percentage of their asset allocation has been directed to tax advantaged investments. Those investments have included natural gas drilling, real estate direct investments and tax credit generating, low-income housing.

With an 11-year, tax-credit program ending in 2001, the Collins were advised by their accountant to seek additional tax shelter for 2002 and beyond. After some careful analysis, the right-sized solution settled on was an investment of $25,000 in a publicly registered investment fund created to drill and produce developmental wells in the Appalachian Basin. The investment gave the Collins a write-off of $22,500 in 2002. That deduction, in turn, provided a tax-refund of more than $7,000. By mid-2003, most of the program’s 47 wells were drilled and produced gas into the pipeline. The sale of the wells’ gas resulted in cash flow to the Collins of $4,310 last year. A portion of that cash flow was sheltered from taxation because of the depreciation of the tangible property involved and the depletion allowance.

Appalachian Basin wells typically produce for 20 to 30 years, so gas sales can be reasonably expected to generate some amount of cash flow in the foreseeable future. However, in any given year, the two big variables involved in gas sales cash flow make distributions from these investments impossible to predict. Those variables are the amount of gas produced and the price at which that gas is sold.

Because gas wells almost always begin with their highest production and gradually produce less gas as the years go by (the “decline curve”), the probable scenario is for a downward slide in income over time. Accordingly, while anticipating a good return, the Collins believe that they are more likely than not to receive varying, but generally declining, amounts of cash flow during the coming years.

The Beat Goes On

In producing electricity, fueling industry and heating structures, natural gas is highly effective and the cleanest burning of the various fuels available. Certainly no authority doubts that natural gas is going to be needed, produced and sold for some time to come. As always, some of it will be produced from the old fields of the Appalachian Basin and its West Virginia component.

For many investors, there are compelling reasons to consider direct investment opportunities in natural gas today in the Appalachian Basin and elsewhere, but the key for a number of wealth planners and their clientele is that industry experts and government observers alike believe that we may have entered a heightened and extended period of opportunity for this asset class because of a supply-and-demand imbalance. While no one can predict the future, widely available statistics report the increasing call for natural gas on one hand and its growing scarcity on the other. That sort of scale tipping often portends a blissful environment for investors.