“Formula for success: rise early, work hard, strike oil.”
—J. Paul Getty
It’s been a wild year for us all, and our industries have not been excluded from the craziness of 2020. In particular, the oil and gas industry is having a bit of a moment. And collapsing prices, which have not been as kind to other industries, are being met with high oil demand. So what does this mean for investors and potential investors? How do you invest in crude oil and gas in 2020?
The beginning of the year destroyed the demand for oil, since many were staying home, and then Saudi Arabia and Russia began competing for the lowest prices. In January an oil barrel was priced at $67.27, and began steadily dropping. On April 20th, oil futures began to freefall and oil was negative $37 a barrel. At that point, companies were having a hard time giving oil away.
Crude oil prices have slowly crawled back up from there, but still hover in the mid $30s, which is below the historical averages. Natural gasses have followed a similar trajectory, bottoming out in April and rising steadily. And like oil, the prices for gas still remain low.
All of this to say, investing in oil and gas looks to be like a solid move with low prices and increasing demand. Yet before any verdict, it’s prudent to look at all the factors. Let’s address the myths surrounding this particular industry.
Myth Busting: How to Invest in Crude Oil and Gas
Myth #1: Oil is disappearing
One of the most frequent conversations around oil and gas is the longevity of the industry. And if you keep up with news headlines, you’d be inclined to think that production and demand peaked long ago. The rise of green alternatives like wind, solar, and biodiesel have only further pushed that narrative. Yet the notion of “peak oil” has turned out to be all wrong.
An MIT study titled The Limits to Growth, published in 1972, shared a scarce view of our world’s resources. Through their simulation, it was predicted that we would run out of resources like petroleum by the 80s. The reality, however, has been much more promising. Scientists and engineers got better at finding and extracting these resources. The US alone produces 28% more oil than we did in our “peak production” era of the 70s. Today, the US is the world leader in oil production, far outpacing Saudi Arabia, the #2 oil producer.
Myth #2: There’s More Opportunity in Alternative Energy
Energy demands around the world are only growing–after all, so is our population and our needs. And this demand is being met by both alternative energy as well as oil and gas. For the foreseeable future, energy production is looking like a “both/and” situation, rather than an “either/or.”
There’s a lot of excitement in the alternative energy space, and the industry is continuing to thrive. There’s real potential for growth there, especially with its compelling environmental benefits. Solar and wind power have continued to decline in cost, making them exceedingly more viable.
Yet alternative energy carries risks and costs, some of which have been shouldered by taxpayers. Because of these risks, and the continuing unfoldment of the industry, gas and oil will continue to be a big player in our world’s energy production.
Myth #3: We’re Going Electric
With alternative energy has come an increasing demand for electric cars. And some would say that the rise of these efficient vehicles is going to undermine the demand for gasoline.
While the world’s energy sources are diversifying–an encouraging development–the demand for oil and gas is still strong. In fact in countries such as China, India, and the US, oil demand is increasing. The chart below illustrates the steady worldwide growth since 2006.
Daily Worldwide Demand for Crude Oil 2006-2020
This increasing demand, despite the introduction of electric vehicles, is likely due to continued population growth and lifestyle demands. Even as the demand for electric cars rises, petroleum contributes to the production of plastics, and trucks and heavy equipment need diesel to operate.
Myth #4: There Isn’t Money to Be Made at $38 a Barrel
In reality, companies in places like Texas are profitable even at $18 a barrel. The shale industry, however, is not profitable at such low prices. We would recommend avoiding shale investments for the time being, yet there’s real opportunity in oil and gas right now.
How to Invest in Crude Oil and Gas
Is the stock market the best way to have exposure to oil and gas?
Most likely, no. The US uses significant tax incentives as a way to motivate our country to energy independence. And we mean significant–drilling costs, from equipment all the way to labor, are up to 100% tax deductible. These investments make excellent write-offs to balance out any income or gains you may have elsewhere. Investing through stocks does not allow you to partake in these deductions, and exposes you to increased volatility. Learn more about risk mitigation from our blog post on investing.
So what are the alternatives? Let’s look at the pros and cons.
Equity Direct Participation Programs
Also called an equity program or a direct participation project (DPP), this is the most profitable way to invest in oil and gas. This type of investment is a non-traded, pooled investment that spans a few years. This gives investors access to a venture’s profit and tax benefits.
DPPs typically fund multiple wells. In the first year, the investor’s biggest upside is the tax write off, which is upwards of 85% of the investment. Once the drilling is complete, in the following 12 months or so, investors receive a monthly dividend. 15% of this income is tax exempt, and the remainder is subject to ordinary income tax.
After 5 years, the venture is often sold to a larger oil company, and the profits shared amongst investors. This profit is taxed as capital gains.
Pros:
- Asset class diversification
- High profit potential
- Substantial tax advantages
- Risk mitigation is not overly complicated
Cons:
- Returns are speculative
- Profit determined by oil prices
- Opportunity available only to accredited investors
Mineral Rights Leases
Though not a direct oil and gas investment, you can think of this like a real estate bridge loan. Investors will receive contractually agreed upon returns on a monthly basis. The interest rate is more significant than what you may see in other vehicles. The time frames are usually between one and three years, and lump sums are required to participate.
Pros:
- More certainty of returns
- Monthly cash flow
- Capital not tied up for long periods
Cons:
- Available only to accredited investors
- No tax benefits (100% taxable as ordinary income)
Should You Invest in Crude Oil and Gas?
Oil and gas can be a profitable portion of your portfolio, and function even better in a diversified portfolio. Direct investments in energy can provide immediate benefits, such as high returns and tax advantages. It’s worth considering in your overall strategy.
The biggest consideration when it comes to investing in gas and oil is that there are qualifications to be met, risks to mitigate, and choices to navigate. The stock market is accessible to most anyone, yet the most profitable and advantageous energy investments are for accredited investors. In some cases, you may prefer to invest in greener energy. Some people like the appeal of the oil and gas industry’s track record.
If you find yourself with more questions, or are interested in diversifying your portfolio, we have a network of financial professionals who are dedicated to growing wealth outside of the stock market. Contact us today to be put in touch with a Prosperity Economics Advisor.
