Energy programs, as investment vehicles, continue to attract investors. While the profitability of drilling projects might wax and wane depending on commodity prices, investors are finding many other ways to get into the game. Securitized ownership of infrastructure — pipelines, fracturing devices, etc. — is appealing to some investors. Energy programs sometimes help investors to lower their taxes, and experienced players are finding ways to reduce the financial risk of drilling.
Shale oil extraction has become safer and easier. Liquid natural gas offers various investment opportunities. Sustainable energy, and programs that might reduce carbon footprints, have their adherents among investors. In all, an investor determined to allocate funds to energy programs will find plenty of alternatives.
According to Matthew Iak, executive vice president and director of U.S. Energy Development Corp. (Arlington, Texas), capital raised for drilling programs is usually a function of the overall perception of pricing of the commodity. Investors get most interested in investing after the price of oil rises, typically above $80 per barrel (bbl), and the news media start focusing on that rise. In time, prices rise too high too fast; then the bubble bursts. Oil and gas drilling funds have historically been designed to make allowance for the nature of drilling, in which the big expense comes in the first year of a project. The economics work so long as prices stay within a reasonable margin or standard deviation from the price when drilling occurred — but if they drop below the drilling cost, the investment suffers permanent damage.
“Investing in direct drilling at the nadir of the market is also risky,” Iak says. “You will end up spending all that money drilling wells that are marginal, at low pricing, hoping for a quick recovery in price. If you are trying to time the market in a drilling program, you should look for pricing off the bottom, yet before markets are peaking again.” That is likely to be somewhere between $50/bbl to $85/bbl in today’s market.
Also, investors are looking at other ways to invest in energy besides drilling. In all, the number of ways to invest in energy programs, directly or indirectly, continues to grow.
Wallace Kunzman, an attorney with the firm of Kunzman & Bollinger (Oklahoma City), notes that drilling programs have gained popularity due to the elimination of some state and property taxes as federal deductions. In addition to intangible drilling cost deductions, drilling equipment can be depreciated in the first year of a drilling program, enhancing tax benefits.
“Drilling programs tend to be tax-driven,” Kunzman says. “But there are lots of ways to make money in oil and gas, creating value and selling at the right time. Upfront fees for IPOs are coming down; front-end costs are coming down; payouts to the investors, before the sponsor gets paid, are more appealing. Bottom lines have improved overall.” While traditional drilling funds will probably see continued popularity over the next few years because of good market conditions, energy funds with structures different from that of a traditional drilling fund will emerge.
Kunzman notes a tendency for investors to treat energy deals like real estate deals, but he is skeptical of that attitude. In energy, the asset is underground; exploiting it depends on scientific processes; its price can change fast due to various geopolitical factors. A sharp uptick in price can be good news, but a rise in costs will follow quickly, whereas if prices drop, it will take time for costs to readjust.
Bradford Updike, an attorney with Omaha-based Mick Law, notes that growth in the energy sector has been slow over the past two years. In 2016, the retail broker-dealer channel hit a low point, where only about $250 million was raised in syndicated programs. Last year, fundraising increased to about $330 million. By contrast, that channel was raising $700 million to $800 million annually, from 2012 to 2014. So, the sector is recovering — slowly.
“We see fewer opportunities today than five or six years ago,” Updike explains. “Back in 2012, we had 20 to 25 companies raising capital in the retail broker-dealer channel. Today, we have perhaps 10, due to companies going out of business when oil prices dropped to $30/bbl. The widespread use of leverage killed off many companies.”
Most of the retail energy capital, Updike says, is raised by drilling partnerships for tax planning purposes. These programs pass through intangible drilling cost deductions, which can amount to 75 to 85 percent of the investment. The depletion allowance shelters about 15 percent of an investor’s gross oil/gas revenue from federal taxation.
Also, mineral acquisition programs that utilize a direct title structure are seeing a decent level of interest from retail broker-dealers. Investors can go into these programs on a 1031 basis and use deferred asset gains from real estate to acquire interests in oil and gas minerals and royalties. Additionally, investors get to use depletion deductions, which again shelters 15 percent of royalty gross income from federal income taxes. Throw in the 199-A deduction, which allows a deduction for up to 20 percent of qualified business income from partnerships, limited liability companies, S corporations, trusts, estates, and sole proprietorships, and the picture looks favorable indeed for investment in energy.
However, aside from the competitive income tax benefits, drilling programs have been challenged from a performance perspective. This, Updike notes, is due to the difficulty in having to commence drilling within the first 90 days of the year following the investment, to accelerate the large intangible drilling cost deductions. On a positive note, the programs that spread out the drilling dollars over multiple years almost always outperform those that are chasing accelerated intangible drilling cost deductions. Updike urges investors to not let the tax tail wag the dog when considering the merits of a drilling program.
Many observers agree that traditional drilling deals have many weaknesses, and limited upside. Safer, more lucrative plays might lie in securities based on infrastructure: pipelines and fracturing devices. Long-term, investment funds may become more agnostic about the sectors in which they invest, and may look to snap up the operating companies that one expert describes as “walking dead,” waiting to be acquired or looking to get rid of noncore assets so they can operate within their cash flow. Such opportunities will remain if oil prices stay in the $50/bbl to $80/bbl range. If prices rise too fast, “stupid money” will enter the market, driving prices and risks higher still.
As for future opportunities, fossil fuel fundamentals will continue to drive demand for retail energy programs in the next few years. Renewable energy programs are best suited to investors in the very highest federal tax brackets, that can use tax credits immediately. The price of shale as a commodity is a concern, but shale drilling has become more of a manufacturing process than a drilling process, now that fracking techniques have become more sophisticated and safer. Liquefied natural gas appears to be a growing industry, with more countries signing on as importers of American LNG. In all, investment opportunities abound in the energy industry overall. Success is a matter of watching the market and choosing (or creating) the smartest vehicle.
By Joseph Dobrian
