What To Look For When Considering Investing In Oil & Gas
Learn some tips and tricks to help invest profitably in Oil & Gas
Introduction
Having spent our entire careers in both engineering and finance roles within the energy and traditional oil and gas sectors, we receive numerous questions from individuals outside of the industry about investing in this space.
Here is a sample of the questions we get daily:
“I saw this ad on Facebook for an oil investment, saying I will be rich?”
“What does working interest mean?”
“Can I use the 1031 exchange to pivot my portfolio into energy?”
“I want to be Billy Bob Thornton.”
“Am I a wildcatter now?”
All are valid questions, and we thought it would be helpful to peel back the onion, so to speak, to equip you with some information about investing in oil and gas, what to look for, what to watch out for, and what questions to ask your sponsor. The goal is to arm you with information to enter the oil and gas investing space profitably.
Oil and Gas Investing 101
There are multiple ways to invest in oil and gas, both as an industry insider and outside. At the top level, any investor has two options:
· Active
o Direct ownership of oil and gas assets.
o Requires operator’s license and bond through each state the assets are located if taking operational lead.
· Passive
o Investing indirectly through equities, non-operated working interest, minerals & royalties or through private placement offerings (known as “funds”).
For someone looking to enter into the oil and gas investment space, passive ownership is the simplest avenue. Owning physical oil and gas assets requires bonding through your state of operations, huge amounts of working capital, geology, engineering, and operational experience to ensure profitable operations. Alternatively, you can choose to invest passively via equities. While benefits from investing in oil and gas equities exist, their performance is not as simple to understand, considering capital markets constantly change the reward function for companies looking to increase their stock price. As we tell all investors who ask us about equities: “If I knew which stocks were going to go up, we would be writing this Substack from the South of France”. For this piece, we are going to focus on the passive investment strategy, as 99% of the questions we get are from non-industry veterans looking to enter this space as limited partners or LPs in a fund.
Overview
There are many reasons an investor might decide to consider oil and gas as part of their portfolio:
Tax Deductions available through the Intangible Drilling Cost Deduction
Reoccurring Income
Overall portfolio diversification
Each of the reasons presents a compelling reason to allocate pieces of your portfolio to oil and gas.
Tax Deductions via Intangible Drilling Cost Deduction
The Intangible Drilling Cost (IDC) deduction offers significant tax advantages for oil and gas investors, especially when investing in projects that include the drilling of new wells, where these IDCs are incurred. IDCs, which include costs like labor, drilling fluids, and other non-salvageable expenses, can often be deducted 100% in the year they are incurred.
Yes, you read that right, 100%! Now, not all dollars earmarked for drilling qualify as IDCs – so you will never be able to write off 100% of your investment. Some of that money is earmarked for Tangible Drilling Costs, some for lands rights, etc…But most of the cost to drill as well qualifies for this IDC deduction. A good rule of thumb is 70% when looking at a drilling project.
Take an example from our oil and gas eBook (click here to download). Let’s assume you make $200,000 per year, which in 2025 puts you in the 32% marginal tax bracket. You have decided to make a $150,000 investment in oil and gas.Your fund manager gives you a K1 at the end of the year with a 70% IDC deduction.The math looks something like this:
Your taxable income drops from $200,000 to less than $100,000, significantly lowering your tax burden. Tax reduction is generally the number one reason non-industry folks discover oil and gas due to the highly tax-efficient nature of the investment. Now, if you are only looking for maximum tax efficiency, you might find slightly more tax-advantaged options. Yet, tax deductions are not the only reason people look towards oil and gas for an investment.
Reoccurring Income
Investing in oil and gas normally (hopefully!) generates income to investors through distributions from the fund manager for sales of oil and gas. These distributions are typically paid monthly or quarterly and stem from the revenue generated by oil and gas production after operational (and perhaps other) expenses are deducted. When layered in with the tax benefits, oil and gas investment becomes a much more powerful investment option due to that dual nature.
Portfolio Diversification
Oil and gas investments also provide diversification benefits due to their low correlation with traditional asset classes like equities and bonds. Since equity values are based on many variables outside of your control, investing as close as you can “to-the-wellhead” can help derisk your portfolio. It also provides some balance when included in portfolios that have real estate and other assets
What To Look For (And Not) Investing In Oil and Gas
Oil and gas – like any specialized business - is very complex. These complexities can take a long time to understand, and even for a seasoned oil and gas pro, can lead to misallocation of capital. We are guilty of this ourselves, even as we have a combined 50 years’ experience in the oil and gas business!
What To NOT Look For
A harsh truth for non-industry folks: Oil & Gas Sponsors LOVE the fact you know nothing about this space and weaponize your lack of knowledge against you to secure an investment riddled with problems.
