By Dr. Jim Dahle, WCI Founder
Numerous “alternative” investments are available for investors to add to their portfolios. Their popularity tends to directly follow a recent run-up in prices. While my portfolio consists of relatively boring stocks, bonds, and real estate, lots of people like to add a little spice to their portfolios using asset classes such as cryptocurrency, art, precious metals, viaticals, timber, reinsurance, commodities, or venture capital. Some invest in oil and gas. None of these investments are mandatory for a portfolio, and you certainly don’t have to invest in everything to be successful.
Oil and gas investments are popular among the “tax break” crowd, especially when the price of a barrel of oil balloons. Like real estate investing, the industry benefits from government encouragement in the form of “unfair” tax breaks that politicians are often trying to end, particularly politicians who favor renewable energy. Also like real estate, there is a wide range of ways to invest in oil and gas.
How to Invest in Oil and Gas
There are numerous ways to invest in oil and gas. Let’s go through each of them.
Future contracts are a useful way to hedge your business against an increase in the cost of oil and its products. These derivatives are most famously used by Southwest Airlines. However, they are also a convenient way to bet on price movements of commodities. Oil futures contracts trade on the New York Mercantile Exchange in quantities of 1,000 barrels of oil. Like any derivative, these can be extremely volatile, and you can lose more than you invested. They are also not tax-efficient at all.
Publicly Traded Stocks
There are plenty of publicly traded companies out there that produce, refine, and distribute oil and gas. Exxon, Chevron, Shell, BP, ConocoPhillips, and Schlumberger are well-known examples. Like any stock, a buy-and-hold approach can be very tax-efficient, although as value stocks, the dividend yields tend to be high. The bigger problem with individual stock investing is that you are taking on uncompensated risk. In investing theory, you should not be compensated for taking on risk that can be diversified away.
Mutual Funds and ETFs
You can avoid uncompensated risk by buying all of the oil and gas stocks via an index mutual fund or ETF. While there is an additional cost to doing this, it is likely worth paying. Even Vanguard has an energy ETF (VDE) with an expense ratio of 0.1%, a dividend yield in September 2023 of about 3%, 112 different stocks, and a 10-year performance of 3.77% per year. (Now you know why hardly anybody has been talking about oil and gas investments for a while.)
There are also ETFs out there that just invest in futures contracts, so it is important that you look under the hood and know exactly what you are buying. Perhaps the most famous is USO, which will manage a portfolio of oil futures contracts for you for 0.6% per year. USO is a very different investment from VDE. It’s much more of a bet on short-term oil prices and probably not a great long-term holding. Fifteen-year returns are -14.71% per year. That means if you had bought it 15 years ago and held it until now, you would have lost more than 90% of your investment.
Mineral Rights (Royalties)
Another method of investing in oil and gas is to own the rights to exploit minerals and to license those rights to others. Despite not being in a solid state, oil and gas are considered minerals. You can invest in mineral rights by simply purchasing land that contains oil and gas. However, be aware that surface rights and mineral rights are not always connected. It’s possible to own the mineral rights without owning the right to use the surface and vice versa. Royalties tend to be relatively low risk and provide quite passive income. That income can be highly variable, however.
Royalties are reported on Schedule E of your tax return, the same form used for many real estate investments. Royalties are taxed as ordinary income, although they are not subject to payroll taxes like Social Security and Medicare unless you are actively involved in the profession producing the royalties. For example, if you’re a full-time author getting book royalties, payroll taxes are due. If you’re an oil driller getting oil royalties, payroll taxes are due. If you’re a doctor who owns a piece of land that receives oil royalties, no payroll taxes are due. A typical royalty may be 12%-25% of the “net revenue interest” of the project. Multiple mineral rights/royalties can be packaged into a private fund or other entity to provide convenience, diversification, and liquidity.
If the mineral rights owner gets 12%-25%, the entity with the “working interest” is getting the rest. This is the highest risk and potentially highest reward way to invest. The working interest entity is actually in the business of getting the oil or gas out of the ground and selling it. A working interest is simply the agreement that allows the entity to exploit the mineral resources, i.e. pump out the oil and sell it. This can still be passive income as long as the investor is not actively involved in running the business. This income is generally reported on Schedule C and is subject to ordinary income tax rates. However, these entities are often set up as partnerships, also reported on Schedule E. If you know someone who “owns an oil well,” this is likely what they have.
