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Investing in Oil and Gas | View information about Investing in Oil and Gas within our Market Watch section by reviewing this area of our website. We provide a wealth of information online to help our visitors become better informed about Portfolio Buzz. |
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Investing in Oil and Gas
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Many investors don’t realize it, but there are ways of making money in the oil industry other than purchasing round lots of Texaco stock. The oil business is one of the last remaining true tax shelters in the United States, and the benefits to be derived from prudent investments are more attractive than ever.
For the investor with a tax problem, buying directly into drilling programs or individual prospects offers certain advantages that may be just what the proverbial doctor ordered. For example, intangible drilling costs are legitimate deductions, and they can even be prepaid (and written off) in the current tax year even though drilling operations may not commence until the following year.
In the event of a dry hole, all drilling costs can be expensed immediately. Should the drill bit find oil or gas, a minimum of 15 percent of the income from the well is free of income taxes forever. If the well is a poor one, a so-called "stripper," the portion of tax-free income jumps to 19 percent. (Most wells—oil and gas alike—become strippers at some point in their lives.)
But be forewarned that there are pitfalls as well as advantages to direct investing in oil and gas deals. Dry holes are an inevitable part of the game, and unscrupulous promoters are out there waiting to prey on the greedy and gullible alike. After oil and gas prices crashed in 2008, a lot of drilling deals went sour, and the petroleum exploration business got a bad reputation with the investment community that it did not necessarily deserve.
Much of the money that was lost then was invested unwisely for one reason or another, and a lot of the red ink could have been avoided by investors doing a little advance research into this risky and fascinating business. Let’s take a brief look at how the oil and gas game is played and see if it might be a suitable vehicle for you.
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Know Your Partners
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It's as trite as it is true, but the first rule of oil and gas investing - like so many other areas of financial endeavor - is: Find out a little bit about your proposed business partners before you invest large sums of money with them. Legitimate exploration companies, however small they may be, all have some kind of a track record. If the drilling deals that they are selling are registered with the Securities and Exchange Commission, that record will be spelled out in their prospectus.
If their deal is not registered (as is the case in the large majority of instances), then you will have to ask around about them. Fortunately, in any given petroleum province in America, the oil business is a fairly small and close-knit community, and you generally won’t have to ask around very long in order to find someone who knows something about the company or individuals that you’re interested in.
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Behind the Scenes of Oil and Gas Investments
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The company that causes a particular well to be drilled in search of oil and gas and who maintains the property after production has been established is called the operator.
It is usually—but not necessarily always—the operator from whom you will purchase your interest in the proffered deal. Hear are a few tips of advice regarding what you should know about how things work behind the scenes at the operator’s office.
The first step in any oil and gas deal is the generation of a prospect; this is almost always the job of a geologist. That geologist may be a full-time employee of the operator, in which case he will probably be paid a straight salary and have no direct financial interest in his own prospects. But on the other hand, he may be an independent geologist who sells the intellectual fruits of his labors for a prospect fee (usually $5,000 to $10,000) and then gets an overriding royalty interest (ORRI) from any production that ensues.
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The Lease
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The “bonus” money, which the operator’s landman pays to the mineral owner at the time the lease is signed, may be as low as ten dollars an acre in areas where oil and gas production is highly speculative, or it may be as high as a couple of thousand dollars an acre in an area where lush production is highly probable.
In most parts of the United States, the average bonus is currently between 25 and 250 dollars an acre. A typical prospect will involve somewhere between 80 and 800 acres; 400 acres is a rough average, although, obviously, this figure can vary greatly.
Additionally, the mineral owner(s) will be paid a percentage royalty for any production that is obtained. Thirty years ago, the standard royalty in most parts of the US was one-eighth (12.5 percent), but most mineral owners have come to expect three-sixteenths (18.75 percent), and in some really hot areas they are demanding a full quarter.
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The Investment Decision
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No one can predict with 100 percent accuracy whether any given oil and gas prospect will encounter commercial quantities of hydrocarbons. But a savvy investor can greatly improve his economic odds by using a little common sense and professional advice when trying to select a potentially profitable prospect. Here are some easy-to-remember suggestions:
• Beware of overly simple deals in which you are approached by a broker or landman brandishing a small lease map with nothing more than a yellow outline on it. A legitimate prospect will almost always be presented by one or more industry professionals who have taken the time to prepare a comprehensive (and comprehensible) brochure that contains maps, several pages of text describing the geology of the immediate area, nearby (and presumably analogous) production data, cross sections, etc. The brochure should also contain a copy of the proposed terms of the deal. (If you end up taking a piece of the deal, the brochure is yours to keep; if not, industry etiquette requires you to return it.)
