Myths Of Investing In Oil Wells
MYTH #1 – YOU CAN LOSE ALL OF YOUR MONEY.
If a well is productive or non-productive, the cost of that well is an “expense” which can be deducted from other sources of income. In either instance a significant portion of dollars at risk would have been paid in taxes anyway therefore your actual dollar risk exposure is reduced by your tax bracket. No kidding! Mandated by Congress in order to encourage domestic petroleum investment, the Tax Code makes investments in oil and gas ventures one of the best tax advantaged investments.
“Intangible Drilling Cost Tax Deduction (IDC)” allows you to write off 100% of the cost for drilling a well. These costs include, drilling rig, location, chemicals, fuel, mud, labor, survey, transportation, cementing, etc., which make up about 65% to 80% of the total well cost. It is important to note that IDC is a 100% write off regardless of the outcome of the well, dry hole or producer. For example, a $400,000 investment would yield up to $320,000 in tax deductions during the first year of the venture. (See Section 263 of the Tax Code).
Tangible Drilling Cost Tax Deduction
The total amount of the investment allocated to the completion of the well such as tubing and production equipment “Tangible Drilling Costs (TDC)” is 100% tax deductible. In the example above, the remaining tangible costs ($80,000) may be deducted as depreciation over a seven-year period. (See Section 263 of the Tax Code)
Active vs. Passive Income
The Tax Reform Act of 1986 introduced into the Tax Code the concepts of “Passive” income and “Active” income. The Act prohibits the offsetting of losses from Passive activities against income from Active businesses. The Tax Code specifically states that a Working Interest in an oil and gas well in not a “Passive” Activity, therefore, deductions can offset against income from active stock trades, business income, salaries, etc. (See Section 469©(3) of the Tax Code
Percentage Depletion Allowance Tax Deduction for Small Producers
The 1990 Tax Act provided special tax advantages for small companies and individuals. This tax incentive, known as the “Percentage Depletion Allowance”, is specifically intended to encourage participation in oil and gas drilling. Large oil companies do not benefit from the Depletion Allowance due to large production rates, over 1,000 BOPD or 6,000,000 cubic feet of gas. The “Small Producers Exemption” allows 15% of the Gross Income (not Net income) from an oil and gas producing property to be tax-free.
Therefore, you see it is true. Congress has provided tax incentives designed to stimulate domestic oil and gas drilling and in theory help, pay for drilling your well. In essence, you could never lose all your money, because it never was all your money in the first place. The government was going to get their part of your income regardless whether you invested in an oil well or not. In fact, they were going to get between 25% to 40% of your income anyway.
There are more incentives concerning oil and gas leases and tax rules concerning the Alternative Minimum Tax. Remember, it is always a good idea to check with your financial consultant before making an investment.
MYTH #2 – IT IS MORE PROFITABLE TO BUY STOCK IN EXXON OR A MAJOR OIL COMPANY FROM MY STOCK BROKER THAN TO INVEST IN AN OIL WELL.
Truth – When you purchase stock from a stock broker or online in essence you are buying tiny piece of a huge corporation with millions of many different pieces. There is some comfort in knowing that it is a large corporation with holdings all over the world, but it also comes with a huge overhead to support. When one purchases stock in such a large corporation with their large overhead it takes a lot of movement in the market for one to make a substantial profit, plus you are buying the stock with “post” tax dollars so you only getting to invest 60% to 70% of the income you had earned. You have already given up a large part of your buying power before you even start. When you invest into an oil well it is called “Direct Participation” and that is what is happening. You are investing directly either into one oil well or a group of oil wells, such as the K*FUND Drilling Program. Your investment is more focused on the production of oil and not on the running of a huge corporation. Your investment will have the chance to grow faster and larger when it is prudently focused instead of invested in a huge corporation where it is used to run the machine.
MYTH # 3 – MOST OIL WELLS ARE A DRY HOLE. THEY ONLY FIND OIL IN ABOUT 1 OUT 10 WELLS DRILLED.
Truth – There are different kinds of drilling when it comes to finding oil. The type that most people have heard of is “Wildcatting”. It is what was talked about on the TV shows of Dallas and other movies about oil wells where the guy goes out into the middle of nowhere and when he is down and out on his last dollar hits a gusher of a well and it blows up in the air and everyone lives happily ever after like the Beverly Hillbillies. In situations like that where one is drilling in the middle of no known oil production the odds of getting a dry hole are probably more like 25 to 1 that you will get a dry hole.
The other type of drilling that is done with a much higher success rate is “Low Risk Drilling”. When doing this type of drilling, you are drilling next to or very near to existing oil wells or in existing oil fields. This type of drilling is very successful and generally has high success rates. When investing in an oil well be sure to clarify if the investment is a wildcat or a low risk drilling project. Chances are if you are investing in a low risk drilling project your odds of hitting oil and making money are greatly increased.
MYTH # 4 – IF SOMEONE OFFERS YOU AN OPPORTUNITY TO INVEST INTO AN OIL WELL IT IS A SCAM.
Truth – The best way to find out if you are getting a good investment opportunity is to do the research. Generally that is why people buy stocks and investments from a stock broker or online service, because they may not have the time to do the research and therefore rely on an expert. An investment representative will ask them their tolerance for risk and then invest accordingly.
