Investment in Oil and Gas Considered Amongst The Best for 2018 Year End Tax Deductions

Investors participation in oil and gas partnerships has reached a multi year high in 2018 primarily due to sustained rise in prices, but also due to capitalizing on large deductions in the year of the investment. Considered one of the top tax advantaged investment, oil and gas partnerships not only offer large deductions but also provide the opportunity to receive tax advantaged investment income.
However, the investment has to be made by December 31st for the investor to receive the tax benefit in the year of investment. The investor should consult their tax advisor to determine their tax liability for the current year and the characterization of the income that caused the liability: passive or non-passive income. Investors should consider their risk tolerance for such a tax-advantaged and illiquid investments though with deductions up to 100% of their investment, investors can easily offset the risk thru tax savings.
Lawmakers in our effort to achieve energy independence added to the Internal Revenue Code incentives to make drilling for oil and gas a very favorable taxable event with such an investment very tax-favored – intangible drilling costs, functional allocation exception to the passive loss rules, alternative minimum tax, and the depletion allowance leading the way.

Intangible Drilling Costs

When wells are drilled, the costs associated with the drilling are divided into two types: tangible and intangible. Tangible costs are defined as a salvageable part of the drilling costs and are depreciated over seven years. Intangible costs are the remainder of the costs incurred to drill and complete a well. Such costs include, but are not limited to, labor, chemicals, grease, fuel, supplies, and other necessary costs for drilling a well, and preparing it for production. Based upon the drilling program, the intangible drilling cost may range from 70-85% of the total cost to drill and complete a well.

Functional Allocation

The amount of tangible and intangible drilling costs allocated to investors is based upon each drilling program. In some programs the investor may receive 100% of the intangible drilling costs and no tangible costs. In other programs the investor may receive 80-90% of the IDC’s and an allocation of the tangible drilling costs. The drilling programs do this based upon partnership accounting that allows a disproportionate allocation of revenue and expenses between partners. The Internal Revenue Code requires the allocation to withstand an economic viability test that requires value be traded for equal value.

Deductibility of Intangible Drilling Costs

When the investor decides which drilling program to invest in, he receives an allocation of IDC’s – for example 80, 90, or 100%. At this point the investor has options as to when to deduct the IDC’s. An investor may deduct 100% of the allocated IDC’s in the year of investment. Or, the investor may choose to amortize the deduction over 60 months, or may elect to deduct part of the IDC’s in the year of investment and capitalize and deduct the remaining IDC’s over a 60 month period. As you can see, there is great flexibility for the investor. The drilling partner’s obligation is to start, or spud, all the wells within 90 days following the end of the year of investment. This makes the IDC’s deductible in the year of investment. At this stage we have touched on intangible drilling costs, functional allocation, and timing of the deduction.
A quick example may help: cost to drill and complete a well, $1,000,000. Amount of cost that are intangible: 85%. Total intangible drilling cost: $850,000. IDC’s allocated to investors: 100%. Total IDC’s allocated to investors: $850,000.

Exception to passive loss rules

An investment in a drilling partnership would typically be in the form of a limited partnership. This would be considered passive activity in that the investor does not materially participate in the operations in a substantial manner. Accordingly, this investment would only be deductible against passive income. However, there is a major exception to the passive loss rules. By holding an oil and gas working interest in an entity that does not limit liability (general partner) during the drilling and completion phases, the investor may take the IDC deduction against non-passive income (earned or portfolio income). This exception to the passive law rules opens up huge opportunities to reduce non-passive taxable income. In most programs investors who elect to be a general partner are converted to a limited partner when all the wells have been completed, as determined by being placed into production. However, if the investor has passive income they can elect limited partner status and receive the benefit of the IDC deduction against their passive income. Hence, you can have your cake and eat it, too!

Alternative Minimum Tax (AMT)

One of the major questions I receive is how AMT figures into the IDC deduction. By regulation, IDC deductions are not tax-preference items. However, if an investor reduces Alternative Minimum Taxable Income (AMTI) by more than 40%, AMT will be triggered. If the investor elects to amortize their IDC deduction over 5 years, none of this will be considered excess IDC’s. When an investment is made in a drilling partnership the investor must monitor his AMTI.

Depletion Allowance

When the wells the investor owns begin profitably producing, the investor will receive income from the wells. This income will be partially sheltered with a depletion allowance. The current depletion percentage is 15%. Accordingly, for each $1,000 an investor receives, $150 would be tax-free.

Summary

As you can see, an investment in an oil and gas drilling partnership is a very tax-advantaged investment. Additionally, with global production nearing peak levels while global demand continues to rise, its a mathematical certainty that unless production output dramatically increases, the world will soon witness a global oil shortfall with prices reaching levels not seen since 2008 when oil reached $147 per barrel.

WTI $76.47 Target Achieved, Where to Next?

