Oil and Gas Investment Partnerships, 3: Questions and Answers

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

Note: To receive sophisticated tax advice suitable to your situation, please consult with your investment advisor, accountant or tax lawyer. This column does not present expert tax advice.

Q. For what sorts of investor might an oil and gas drilling partnership be suitable?
A. These are partnerships designed to bring together sponsors with experience in oil and gas drilling with investors seeking to participate in the risks and rewards of drilling. They are most suitable for accredited individual investors paying US income taxes in a high marginal tax bracket and who have ample financial liquidity set aside.

Q. What is an accredited individual investor?
A. An individual with at least $1 million in net worth (alone or together with spouse) or $200,000 in annual income ($300,000 if filing jointly with spouse). (For greater detail, please visit: Definition of Accredited Investor, at SEC Website).

Q. What kind of drilling risk does such an investor take?
A. There are broadly, three kinds of drilling partnerships, depending on the goal: exploratory, developmental and mature. Exploratory deals take the most drilling risk; mature deals the least. For many investors, development deals offer the best mix of risk, reward and tax benefits.

Q. What kinds of geological risks are faced by investors in a developmental deal?
A. One particularly favorable set of risks involves “fully blanketed formations,” where drilling is adjacent to, just above, just below, or sandwiched between known pockets of oil and gas. In many such efforts, the risk that any single drilling will result in a dry hole is estimated at less than 5%. Geographical diversity of drilling lessens aggregate risk. There is potential environmental cost, including water treatment and land reclamation. Another favorable set of risks involves drilling within a limited region whose perimeters include productive wellheads.

Q. What are the potential tax benefits of such partnerships?
A. The tax benefits include deductions for intangible drilling costs (IDC’s), tangible drilling costs, oil depreciation allowance, and write-offs for abandoned wells (if any, minus salvage value). Most exploratory and developmental deals offer opportunities to take tax deductions of about 80% of total invested amount in the first year of investment. Such investment must be made by December 31st of the tax year to qualify. Partnership income is generally excludable from taxes, in part, under the oil depletion allowance and other provisions of the tax code. Investors must take heed of the Alternative Minimum Tax (AMT) in relation to the intangible drilling costs, if taken all in the first year rather than capitalized over five years; however, there is a 40% safe harbor exclusion.

Q. Why are these tax benefits available?
A. Such benefits, including the Mineral Depreciation Allowance, have a long legislative history. Broadly speaking, Congress intended to encourage extraction of domestic mineral resources. In recent years, this has been reinforced by a desire to reduce our dependence on imported oil and gas. Oil and gas drilling by independent producers (and their investment partners) has been particularly favored in its tax treatment. Such officially sanctioned tax incentives, properly employed, should be distinguished from abusive tax shelters based on gimmicks and supposed “loopholes” in the tax code.

Q. What category of partnership risk does the investor take?
A. If the investor is seeking to offset passive income, such as from rents, the investor may go in as a limited partner from the start; risk is limited to loss of investment. If the investor seeks to offset ordinary income, or portfolio income, then the investor must go in as general partner and face unlimited liability. However, in many deals of this sort, there is provision for conversion from general to limited partner status after an initial interval has passed, such as one year. Most investors go in initially as general partners.

Q. What other partnership risks does the investor take?
A. There are potential conflicts of interest for the sponsor between its role as managing general partner of the partnership and its role as acquirer of leasehold interests, seller of drilling services or supplies, receiver of certain fees and interests upfront, and sponsor of other activities or transactions. There are also issues of partnership governance and the typical problems faced by minority investors in any entity.

Q. Where can I find disclosure of the risks and rewards of an oil and gas partnership?
A. The definitive source of information is contained in the Private Placement Memorandum (PPM). This document will include or be accompanied by a Subscription Agreement, if you should decide to invest. Do not rely on oral representations.

Q. How do I recover my investment?
A. A portion of the recovery may come from tax benefits, including IDC’s received in Year One. Payout from oil and gas drilling is more or less predictable depending on the nature of the risk taken: exploratory, developmental or mature. Most development style deals experience “payback” of initial investment (in nominal terms) within three to five years, but of course this is not guaranteed. Residual payout may continue up to 20 years; the so-called “decline curve” varies from deal to deal and is not entirely predictable.

Q. What characteristics distinguish a high quality sponsor?
A. One of the most important characteristics of a highly qualified sponsor is a track record of successful past deals, with attractive returns shown over time for investment partners. Be wary of the risk of bogus or fraudulent transactions by unknown or unreliable sponsors. Investigation, expert advice and due diligence are essential.

Q. How do I understand the risk presented by fluctuating commodity prices?
A. The price of oil and gas, and the percentage of each produced, will directly affect the dividend payout (usually monthly) to partners from successful production. The Sensitivity Analysis, which should be found in the PPM, shows in tabular form how the investor’s rate of return on investment will likely be affected by such fluctuations.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

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