“Formula for success: rise early, work hard, strike oil.”
—J. Paul Getty
2020 was a wild year for the oil and gas industry, to be sure! Circumstances brought a perfect storm of collapsed prices and demand.
About the same time the pandemic destroyed demand, Saudi Arabia and Russia got into a price war to see who could go the lowest. Prices edged down, from a high of $63.27 per barrel (WTI) in January to $20… $19… $18. Then, on April 20, the unthinkable happened: oil futures went into a free fall, finally bouncing at negative $37 a barrel.
“A barrel of oil is cheaper than the price of beer,” declared a CNBC headline. Demand had fallen so low, companies couldn’t give oil away! Instead, producers were paying tankers high fees to simply “park” oil temporarily.
What does that mean for oil investors—or potential investors now? Is oil still a good investment in 2021 and beyond?
Since 2020, crude oil prices have experienced a tremendous rebound. In February 2021, oil prices hit pre-pandemic prices of $60 a barrel. Similarly, natural gas prices, which bottomed out in April 2020, have rebounded.
So, is oil a good investment now? The short answer is “yes, it can be an excellent investment.” But first, let’s bust a few oil industry myths:
Myth #1: We’re running out of oil.
If you read the headlines in most newspapers, you might think that oil production and demand peaked a long time ago, especially with the rise in solar, wind, biodiesel and other green alternatives. The idea of “peak oil” as popularized by the influential “Club of Rome” consortium of industrialists, scientists, economists, and government officials turned out to be all wrong.
The Limits to Growth was published in 1972, an alarmingly pessimistic report based on MIT computer simulation of economic and population growth and resources perceived to be in short supply. The model predicted that all known petroleum reserves would be entirely used up by the end of the century at the same consumption levels. If consumption rates continued to increase, gas and petroleum would be gone by 1982.
What actually happened was that we got better at finding and extracting oil and gas! This was due to both improved technology and new discoveries. In the US alone, we now produce 28 percent more oil than during our previously accepted “peak oil production” era of 1970. Today, the US is the world leader in oil production, far outpacing #2 Saudi Arabia.
Myth #2: Alternative energy is where all the opportunity is!
The truth is that energy demands around the world are steadily growing, and this demand is being met BOTH by growth in alternative energy as well as oil and gas. For years to come, we believe energy will be a “both/and” game, not an “either/or” situation.
Alternative energy is an exciting, booming industry with tremendous growth potential. It is compelling for environmental reasons. It is also not without tremendous risk and costs, some of which have been born by taxpayers.
Some green energy technologies have shown themselves to be winners. The cost of solar and wind power continues to decline. Solar energy has proven itself so effective that its storage is also now a viable industry. Electric vehicles are common and desirable, which leads to the next myth:
Myth #3: Electric vehicles have decreased the demand for gasoline.
While energy sources are diversifying in the US and around the world—a positive trend, this has not decreased the demand for oil and gas. Oil consumption is still increasing—especially in countries such as China and India—and also in the U.S. As the chart below shows, demand for crude has steadily increased since 2006.
In spite of the rise of electric vehicles, the demand for all kinds of energy has only risen due to growth in population and rising lifestyles. Even as more people buy electric vehicles, we will always have a demand for oil due to plastics (made from petroleum) and trucks and heavy equipment that requires diesel. (The chart below from eia.gov does not cover the most recent quarter.)
Myth #4 Oil companies and investors can’t make money at $35 an barrel!
The truth is, companies in places like Texas ARE profitable even at $18 per barrel. However, the shale industry requires higher barrel prices to be profitable. We would not recommend investing in shale companies. But there is real opportunity even at current barrel prices!
How to Invest in Oil and Gas
Wouldn’t the stock market be the best way to have exposure to oil and gas?
Probably not. To motivate the country towards energy independence, investments receive significant tax incentives. In the oil and gas industry, this means that drilling costs—from equipment to labor—are up to 100% tax deductible. Oil and gas investments are an excellent write-off against income or gains in other areas. This makes oil a very good investment for many!
There are several ways to invest in oil and gas, and stocks would be our least favorite. Let’s look at three options and some of the pros and cons of investing in oil and gas with each:
Stocks and Mutual Funds
This could include ETFs, mutual funds, large or small-cap stocks. Stocks have limited upside for shareholders, as most of the profits are reinvested. Large companies and their stock prices can also be impacted negatively by oil spills and other negative press.
On the positive side, an oil-and-gas mutual fund or ETF offers some risk protection through diversification of companies. And if you don’t have a lump sum to invest with, investing through the stock market may be your only option.
Unfortunately, shareholders won’t get a major benefit of investing directly: the tax write-offs!
Equity Direct Participation Programs
An equity investment or Direct Participation Project (DPP) is the most profitable way for most investors to participate in oil and gas. A DPP is a non-traded pooled investment that operates over a several-year time frame and offers investors access to an energy venture’s cash flow and tax benefits. (Investors may also be familiar with real estate DPPs, which operate in a similar fashion and—like oil and gas DPPs—can participate in 1031 tax exchanges.)
A DPP typically funds oil and gas development in multiple wells. In the first year, the benefit for the investor is the tax write off, which can be upwards of 85% of the investment. After about the first 12 months, when the drilling is complete, investors begin to receive a monthly dividend. The returns can vary from very modest to very profitable, depending on success of the drilling. 15% of this income is tax exempt, and the remainder is treated as ordinary income. (Speak to your tax advisor.)
After about 5 years, the well package is then typically sold to a larger oil company. The profit from the sale is then distributed proportionately to the investors, and the returns are treated as capital gains.
Advantages of direct investments in oil and gas include asset class diversification, high profit potentials and the significant tax advantages. Risk can be somewhat mitigated through multi-well packages and experienced operators. However, investors must be aware of the disadvantages. Oil and gas investments are illiquid and speculative in nature. While returns can be significant, they can also be non-existent. Profitability is affected by oil prices. And investments in DPPs are available only to accredited investors.
Mineral Rights Leases
This is not an investment in oil and gas itself, but a private lending agreement that functions like a real estate bridge loan. Investors receive contractually agreed upon returns that can provide monthly cash flow. Investment time frames are usually between one and three years. Lump sums are required to participate in mineral rights leases.
Learn more about mineral rights leases in this podcast with Kim Butler: “Investing in Mineral Rights.”
Is Oil a Good Investment for You?
Do oil and gas belong in your portfolio? Direct investments in energy projects can bring substantial and nearly-immediate tax advantages, while diversifying investments and bringing potentially higher returns. Such benefits make oil and gas investments worth considering in your overall strategy.
Oil and gas may be a good investment for some, but not for others. There are there qualifications to be met, risks to be managed, and choices to weigh. The best investments in this space are for accredited investors only. Some investors prefer to invest their dollars towards greener alternatives, while others are attracted to the more proven track record of profits in the oil and gas industry.
You may have other questions about investing in oil and gas. Chances are, we have answers! Partners for Prosperity specializes in growing wealth outside of the stock market. Book a complimentary consultation today to learn more about hedging risk, increasing cash flow, and creating wealth that is not dependent on Wall Street risks!