West Texas Intermediate(WTI) ($76.37)

Technical Outlook

West Texas Intermediate reached the $76.47 target cited in our January 2018 and March 3, 2018 today with an intraday high of 77.06 and closed today at $76.37. This level found bids in 2011-2012 when prices ranged $74.95-112.56 for several months before a downside break of this $75 level in Nov 2014. Look for offers to initially limit the upside as witnessed during the first week of July 2018 when prices reached $75.37.  However, after testing offers at $75 last July, prices eventually moved lower to challenge bids at $64.58 which is just a few cents above the 200 month simple moving average. As to the upside, look for daily prices to open above $77.06 and close higher followed by a weekly open and higher close above $77.06 to confirm further price rise is once again under with $88.67 as the next upside target. As to the downside, $57.46 remains as key mathematical support while the recent $77.06 limits the upside as a daily open and lower close below $57.46 followed by a weekly open and lower close will complete the rise from the Feb 2016 low of $25.75 at $77.06 with further price decline to test bids at $51.41. The more probable outlook with a 77% probability will be a sustained break of $77.06 for $88.67 target. Above this level will witness a 93% probability of prices continuing higher to $105-108 in the months ahead.  More on that outlook later as this scenario unfolds.

Fundamental Outlook

Global demand by rapidly developing and technology driven expanding emerging economies is the primary reason for sustained oil prices as this coupled with global production currently at 92% of capacity will continue to witness rising prices into the months ahead.  The vast majority of the world economies are emerging as opposed to the advanced economies such as USA, Canada, Japan, France,  UK, Germany, Italy,   These emerging economies have average growth in Gross Domestic Product (GDP) of 6% per year for the last five years with the top emerging economies averaging over 10-15% per year since 2013. (GDP is the total goods and services produced by an economy in a monetary measure.) And all  these economies need oil and the three largest producers of oil in the world are the United States, Saudi Arabia, and Russia. Current global consumption is approximately 100 million barrels per day with current global output essentially the same. Consumption Forecast for 2019 are 104 million barrels per day and the current maximum capable production of oil in the world from all sources at 100% utilization is approximately 107 million barrels a day. Do the math, the world is nearing a global energy shortage. Oil is used to run the power plants which produce most of the world’s electricity. The world is on a razor thin margin between surplus and deficit. Unlike the great wealth transfers from the oil booms of the 1970’s. 1980’s and 1990’s where the middle east was the beneficiary, this time it will be the Untied States and it’s oil producers and partners.

Ronald Welch, Research Analyst

ron.welch@vipercapitalpartners.com

cactus in Texas

West Texas Intermediate (WTI) Technical Outlook

West Texas Intermediate(WTI) (69.01)

Short Term Outlook– WTI achieved $75.38 last month, just about a buck shy of the $76.47 target from our January 2018 forecast and restated in our Mar 3, 2018 forecast. Short term prices at this writing showing evidence to move lower as daily prices have opened and closed below the 20 day moving average (69.65) though remaining above the 200 day moving average since Sept 2017.  Key mathematical support comes in at 63.95 and the 200 day moving average at 64.16, as these levels found bids in June with institutional buying and futures traders bids moving prices to the 2018 high of 75.38 in July.  To the downside, look for daily prices to open and close below 63.95 to support further price decline to 60.42 as a daily open and lower below 63.95 followed by a weekly open and lower close will complete the rise from the September 2017 low of 45.48 at the 2018 high 75.38 and risk further price decline to 56.90 with probability of price consolidation within a 56.90-63.95 zone.

As to the upside, only a daily open and higher close above 75.38 will support further rise to our 2018 target of $76.47 and higher.  More on this outlook as it unfolds..

Medium Term and Long Term Outlook-Both the medium term and long term models support continued prices rise in WTI into the months and years ahead as both models confirming 77% probability that prices will witness 108.11 (2014 high)  before 25.75 (2016 low), though this %  probability will dramatically improve as weekly and monthly prices open and close above the following mathematical levels resulting in the subsequent probability % outcome, 76.47 (83%), 88.32 (93%). In other words, weekly prices and monthly prices opening and closing higher above 88.32 will result in a 93% probability that prices will move to 108.11. However, until such a break occurs,  both the medium term and long term models support a broad range of 45.08-88.32 into the months ahead and a short term range of 56.90-75.38.   ONLY a sustained move outside either range will witness continued price move in the direction of the range break. More details on this scenario once the breakout occurs.

Fundamentally speaking, what is supporting our mathematical model continues to be the rapidly developing and expanding emerging economies. The vast majority of the world economies are emerging as opposed to the advanced economies such as USA, Canada, Japan, France,  UK, Germany, Italy,   These emerging economies have average growth in Gross Domestic Product (GDP) of 6% per year for the last five years with the top emerging economies averaging over 10% per year since 2013. (GDP is the total goods and services produced by an economy in a monetary measure.) And all  these economies need oil and the three largest producers of oil in the world are the United States, Saudi Arabia, and Russia. Current global consumption is approximately 100 million barrels per day with current global output essentially the same. Consumption Forecast for 2019 are 104 million barrels per day and the current maximum capable production of oil in the world from all sources at 100% utilization is approximately 107 million barrels a day. Do the math, the world is nearing a global energy shortage. Oil is used to run the power plants which produce 80% of the world’s electricity. The world is on a razor thin margin between surplus and deficit.

