Oil and gas limited partnerships come in several forms, each with its own benefits and risks. Even so, many oil and gas programs aim for the same two outcomes: potential profits and tax advantages.
Intangible drilling costs (IDCs) are tax-deductible expenses that support drilling activities but aren’t tied to the physical drilling equipment itself. These costs can include fuel, moving and setting up drilling equipment, and wages paid to employees involved in locating oil. Many IDCs are incurred while transporting and repositioning equipment during the search for natural resources. In the first year of operation, limited partnerships can typically write off these costs and pass the deductions through to the limited partners (passing through losses).
Depletion allowances provide another tax benefit. The IRS allows a tax deduction for each barrel of oil removed from the ground. This deduction is intended to offset the declining income potential as an oil well’s reserves are depleted.
There are three general types of oil and gas limited partnerships: income wells, developmental wells, and exploratory wells. Each has a different risk/return profile and different levels of IDCs and mineral rights costs.
Income wells, also known as stripper wells, invest in proven oil wells. If the general partner purchases a well that has already been producing, the investment generally involves less uncertainty than drilling in an unproven area. The main risk is that the well may be closer to running dry.
Because the landowner knows oil exists on the property, the mineral rights (fees charged by the owner of the land) are typically high. Those costs may be offset by the value of the oil produced. Income wells are generally lower risk with lower return potential, and they usually have little to no IDCs. Since the well already exists, there’s typically no need for significant IDC spending.
Income (stripper) well summary
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 might purchase drilling rights a mile or two away, expecting that the oil field extends beyond the currently producing site.
Developmental wells require IDCs, but they’re usually lower than in exploratory projects because drilling occurs near a proven well. Mineral rights (fees charged by the owner of the land) are generally lower than for income wells because oil hasn’t been proven on the specific drilling site. Developmental wells are typically intermediate risk, with mid-level return potential, and some IDCs.
Developmental (step-out) well summary
Exploratory wells, also known as wildcat wells, invest in drilling projects in unproven areas. These projects may be far from established oil fields and are undertaken in hopes of discovering new reserves.
IDCs are typically high because equipment may need to be moved and repositioned multiple times before oil is found (if it’s found at all). Mineral rights (fees charged by the owner of the land) are usually low because oil has never been proven in the area. In most cases, oil isn’t found, but exploratory wells can be very profitable when they are successful. Wildcat wells are high risk, have the potential for high returns, and can involve significant IDCs.
Exploratory (wildcat) well summary
When an oil and gas limited partnership is formed, investors (potential limited partners) should review the agreement of limited partnership. This document explains the partners’ rights, duties, and restrictions. It also spells out the relationship between the general partners (GPs) and the limited partners (LPs), including how cash flow and income are distributed. Several common arrangements are important to recognize:
Functional allocation
Reversionary working interest
Disproportionate sharing
Overriding royalty interest
In conclusion, DPPs offer a different way to invest in a business, with returns often tied closely to tax treatment. Because these securities can offer tax benefits but tend to be illiquid, they’re generally suitable only for wealthy individuals seeking tax benefits who can tolerate being unable to sell the investment for long periods of time.
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