With all due respect to Charles Dickens, the oil and gas sector is increasingly a tale of two markets. Depending on where you focus, it is the best of times, and it is the worst of times.
For the past few years, professionals in the oil and gas industry have expressed their dissatisfaction with the state of the sector. The use of oil and gas has diminished, and prices have proven volatile due to the global slowdown caused by COVID-19.
The world economy has somewhat recovered, resulting in a banner year for oil majors in 2022. However, fears of an imminent recession coupled with stagnant natural gas prices, rising costs of production and a particularly acute economic slowdown in China have restrained any palpable sense of optimism for some.
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Not to mention…
ESG carries the day. The fossil fuel industry is under sharp focus due to the rise of prominence in ESG (environmental, social and governance) standards. ESG advocates have already achieved substantial progress toward their overall goal to get pensions, banks, insurance companies and endowments not only to shed their existing holdings in public oil equities, but also to shun new investments in drilling and exploration. The ESG movement has successfully shifted growth from fossil fuels to renewables, as we will explore shortly.
Inflation marches on. Exploration of new oil and gas fields has become more expensive due to external factors like inflation, resulting in rising costs. Inflation numbers are certainly trending in a more optimistic direction than they have been over the last two years, but there is only talk of “pausing” interest rate increases in the U.S., not of stopping them entirely or even reversing them.
The world is an unstable place. Furthermore, the industry has faced an additional challenge due to geopolitical uncertainties. The war in Ukraine plods on, disrupting oil and gas supplies from Russia, resulting in higher prices in the European nations that rely on Russia for a significant portion of their energy.
Since China is the world’s second-largest consumer of oil and gas, its economic struggles continue to dampen demand and present significant impacts on the global oil and gas market. And across the globe, concerns about climate change have resulted in significant regulatory barriers for fossil fuels and increased subsidization of the clean energy industry poised to at least partially replace them.
Now seems the perfect time to reconsider Warren Buffett's advice to be greedy when others are fearful. Fear is clearly carrying the day in the oil and gas industry. However, let's examine what reasons might exist for investing in oil and gas.
Reasons for investing in oil and gas
1. Demand for energy is strong and getting stronger.
The world may one day be headed toward a future where electric cars replace conventional ones, biomass heating replaces traditional heating, and coal usage is eliminated, but this transition will not occur overnight.
Even if car companies make good on their pledge to produce only electric vehicles by 2035, it will take decades to transition away from fossil fuels. And by all accounts, the demand for energy is growing by the day.
The world's energy may be getting cleaner, but it is not yet entirely clean. Despite the world's wishes, it will still require a significant amount of oil and gas for the foreseeable future, which presents an issue, because...
2. The supply of energy is low and will take a while to recover.
As previously mentioned, the rising costs and falling prices are discouraging the industry from investing heavily in drilling. Although the market hasn't shown it yet, the decreasing oil and gas supply will pose problems in meeting global energy demands. No amount of wishful thinking about green energy replacing fossil fuels will address this situation in the short term, regardless of the long-term future of renewables.
3. The law of economics remains intact.
Put simply, an increase in demand for a limited commodity does not necessarily mean the end of the oil and gas industry, despite the desires of ESG advocates.
In his recent white paper on the future of energy, John Mauldin, a noted financial expert, economist and visionary thinker, pointed out that the ESG movement unintentionally reduced energy supply, leading to spiking energy prices in the face of increasing demand. However, no responsible country is likely to advocate against their citizens’ needs for power and clean water, both of which require oil and gas, making a compelling case for medium- and long-term energy prices.
Add it all up, and opportunity may be knocking
So the oil and gas sector appears to be ripe for new investment. Now comes the tricky part: How best to invest in this opportunity?
Generally speaking, most oil and gas investors tend to confine themselves to traditional energy investments in the stock market, buying shares in integrated oil companies like Fortune 500 stalwarts ExxonMobil and Chevron, or in MLPs that store and transport oil and gas to refineries. These stocks tend to be conservative, reliable dividend payers and can certainly reward patient investors over the long run, particularly if the shares are bought in an IRA or other tax-sheltered investment.