• A slick brochure is no guarantee that the prospect has any geological merit. Your best bet is to hire a consulting geologist for half a day to take a look at the information the operator has furnished you and render an opinion. For a small fee, you may save yourself many thousands of dollars. If the prospect is predicated almost entirely on seismic data (which is unusual for small oil companies, but it happens), you may want to additionally hire a geophysicist to review the raw data, especially if you are contemplating taking a relatively large part of the deal.
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Calculating the Promote
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In years gone by, the standard carried interest was the famous “third-for-a-quarter” deal in which the investor paid a third of the working interest costs in exchange for a quarter of the working interest revenues.
The operator was carried for the resulting 8.33 percent interest (33.33% – 25%). If the operator succeeded in selling all three thirds of his deal, he ended up being carried for a quarter of the entire well (8.33% x 3). But since the oil and gas business has fallen upon hard times, third-for-a-quarter deals have largely disappeared, and knowledgeable investors can usually expect to pay a less rigorous promote.
“Carried for an eighth” is more the norm nowadays. Please note that this is not exactly the same promote as “cost plus an eighth.” Most of the common promotes can stated in two or three different ways, and the investor should not be confused by the terminology.
Below are some easy algebraic expressions that will allow you to quantify the severity of a promote factor (P) based upon how it is represented to you by the operator. Bear in mind that a promote factor of P = 1.0 means no promote at all.
| If the Operator says the deal is: | Calculate the promote factor (P) using: | | Pay a/b for c/d | P = ad/bc | | Cost + x% | P = 1 + x/100 | | Carried (“Back in”) for x/y | P = 1 + x/(y – x) | | Carried (“Back in”) for x% | P = 1 + 1/([100/x] – 1) |
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The Casing Point Decision
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Sometime prior to the date that the proposed well actually “spuds” (i.e., commences drilling), the investor will execute a contract that spells out in some detail what the obligations of the operator and all the working interest partners are between and amongst themselves. The investor will also be required to put up all or most of his proportionate share of the estimated expense of drilling the first well to its proposed total depth. When everyone’s money is safely in the operator’s bank (preferably in an escrow account), the real fun begins.
As soon as the well is spudded, the investor will be entitled to receive daily drilling reports to keep him abreast of the well’s progress. Ordinarily, all working interest partners are responsible for their proportionate part of the drilling costs, regardless of what the operator’s initial cost estimate was or how much money they have prepaid. If the well goes over budget, the investors may be called upon to contribute additional funds to keep the drilling rig going. A partner who fails to respond in a timely manner may forfeit all or part of his interest in the well.
Most drilling deals are structured so that the operator must decide whether or not to assume his carried interest at the casing point. This is the moment of truth in the drilling operation when the working interest partners must determine if the information gleaned from the logs and drill cuttings justifies the additional expense of cementing an expensive string of casing in the hole and attempting to coax oil or gas out of the rocks and up to the surface. That process is called the completion attempt, and since it commonly represents almost half of the total expense of the well, it is not a decision to be taken lightly. Sometimes the casing point decision is an easy one, and the operator will not hesitate to run pipe in the hole (or, in the case of a dry hole, plug it). Other times, the completion attempt is not a sure thing, and setting pipe may prove to be an exercise in throwing good money after bad.
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The Check is In The Mail
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If the initial test well on the prospect is a dry hole, most investors will have no enthusiasm for financing a second well on that property. The acreage block will be allowed to expire unless the operator can find some other oil company that wants to purchase it (in which case the investors will get a part of the proceeds and a few pennies back on their dollars).
But if pipe is set on the first well, the investors will continue to receive daily reports from the operator documenting the progress of the completion attempt. Not all completion attempts are successful, and the well may still turn out to be a dry hole. And even if the well is a good one, the investors should not expect to see a check immediately. In the event that the hole is completed as a gas well (or an oil well with substantial amounts of associated “casinghead” gas) there will be delay—at least for several weeks and sometimes for months—before the well can be hooked up to a gas pipeline.
When the well finally goes on production, the operator will hire a lawyer to draw up a legal document, called a “division order,” which specifies exactly what fraction of the income from the well will go to which royalty and working interest owners. This process commonly consumes another few weeks. But the checks will eventually start to arrive, and the first one is usually a big one.
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A Few Miscellaneous Tips
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In no particular order, here are a few random pearls of wisdom pertaining to oil and gas investing in general:
• Beware of promoters who want to sell you “shares” or “units” instead of a conventional fraction or percent. Shares and units are usually sold for a flat fee (at least until casing point, at which time you’ll be called upon to pony up some more), and the fees that they charge are far in excess of what a reputable operator would spend to drill the well. It’s not uncommon for these shares-and-units guys to collect two or three million dollars to drill a one-million-dollar dry hole.
• Serious oil and gas operators never go out and try to drill a good well; they try to drill a good well that has the potential for several more equally good (or better) offset wells all around it. The serious investor should have a written understanding with the operator that if the test well is successful, there will be enough additional acreage included in the deal for the drilling of at least two or three (or more) adjacent wells.
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