- Direct Participation (Partnerships)
Direct participation in oil and gas exploration and production simply means having part ownership in a well that produces revenue from the oil that’s sold from the well.
Direct participation in oil and gas projects offers qualified investors the tremendous potential for returns, outpacing what investors usually get in the stock market. Annualized returns for producing oil and gas wells – even with current high costs for labor and materials – can be as much as 45% even at $60 per barrel oil.
These partnerships also offer the investor the chance to be active, that is, have a say on how their capital is deployed. Getting in touch with the manager of these investments is often more possible, too, since there are a limited number of partners who often need to approve new partners. so for investors who crave a partner-first attitude and a community of like-minded folks, project partnerships might be the way to go.
But perhaps the biggest advantage is taxes. All the costs of prospecting for oil and gas can be written off on taxes in the first year if drilling starts shortly after prospecting is complete and most of the taxes of drilling can be depreciated over the following 5 to 7 years. And even if the well is a “dry hole” the entire up-front expense can be written off.
There are two main partnership avenues that investors can take to invest directly: Limited Liability Partnerships (LLP) and Joint Venture (JV) partnerships. Both have their advantages and disadvantages.
The advantages of LLPs include corporate structuring, which reduces investor liability should something go wrong. The second is diversification, LLP projects often have more wells, which means a higher chance that some wells are more commercially viable.
More money is often required up-front for LLP projects, however, because cash can’t be provided at intervals on an as-needed basis. Also, because these projects are larger and have more partners, they take more time to start producing.
Joint Venture partnerships, however, do not require 100% of the capital to be paid up-front, lowering the amount of “at-risk” capital. Joint Venture partners also have more say in whether or not to proceed with a project, given well data and potential return on investment (ROI). They also can remove the manager of the JV if they don’t believe they are acting in the best interest of the partners.
- Futures and Options
If you have deep pockets, you could purchase thousands of barrels of oil on the spot market from a tanker and/or pipeline and store them. However, a more realistic option might be to purchase oil futures and or options.
Futures and options provide the right (in the case of options) or obligation (in the case of futures) to purchase barrels of oil on the open market.
It’s called “direct” exposure because it’s more direct than option 3 below, but investors rarely intend on taking ownership of the underlying asset (that is, barrels of oil).
The advantage of futures and options is flexibility, and investors can hop in and out of positions much more quickly than in direct project participation. Qualifying for making these kinds of trades is also easy and fast through online brokers – and chances are, if you qualify for project partnerships, you would qualify to buy contracts directly through your broker or through a commodity trading advisor (CTA). Even easier is investing in an exchange-traded fund or note (ETF or ETN) such as USO, which invests in oil futures.
While these options are quick and easy for retail investors, they aren’t suitable for long-term buy-and-hold strategies (if you bought and held USO since its inception in 2007, you’d be down 90%!). Another disadvantage is taxes: Commodities ETFs are taxed annually even if they remain in an investor’s portfolio.
See also this summary from Seeking Alpha for more on futures and options.
- Energy Company Stocks and Funds
For investors seeking indirect exposure to oil and gas, energy stocks, energy ETFs and mutual funds are an option. The most popular ETF is the Energy Select Sector SPDR Fund (XLE), which represents some of the biggest publicly traded oil companies in the country (traded on the S&P 500). If you want to get specific, there are many other ETFs that focus on refiners, oil services (drilling rigs, etc.), and pipelines (sometimes called midstream companies). These funds can be as general or specific (depending on which part of the upstream/downstream continuum you want to be on). Alternatively, directly buying a few stocks of energy giants such as Exxon (XOM) and Chevron (CVX) can help you save a bit on the management fees of ETFs (though these aren’t usually onerous).
Investors don’t have to be qualified investors to make these trades, and trades can be held for 5 minutes or 5 years or more. The downsides include capital gains on sale of these funds and stocks, and a long-term lack of performance when compared to owning producing wells in an oil and gas partnership.
Another downside is that you are exposed to the volatility of individual stocks as well as poor long-term performance. In fact, over the last 10 years, investing in energy sector stocks would have yielded a return of about 28%. Not bad, but compare that to the S&P 500’s gain of 175%, and you can see how the energy sector falls flat, even despite its recent outperformance of the overall market. Finally, many of these major producers are under pressure from ESG trends to diversify into renewables or curtail operations, which may make them less profitable in the short term.
Conclusion: Based on the advantages and disadvantages elaborated on above, we believe that direct participation in oil and gas projects is the way to go for most qualified investors interested in long-term oil and gas investing. All oil and gas investing involves risk, including loss of principle. Always consult a certified tax professional, too.
However, the tax benefits and regular income of partnerships make these opportunities worth exploring first.