Investing in Oil & Gas DPPs (Direct Participation Program)
Is now the time to consider diversifying your portfolio by adding a small oil and gas component? What do I need to know about a direct investment in oil and gas? What are the caveats, risks and the opportunities? What is a Direct Participation Program (DPP)?
Why invest in oil & gas? Here is a summary of benefits and reasons to invest:
- Some choose to invest because oil & gas can act as a hedge against rising prices. In the simplest of terms, if petroleum prices are high and you are paying a lot more at the gas station than you would like, this can be offset by the returns you can get from an investment in oil and gas.
- Some investors choose oil & gas as a hedge against movements on stocks or interest rates. Despite similar volatility, equities and commodities have rarely fallen in the same year – they tend to move in opposite directions. Over the five-year period ended March 31, 2006, the Dow Jones AIG Commodity Index has returned 10.6%, versus 2.6% for the S&P 500, according to PIMCO (Pacific Investment Management Company) website. “Oil has become the ‘new gold’—a financial asset in which investors seek refuge as inflation rises and the dollar weakens,” said Daniel Yergin, head of the Cambridge Energy Research Associates (CERA) on the CERA website. Mr. Yergin is also a Pulizer prize winner for a book on oil & gas entitled “The Prize”. “The credit crisis has been fueling the flight to oil and other commodities, and that will last until the dollar strengthens or the recession becomes more pronounced,” he said in a March 19, 2008 press release found on the CERA website.
- Other investors choose an oil or gas investment because they see that these commodities are in low and finite supply with rising demand, and the trends continue upward. Oil & gas are commodities, and commodity prices have recently been driven higher by a number of factors, including increased demand from China, India and other emerging countries that need oil, steel and other commodities to support manufacturing and infrastructure development. Said in another way, when there is high demand (whether it is sudden, expected or unexpected) and it strains existing supply or production, buyers compete for the scarce supply and prices rise.
- Some investors want to invest to add diversification to their overall holdings. While diversification does not guarantee against loss, it is a key strategy used in financial planning to spread risk. The goal is to make investments in a number of different asset classes, each with their unique risk reward characteristics, so that when one asset class is out of favor the other(s) will not be directly correlated and still maintain growth potential. It might be helpful to think of this like a teeter-totter. Ideally you will have one asset class on each end where they move in opposite directions. But the more similar the investments, the more they tend to move in the same direction until you have both investments on the same side. While they may move at different rates, they generally move in the same direction at the same time.
- Potential payback on drilling programs. The payback rate will obviously vary with the price, structure and success of the program. Returns are not guaranteed, of course. Because oil and gas are depleting assets with nothing left at the end, it is essential for potential investors to understand that their return of principal, or payout, comes back to them during the initial years of production. Then the declining yield curve will kick in, with diminishing returns each year. Many programs would be economically attractive if oil price would fall greatly though payoutback would take longer; make sure to study offering memorandum and the sensitivity studies with your advisors.
- Many investors choose a drilling program because of the generous tax benefits available. Most oil & gas investments have some tax benefits, while drilling has much higher benefits not available in the tax code to other types of investments. Details on tax benefits are found in the Tax section (can provide a link here)
Tax laws are subject to change without notice. Neither Kathy Heshelow nor CapWest Securities Inc., provide legal, tax or estate planning advice. For questions about a specific situation, please consult a qualified advisor.
What are reasons NOT to invest? What are general risks and caveats?
- Oil & gas investments can be volatile. Cash flows are tied to two main variables — the price received for, and the amount of, oil or gas produced and sold. The supply and demand curve, as well as the actual functioning of the wells, which includes both the cost of maintenance and the amount and quality of the production, affect cash flow. Price is affected by a myriad of issues; political, economic, weather, and supply-demand just to name a few.
- Type of ownership. There are several different types of ownerships (limited partnership, general partnership, LLC, etc.) that may be encountered, but one common type is as a general partner. In contrast to a limited partnership, where the liability is limited to the amount of the investment, a general partnership has no such limit to its liability. If the expenses exceed the income generated by the investment, a general partner may have to bring in additional money to fund the shortfall. A general partnership is not an appropriate ownership type for all investors.
- Risks tied directly to the sponsor/and or company in charge of drilling and operating the wells – their success will be your success. It takes more than high oil and gas prices to make money! Knowing the background and track record of the company – who you will be doing business with – is very important in the due diligence before choosing to invest.
- Drilling issues and other problems that can occur (i.e. a dry hole or uneconomic hole, delays due to weather, teams on the ground awaiting drilling rigs, etc.). Drilling programs that are in proven fields or next to producing wells are called development programs, and are considered less risky than experimental programs (‘wildcatting’).
- Oil and gas are depleting assets. Typically one invests, gains the cash flow and tax benefits, and owns the interest until the wells runs out or become uneconomical to produce. Typical life of an oil well can be 20 to 30 years, with declining returns after perhaps the first few years, depending on location and other factors. Sometimes the wells or property are put up for sale after a few years; others times they may not. Make sure you understand the “exist strategy” for any investment you are considering, if there is one.
- Relatively Illiquid. Some oil and gas shares can be sold or resold in an auction style situation, however, any investment that does not trade on a major exchange should be considered illiquid and long-term.
- External economic and political events affect oil and gas pricing and availability.
Because of this volatility, an investor should have a high risk tolerance. Among energy choices, there are varying degrees of risk: while all should be considered high in risk, royalty programs are generally more conservative while the most speculative are the experimental drilling programs (as opposed to developmental drilling).
What is a DPP?
A Direct Participation Program or DPP is an investment program designed to let investors participate directly in the cash flow and tax benefits of the underlying investment. Investors own a percentage interest or units in the offering or a share of the actual assets of an operating company, and receive directly the cash flow and tax benefits from their investment.
So for instance, if you buy an energy stock, you are a stockholder of the company but the actions, tax write-offs and net cash flow are all received by the company itself, not the stockholders directly (you can’t write off drilling costs on your own tax returns, for instance). The energy companies often reinvest profits back into development, exploration and growth, effectively giving away control of your profits. Not so in a DPP. The pooled investment monies are used for the program’s goals, such as drilling, extracting and then selling oil and gas for the cash flow, or acquiring producing wells or mineral rights with royalty payments. The advantage of this is that you get the benefits of being an owner without having to set up a company or become an oil expert, which is the role performed by the programs sponsor. You receive revenues, you directly deduct expenses, and you receive your tax benefits (depending on the type of program, these benefits vary). While each program has a stated investment goal, there is no guarantee the stated investment objective will be achieved.
DPPs are generally available only to accredited investors – that is, investors with a net worth of one million dollars (or salary of $200,000 alone or $300,000 with spouse), sold under what is called Regulation D. Suitability for any investment is also necessary.
Please explore this website and feel free to contact Kathy at your convenience with any questions. Toll free 866-891-1031
This is not an offer to buy or sell any security. Securities are only offered by PPM to accredited investors. Investments are highly speculative, subject to up-front fees and expenses that may impact investor returns and outweigh the tax benefits, are generally illiquid, the stated investment objectives may not be met, appreciation and income are not guaranteed and there is the potential for the loss of principal invested.
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