Have you ever wondered what they are or whether they are an appropriate investment for you?
An oil and gas partnership is a direct investment in exploration and production for energy resources. These investments have minimum net worth and income thresholds, although do not generally require accredited investors. Investors typically receive monthly cash distributions (these are not guaranteed) that will continue as long as there are productive wells, years into the future.
Oil is a true global commodity, subject to supply and demand fundamentals, as well as geopolitical risks. Natural gas tends to be more impacted by local supply and demand characteristics. Currently, we are more favorably disposed toward gas-related projects over oil-related ones, with oil currently trading around $90 per barrel and gas trading around $7 per million BTU. The BTU conversion factor is about 6:1.
Approximately 85% to 90% of the investment can be written off in the form of intangible drilling costs (IDC) in the first year of investment, plus future write-offs in the form of ongoing depletion allowances. As long as the IDCs do not reduce AMT income by more than 40%, they are not considered a preference item. Your investment will be reported to you each year by early March on Schedule K-1. Unless you can take full advantage of the associated tax benefits, the rates of return may not make sense for you to invest. Check with your accountant to discuss your particular tax situation first.
These are illiquid investments; generally you cannot sell for the first five years (sometimes longer) after your investment. Other risks include: (1) Variability of the commodity price. The price of oil and/or gas during the first few years are critical to determining overall investment returns, as this is the period of ‘flush’ production. (2) Most partnerships are structured that the investor is a general partner for the first year or more, which allows them to deduct the IDC on their taxes. However, this also means you have unlimited liability for the partnership activities (possibly mitigated by liability insurance). After that time, investors are converted to limited partners and their loss is restricted to the amount invested. (3) Not all wells are likely to produce sufficient oil and gas to be economic and dry holes are also possible.
The key is to find an investment company with a good track record of drilling and completing wells. Be aware of what portion of production is hedged into the future to determine how price sensitive the partnership income is likely to be.
An alternative to illiquid oil and gas partnerships are MLPs, which are structured like a real estate investment trust (REIT), in that they do not pay income taxes and investors receive favorable tax treatment as well. Dividends are taxed at the qualified rate of 15% under current tax rules. The remaining distribution is considered return of investment principal and will reduce your cost basis
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