Oil & gas

Oil and gas limited partnerships come in various forms with different benefits and risks. Regardless of form, many oil and gas programs seek the same goals. Intangible drilling costs (IDCs) are tax-deductible expenses that are not associated with actual drilling. These costs include fuel, relocation costs of the drilling equipment, and employee wages related to discovering oil. Many of these costs relate to moving drilling equipment while trying to find natural resources. In the first year of operation, limited partnerships can fully write off these costs and pass them through to the limited partners (passing through losses).

Depletion allowances also provide a tax benefit. The IRS provides tax deductions for every barrel of oil pulled from the ground, which are used to counter losses of income when an oil well begins to run dry.

There are three general types of oil and gas limited partnerships. We’ll discuss income wells, developmental wells, and exploratory wells. Each comes with unique risks and benefits.

Income wells, also known as stripper wells, are investments in proven oil wells. If the general partner purchased an oil well that has been producing, there isn’t much risk involved. While the oil well may be inching closer to being exhausted, it’s a less risky venture than drilling for oil in unproven areas and not finding it. Because the landowner knows there is oil in the ground, the mineral rights (fees charged by the owner of the land) are fairly high. These costs can be offset by the value of the oil pulled out of the ground. Income wells are generally low risk, and have the potential for low returns, with little-to-no IDCs. As the well already exists, there is no need to spend money on IDCs.

Income (stripper) well summary

• Obtaining oil from existing wells
• Low risk and reward potential
• Low or no IDCs
• High mineral rights

Developmental wells, also known as step-out wells, invest in drilling projects near proven oil wells. For example, if oil is found in a remote area in Wyoming, the general partner may pay for oil drilling rights a mile or two down the road in hopes that oil can be found near the proven well. IDCs need to be spent, but they are fairly low as the general partner is staying close to a proven well. Mineral rights (fees charged by the owner of the land) are less than income wells as oil hasn’t been proven in the drilling area. Developmental wells are intermediate risk, and have the potential for mid-level returns, and some IDCs.

Developmental (step-out) well summary

• Search for oil near proven areas
• Moderate risk and reward potential
• Moderate IDCs
• Moderate mineral rights

Exploratory wells, also known as wildcat wells, invest in drilling projects in unproven areas (sometimes in the middle of nowhere). This type of well is known for drilling in unproven areas in hopes of striking oil. IDCs are high as equipment typically needs to be moved multiple times to find oil. Mineral rights (fees charged by the owner of the land) are low as oil has never been found in the drilling area. In most cases, oil isn’t found, but exploratory wells are very profitable if they do. Wildcat wells are high-risk, have the potential for high returns, and can have significant IDCs.

Exploratory (wildcat) well summary

• Search for oil in unproven areas
• High risk and reward potential
• High IDCs
• Low mineral rights

When an oil and gas limited partnership is formed, it’s very important for investors (potential limited partners) to look at the agreement of limited partnership, which details the rights, duties, and restrictions of the partners. In particular, the agreement will detail the relationship between the general partners (GPs) and the limited partners (LPs) in terms of who gets paid and when. There are a few key arrangements to be aware of:

Functional allocation

• GPs liable for tangible drilling costs
• LPs are liable for IDCs (and get deductions)
• GPs and LPs share revenue

Reversionary working interest

• GPs not liable for any expenses
• GPs do not collect revenue until LPs regain invested money

Disproportionate sharing

• GPs are liable for a small portion of expenses
• GPs keep a larger portion of revenue

Overriding royalty interest

• Typically non-partners (land owners, geologists, and brokers) help the partnership
• No liability for expenses
• Obtain a small portion of revenue immediately

In conclusion, DPPs provide a different way of investing in a business. Investors are more closely aligned with their DPP investments, especially from a tax perspective. With the tax benefits and low liquidity of these securities, they are only suitable for wealthy individuals seeking tax benefits that can withstand the inability to sell their investments for long periods of time.