When investing in an oil well do the research. Companies like Kitty Hawk Energy will invite you to their offices, outline their drilling program. You should be able to hear what the geologist, geophysicist, and engineer have to say about the wells to be drilled. Successful oil companies are willing to educate the investor who wants to learn more about the process of drilling and producing wells. They welcome questions and comments. As an investor you should always be able to communicate with the people who are making the decisions. Knowledge is power. If you want to increase your chances for success and reduce your risk, ask questions and learn.
MYTH #5 – I KNOW THAT THE ONLY REASON I AM ASKED TO INVEST INTO AN OIL WELL IS BECAUSE THEY KNOW IT ISN’T GOING TO BE A GOOD WELL.
Truth – If anyone really knew the outcome of a well before it was drilled do you really think they would be asking you to invest? No one knows for sure but through rigorous study the geologists, geophysicist, and petroleum engineers have a solid realistic idea based on factsWhen drilling low-risk prospects the results are much easier to calculate. Wells , each one has its own personality and production profile. Wells are different, Wells can be right next to each other with different results. That is why oil operators share the wealth and the risk when drilling. Even the largest companies in the world like Exxon, Shell or BP share the risk when they are drilling new projects, because they too know that there are risk factors that need to be managed. Remember, it is better to have smaller interest in multiple wells than have a large interest in one well.
MYTH #6 – INVESTING INTO AN OIL WELL IS EASY, BUT IT IS AFTER THEY START THE WELL IS WHEN IT GETS EXPENSIVE.
Truth – With rare exception, are the costs associated with operating and producing a well more than the cost to prepare, drill and complete the well. Well workovers do occur periodically but are necessary to keep production rates high. Since operators of wells have their money invested right along with the investor their economic incentives are aligned. Keeping lease operating expenses (LOE) low is always a main concern for the operator. Reducing costs for rental equipment, chemicals, labor, insurance and administrative overhead, to name a few, are very important. Good operators have standing policies. They take several bids for well work to insure competitive pricing. However, knowing the contractor or service provider is paramount in reducing costs and insuring quality.
MYTH #7 – DRILLING OIL WELLS SOUND DANGEROUS AND COULD HAVE A LOT OF LIABILITY AND I DON’T WANT TO BECOME PART OF THE LIABILITY FACTOR.
Truth – Investing into oil wells is like when you buy stock. You are only liable for your investment. In the stock market if the company you invested in goes broke or has a product liability issue you are not affected by these issues other than your investment may go down or become worthless. The same is true when investing in an oil well where you have an operating agreement between yourself and the operator stating the responsibility and liability. It is like getting the best of both worlds. You are on the ground so to speak in the front row watching your investment, but without any of the liability.
MYTH # 8 – OIL WELLS DON’T HAVE A VERY LONG LIFE SPAN.
Truth – Oil wells generally have a long-life span, obviously, production rates with higher pressures occur earlier in the life of the well. Wells do deplete over time as the drive mechanism in the reservoir reduces. Some oil wells may need help later in life. Pumping wells and using gas lift are two examples to extend the productive life of a well. But generally, an oil well has a long life. The production rate won’t always be at a high daily rate, but with prudent management and attention to detail, wells can last many, many years.
MYTH # 9 – IF THE PRICE OF OIL GOES DOWN AND THE WELL IS A LOW PRODUCER I WON’T EVER GET MY MONEY BACK.
Truth – Everything in life is cyclical. Things go up and thing and things go down. And the price of oil is different. However, in today’s world the market place is different. We now have 1 Billion people in India with a 300 Million middle class that is evolving and we have 1.1 Billion people in China that has 300 Million middle class that is evolving there too and are consuming more and more energy as their countries grow and prosper. Plus, like the stock market oil wells are known to be long performers and continue to produce and give an economical return to their investors. In the stock market if the sales of a company should tumble and go into the negative column as it did with General Motors and all the investors’ money was wiped out with the company filing bankruptcy due to low sales. In the situation of an oil well if the market price should drop below the amount needed to be profitable you can shut the well in and wait until the market conditions improve. Remember, it always cycles back around again to profitability in the oil business. After doing the math on the amount of money you have invested that over time before factoring in your tax benefits that oil investments generally have a very high rate of return.
MYTH # 10 – IF I INVEST IN AN OIL WELL I WILL BE STUCK WITH IT FOREVER AND WON’T BE ABLE TO SELL MY INTEREST.
Truth – An interest in an oil well is sellable, because it is based on cash flow. Just like a stock is priced based on earnings times a multiple an oil interest is the same way. The longer you own an oil interest and the more established the production becomes the easy it is to sell, because it has a proven cash flow record just like a stock in a company would have.
MYTH # 11 – THEY HAVE FOUND ALL THE OIL THERE IS TO BE FOUND SO WHY WASTE THE TIME TO DRILL?
Truth – It is believed that all the big oil or easy oil has been found in the Continental United States. Resource oil plays are ‘en vogue’ but let’s not forget the tremendous opportunities remaining in conventional oil. There are thousands of proven oil fields in the United States with oil reserves in place that have yet to be exploited. With the continuing advancements in technology, such as well logging and fracking, fields that were once dormant are coming to life again. At today’s prices, low risk drilling, in and around existing oil fields can be very profitable and cost effective. Given today’s market. Louisiana ranks as one of the top producing states in the United States. One reason for this is the complex geologic setting these reserves are found in.