This is not true for all sponsors, but, unfortunately for the industry, there are enough of these bad actors that you are bound to come across these folks in your investment journey. The key to weeding through the muck is to understand a few basic truths about this business:
Divestiture events or exit events – what many funds base their projections on - are much harder to obtain than your sponsor will tell you. Unlike real estate, selling an oil & gas asset is very complex, requires specific timing, a great development plan, and most importantly, luck. I don’t know about you, but anytime an investment I make hinges on luck, I basically risk that down to a 0% chance. It doesn’t mean oil and gas assets can’t be sold; they can and do, but much of that is out of the sponsor’s control.
Underwriting inputs can significantly raise or lower projected returns. In our models, we have over 65 different inputs when we look at underwriting oil and gas assets, each with their own effect on the projected financial returns. They can be easily modified and changed to enhance projected returns. This includes increasing the b-factor, lowering the variable operating expense, assuming saltwater disposal, using “offset” wells from 20 miles away, high oil and gas prices, and confusing waterfall structures among numerous others. These hidden inputs can be tweaked subtly to ensure an outcome that looks great on a slide deck but doesn’t represent the reality of the project.
Every investment includes fees. While this might seem obvious, some sponsors will claim “No Management Fee” or “No Operator Fee”. While they might not have fees that are directly called that, trust me when I tell you: most fund managers are making out just fine with your investment even if you’re not.
Non-licensed salesmen can be very tricky and 99.9% of the time, if they are not a part of the management team or play a significant role outside of fundraising for the sponsor, it can be a violation of the broker-dealer laws, which require specific licenses in order to raise capital.
Extremely long placement agreement. If you need to set aside a weekend to read a 600+ page PPM and spend thousands of dollars in legal fees to understand this investment, that should tell you something about the nature of the sponsor and their operations
If the multiple on exit seems too good to be true, it probably is. This goes for any investment, but specifically with oil and gas. Folks tend to hear stories of the wildcatter hitting a gusher, or a new wells drilled in the middle of nowhere making 15x on their investment, and believe all investments into oil & gas work that way, which they don’t. Generally speaking, with increased reward comes increased risk.
What To Look For
Just because it is a complex business does not mean it’s impossible to invest profitably. On the contrary, there are great sponsors and firms to invest with – the key is knowing what to look for.
Industry veterans are critical. Sometimes, the smartest folks in the investment business are just starting out, sometimes they have been in business 45 years. The length of time (or number of funds) is important, but what is generally more important is the folks you are considering partnering with oil and gas experts? Have they spent time learning the business, gaining the needed scar tissue by making mistakes firsthand to ensure they are playing offense with your capital, not defense?
When looking at a sponsor’s investor base, if it is filled with folks in the oil and gas business, you can feel reasonably confident that the thesis is solid. If an oil and gas lawyer, engineer to accountant invests with a fund manager who has a strategy that includes tax savings, distributions, and a diversified investment thesis, that should signal to you that people who understand the business have found it compelling enough to risk their capital on the strategy.
Standard fees and commission structures is another critical green flag. Anything besides a traditional “2 & 20” model should be looked upon with some skepticism. In cases, higher management fees are needed if there are massive operational needs, but those instances are the outlier, not the norm.
Short, concise documents and private placement agreements. Anytime you can read and understand a PPM or subscription agreement, it at least means your sponsors aren’t trying to fool you by placing something on page 456.
Questions to Ask During Diligence
Regardless of how confident you might feel about an investment and management team, it is important to ask some critical questions during your diligence period. Here is some recommendations from us for some questions to ask:
Fee’s & Commissions
How many of your after-fee dollars are being spent on drilling, assets, etc.
How is the person you’re talking to being compensated?
Is my point-person working directly for the sponsors in another role (finance, investor relations etc…) and if not, are they are broker-dealer?
Can someone clearly spell out all the fees to you?
What expenses are being charged to the fund?
Profit Share / Waterfall
Is the management team participating in distributions? If so, when and how much
Is the fund recycling/withholding distributions for future investment?
Do industry veterans invest with these folks?
Fund Thesis
What is the overall strategy for your fund?
How long is the holding period?
Can I ever achieve liquidity?
Conclusion
Investing in oil and gas is one of the few capital allocations an investor can make that has great tax efficiencies, monthly/quarterly liquidity and provides non-correlated diversity to a larger portfolio.
If you are interested in learning more about oil and gas investing, take our Oil And Gas Portfolio Survey to get more information from us about investing in oil and gas, and depending on your response, point you in a direction to help begin that journey!
As a 51 year veteran in the industry I would add one thing to the title after got taxes - that is got money?