And while there’s nothing wrong with that approach for most people, sophisticated investors would do well to take a close look at three ways to invest in the oil and gas sector. All three investments take into account three universal truths of investing:
- First, the ideal investment minimizes risk while maximizing return
- Second, the ideal investment does not exist, and our goal is simply to come as close as possible to that ideal
- Third, taxes are the silent killer of any investment and should always be in the crosshairs of any investment philosophy, including these three timely and tantalizing oil and gas investments
Three ways to invest in the oil and gas sector
1. Mineral rights
Recall John Mauldin’s observation that the ESG movement appears to be succeeding in reducing supply exactly as demand continues to increase. Nowhere is this phenomenon more evident than as we examine mineral rights, a concept on the lower end of the risk spectrum of the three ideas I am outlining.
Historically, generational wealth has been created through mineral rights, which involves the ownership and subsequent leasing of land to oil and gas drillers and operators, who develop and produce wells. Landowners thus have a royalty interest in the land, but no responsibility to undertake its development directly.
Some of the institutions and funds that have been owners of these rights for decades are now under pressure to comply with ESG-friendly board members to divest of as much as possible of their hydrocarbon-based assets. These assets include land located in some of the most energy-rich basins in the country. As these funds sell some of their best-performing assets, mineral rights funds are perfectly positioned to scoop them up, building their portfolios with timely purchases that are likely to increase in value over the next several years.
Mineral rights funds have tremendous appeal to savvy oil and gas investors with an approximately five- or six-year time horizon. They are capable of producing instant cash flow, which is likely to increase over time as the number of productive wells within the fund increases, with a goal of double-digit cash flows. There is also tremendous capacity for capital gains, as most funds operate with the goal of developing their properties and ultimately selling them to generate further returns.
Finally, because mineral rights are investment properties that are eligible for 1031 exchanges, which can shield investment returns from capital gains taxes indefinitely when properly structured, the funds may well be eligible for preferred tax treatment, either on the way in or the way out… or both. It’s important to note that investors can use a 1031 exchange to move funds from a realized investment gain into a mineral rights fund, but they are not required to do so; mineral funds can be purchased with cash as well as through a 1031 exchange.
2. Oil and gas drilling funds
For investors who are less concerned with income and more interested in potential tax benefits as a precursor to possibly larger capital gains, drilling funds might provide an excellent opportunity.
Drilling funds can provide a massive tax advantage on the front end of the investment, with a tax write-off of up to 80% to 90% of the value of the investment.
The deduction, which is actually for the intangible drilling costs, or IDCs, represents the cost of exploring and drilling oil and gas wells, which are deducted in the year they are incurred. IDC deductions offset ordinary income, so that a $300,000 investment in a drilling fund might enable an investor to lower their taxable income by as much as $270,000 in the year the investment is made.
In addition, subsequent depletion allowances permit investors to deduct a portion of the value of their oil and gas reserves each year, even if they do not sell any oil and gas. The amount of the deduction is based on the type of the property, the production level and the cost of the property. This could be as high as 15% of the gross income from the property, though the amount is impacted by both the taxable mineral income from the property as well as the taxpayer’s overall gross income. Depletion allowances are phased out based on gross income, so the input of a qualified tax adviser is essential.
3. Qualified opportunity funds in the energy sector
A qualified opportunity fund (QOF) investment addresses one of investors’ primary concerns (capital gains taxes) without sacrificing its focus on the other (investment returns). By using a realized gain to fund a QOF investment, investors can defer the tax on that gain until Dec. 31, 2026. More important, they can avoid paying taxes on the QOF investment itself simply by holding it for a minimum of 10 years. The ability to defer a current gain and avoid a future one entirely represents a generational opportunity that higher-net-worth investors should take seriously.
By selecting an investment in one of the many QOFs that are located in areas of the country that specialize in energy exploration and production, savvy oil and gas investors can position themselves to take advantage of the outstanding 10-year prognosis for the industry.
Whatever may be true of the death of fossil fuels in America and the world, our short- and medium-term future as a society is inextricably linked to the continued availability of oil and gas and their related products. Clean energy’s future may be bright, but the bridge between our present and that future is linked to a robust oil and gas industry that appears to see strong demand for the foreseeable future.
It goes without saying that investment gains are never guaranteed. Also, it is true that the exploration and production (E&P) division of the oil and gas sector is one of the most speculative. But it's also true that investments in QOFs rely on guidance from teams of experts with knowledge of the energy industry and qualified opportunity fund structures. Accredited investors willing to take risks and work with expert advisers can gain exposure to what many consider to be one of the most important asset classes of our time.
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