Investing in Oil & Gas: Kathy Heshelow

General Types of DPP Offerings in Oil & Gas

The Securities Act of 1933 defined ‘securities’ to include any profit sharing agreement, investment contract or fractional undivided interest in oil, gas or mineral rights. Hence oil and gas programs are sold as securities, no matter how the basic structure is set up (Limited or General Partnership, LLC, etc.).  So, you will need to work with a securities broker-dealer and one of their registered reps to help evaluate and choose your investment.  According to the Oil & Gas Financial Journal, more than $696 million was invested into private placement drilling programs in 2005.

These offerings will always have disclosure documents – or they should!! -  key of which is the private placement memorandum (PPM).  The sponsor and their background, the structure of the deal including proformas, and other key information about the investment offering will be included.  If you want to refresh your memory about Private Placements in securities, click here.

What are some of the programs?

Drilling programs are perhaps the most popular among the offerings, and the more numerous. They are chosen by investors who want a tax write off (in the year of investment), and who would like to see some potential increased cash flow in subsequent years (after the wells are drilled and producing). As a rule of thumb, if you invest in a Drilling Program, you will probably not receive any income for at least 6 months to a year, while the wells are being drilled and brought online.  In exchange, however, you are able to gain tax write-offs in year one. Thereafter, you will be able to claim depletion on the income (if any) generated from the wells.

Before investing in a Developmental Drilling program, understand where the drilling is to occur – is it in an area of proven reserves and/or next to producing wells? ?  What does the engineering report indicate? It is shallow drilling (usually 3,000 to 5,000 feet); or perhaps deep drilling in the Gulf of Mexico (which is more expensive and riskier)?  How are the proven wells performing?  What is the expected (conservative estimate) amount of barrels per day, and how and at what price are the estimates based? One of the more important aspects is the sponsor of the offering. What is their experience and track record, how is their organization set up? Their success will be your success.  Keep in mind that a track record isn't a substitute for review of each program, but the sponsor’s track record is a reasonable demonstration of their past management and technical success.

Look for a group of wells in an offering – rather than investing in the drilling of just one or a few wells. There is not enough diversity and more risk. For instance, if one of the two wells failed, 50% of your investment is not producing any revenue.

Working Interest programs with producing wells are chosen by investors who desire cash flow immediately.  Obviously, the tax benefits from the drilling are not present, but the immediate cash flows can be and the depletion allowance is.

Potential investors in any oil and gas program should understand that they are typically paid 60 to 90 days after the oil or gas is pulled from the earth and sold.  So when prices fluctuate, you don’t see the change (either up or down) immediately in the current month’s distribution.

Some investors like an offering that combines working interests (current cash flow) and some drilling (some tax benefits and potential upside longer term).

Rework Offerings are sometimes found as a program by themselves or in combination with working interests or drilling.  Reworking the wells usually means cleaning, flushing or repairing an existing well to bring better functionality and production, and hence more income.  Sometimes large companies will come in, drill and extract, and then move on.  Smaller companies can pick up these wells and make them more profitable by cleaning and repairing them.  Sometimes, wells are owned by smaller ‘mom & pops’ who cannot afford the expenses of reworking.

Some considerations include, the age and expected life of the wells, the engineering reports, and understand who the sponsor is along with their track record in the business.

Royalty programs used to be more common, but the prices to acquire them and to make them work for investor cash flow expectations has become more difficult.  There are few pure royalty programs these days.

Royalties are funds received by the land owner from the oil company for the production of oil or gas, net of costs except taxes.  Because royalty programs and some drilling/working interest programs involve land leases (royalty ownership or working interest ownership), considered “like kind” property, occasionally they are structured and offered as a 1031 tax-deferred exchange.

Note - if you conduct a 1031 exchange from real estate into an oil and gas program, you will not be able to roll back out into real estate if the oil and gas program is sold later (full circle deal) without incurring recapture taxes.  If you exchange into an oil or gas program, you should expect to stay in an oil and gas investment with those funds.  Always consult a CPA!

When reviewing a program, look at the estimates of production and the price on which they are based.  Refer to the engineering reports and data – make sure they are provided. 

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.

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.