Master Limited Partnerships
A master limited partnership (MLP) combines the benefits of a publicly traded company (liquidity and daily pricing) with the benefits of a partnership (pass through of losses). Due to the unique taxation of oil and gas investments, this is a common form of investment. Like a REIT, an MLP has to distribute 90% of its income, and a good chunk of its distributions are considered a non-taxable return of capital for tax purposes. There are currently 42 of these MLPs that are taxed as partnerships (there are some others that have chosen to be taxed as corporations), and almost all of them are in energy. Yes, there is an ETF that invests in all of them that costs 0.45% per year. MLPs are often involved more in the transport of oil and gas (think pipelines) than the actual production of oil and gas.
Private General and Limited Partnerships
Just like in real estate, you can invest in private partnerships as well. Typically you must qualify as an accredited investor (income of $200,000+ for each of the last two years or $1 million+ in investable assets). Most of the time you are a limited partner in these partnerships (no control but your loss is limited to your investment). However, there are some unique partnerships set up such that you could participate on the general partner side as well.
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Tax Benefits of Oil and Gas Investing
First, any business expense is deductible. That’s not some huge tax break or anything; that’s just the way business works. But when you ask anybody about the tax benefits of some investment, they’ll cite all kinds of things that are basically just business expenses. “If you get a rental property, you can write off the cost of repairing it!” Uh . . . OK, that’s great, but not something that is going to entice me to invest due to “huge tax breaks.” But now, we’re going to focus on the two “huge tax breaks” of oil and gas investing. But before we do so, we need to do a little bit of terminology first.
Intangible and Tangible Expenses of Drilling
When you go to drill an oil well, there are two types of expenses: tangible and intangible. Tangible expenses are primarily drilling equipment, and they must be depreciated over seven years. These are typically about 25% of the cost of drilling a well. Intangible expenses are immediately deductible and include items such as labor, grease, chemicals, “mud,” etc., and they make up about 75% of the cost of drilling a well.
Active vs. Passive
A royalty interest is considered passive income, but a working (or operating) interest is considered active income. Active losses can be used against other forms of active income, such as clinical income. The equivalent in real estate is Real Estate Professional Status (REPS), where you can use your depreciation losses against your (or more likely your spouse’s) clinical income. You’re basically a general partner running a business with unlimited liability.
If you go to drill a new well, you get most of your expenses (and tax deductions) upfront. That can be helpful in offsetting other income.
But all that is really just deducting business expenses. Yes, you can take more of these expenses as deductions upfront than you can with other businesses, but in many situations, that isn’t worth all that much.
Exception to Passive Loss Limitation
What is unique here with oil and gas investing compared to real estate is that you don’t have to actually be actively involved in running the business to use these passive losses against your active income. There is no REPS status for oil and gas. Everybody gets “oil and gas REPS status” without having to do any work.
Small Producer Depletion Allowance
A second unique tax break is that if a company is producing less than 50,000 barrels of oil a day, it qualifies as a small producer. That means you can deduct 15% of the gross income from oil and gas drilling activities as a “depletion allowance.” This cannot be more than the net income from the venture. But 15% of gross income can be a huge chunk of net income, and it is basically tax-free. That’s a big tax break.
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An Example of Oil and Gas Investment Tax Breaks
Let’s say a highly compensated ($800,000) California physician is planning to work for a few more years. They are interested in investing in oil and gas with part of their portfolio. They make a $250,000 investment into an oil and gas limited partnership. They never visit the site or do anything else with the company. The doc goes back to their practice and sees patients and operates on them.
The partnership uses the doctor’s money to drill a well. It doesn’t actually produce any oil that year. All expenses and no income. The doctor gets a K-1 at the end of the year showing a loss of $180,000. They subtract that from their income and save about $90,000 in taxes that first year. Eventually, the well starts pumping oil and their investment starts paying off and sends them passive income for another decade. However, by that point, the doctor is retired and in a much lower tax bracket.
Is Oil a High-Risk Investment?
That example doesn’t mean it was a “no-brainer investment.” It’s entirely possible that the well never found enough oil for the doctor to get back their $160,000, much less $250,000. It’s a risky investment. But it does come with a pretty good tax subsidy. Even if the well never found oil, their $250,000 at least bought them a $90,000 tax break. But you shouldn’t let the tax tail wag the investment dog.
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Are Oil and Gas a Good Investment?
Oil and gas can be a good investment for those who know what they’re doing. It does have some unique tax breaks associated with it. However, like any alternative investment, it isn’t mandatory for your portfolio. For me, I don’t have any plans to invest in oil and gas other than continuing to own shares of total stock market index funds.
What do you think? Have you invested in oil and gas? In what form? How did the investment turn out? Comment below!