Unlike the great wealth transfers from the oil booms of the 1970’s. 1980’s and 1990’s where the middle east was the beneficiary, this time it will be the Untied States and it’s oil producers and partners. Oil prices are going higher and it will dramatically change our way of life in the future.

 

mountains and skyline view

Appalachian Basin Forecast to Become United States Most Profitable Petrochemical Region

US Department of Energy (DOE)  Secretary Rick Perry recently testified before the US House of Representatives Committee on Appropriations that DOE is actively working on plans to transition Appalachia into a petrochemical refining center with investment in the region a priority for national security.  Perry further explained the Appalachian region “makes sense because you’re sitting on top of the Marcellus and Utica which are prolific gas fields, and helping transition the workers who are either out of work or not working in jobs that are satisfactory from their perspective into higher-paying refining and petrochemical type jobs. That is a something we’re working on actively today at DOE.”

In recent months there has been a growing body of research on the advantages the Appalachian Basin petrochemical industry has over the Gulf Coast region.  These advantages include abundant natural gas, access to water, proximity to markets, skilled labor and cost advantages all exceeding that of the gulf coast region.

Natural Gas

The Appalachia Basin sits atop the Marcellus and Utica Shale formations, two of the most prolific shale plays in the world.  Natural gas from the Marcellus and Utica shale plays accounted for approximately 30% of total U.S. natural gas production in 2017, and is expected to account for more than 40% of the nation’s production by 2030

Water

The Appalachia Basin provides ample room for large manufacturing complexes, but still provides convenient access to large waterways, such as the Ohio River and its many tributaries.

Proximity to Markets

Businesses in the Appalachia Basin have a significant geographic advantage over Gulf Coast due to the following:

  • Within one day’s drive to 50% of high-demand North American markets
  • Within one day’s drive to 70% of polyethylene demand
  • The lowest natural gas prices within the developed world

Skilled Labor

With one of the lowest employee turnover rates in the country, the Appalachia Basin has world-class workforce, combining a storied history of manufacturing and a world-renowned, forward-thinking plastics manufacturing industry

Cost Advantages

Appalachian Basin has dramatic cost advantages over the Gulf Coast region with availability ethane, ethylene and  polyethylene at cost of on average 23% less than that in the Gulf Coast region. These and other cost savings simulated over a period of 20 years, from 2020 to 2040, result in a net present value cash flow advantage of $713 million, or a pre-tax cash flow advantage of $3.6 billion or 4 times the savings of that in the Gulf Coast region.

These advantages over the Gulf Coast region will move the Appalachia Basin and region into a unprecedented growth in all areas of the region as the Untied States remains the worlds leader in natural gas and oil production.

 

$100 bills

Primary Tax Benefits of Investing in Oil

There are several major tax benefits available to oil and gas investors which makes this investment unique above all others. U.S. tax codes favor investment in energy resources and oil and gas leads the way with a catalogue of incentives for investors as well as oil producers. Below are just a few of the key incentives.

Primary Tax Benefits of Investing In Oil

  1. Intangible drilling cost:
    These include everything except the actual drilling equipment. Labor, chemicals, mud, grease, paraffin, and other miscellaneous items necessary for drilling.  These expenses generally constitute 65-80% of the total cost of drilling a well and are 100% tax deductible in the year incurred. So, a million dollar investment could deduct approximately $800,000 right away, which would generate a net tax savings of approximately $280,000 in year one (assuming a 35% tax bracket), reducing the net investment by 28%. Furthermore, it doesn’t matter whether the well actually produces or even strikes oil. As long as it starts to operate by March 31 of the following year, 100% of the deduction will be allowed, otherwise prorated on starts after March 31 of the following year.
  2. Tangible drilling costs: Tangible cost are those directly related to the cost of the drilling equipment. These expenses are also 100% deductible, but must be depreciated over seven years. Therefore, in the example above, the remaining $200,000 could be written off according to a seven-year schedule.
  3. Active vs. Passive Income: The tax code specifies that a working interest (as opposed to a royalty interest) in an oil and gas well is not considered to be a passive activity. This means that all net losses are active income incurred in conjunction with well-head production and can be offset against other forms of income such as wages, interest and capital gains.
  4. Small Producer Tax Exemptions: This is perhaps the most enticing tax break for small producers and investors. This incentive, which is commonly known as the “depletion allowance,” excludes from taxation 15% of all gross income from oil and gas wells. This special advantage is limited solely to small companies and investors. Any company that produces or refines more than 50,000 barrels per day is ineligible. Entities that own more than 1,000 barrels of oil per day, or 6 million cubic feet of gas per day, are excluded as well.
  5. Lease Costs: These include the purchase of lease and mineral rights, lease operating cost and all administrative, legal and accounting expenses. These expenses must be capitalized and deducted over the life of the lease via the depletion allowance.

 

DISCLAIMER: Viper Capital Partners LLC, is not a Tax Advisor, CPA, or Tax Attorney and is not certified to give any tax advice. The information on this page is for educational purposes only. Individuals should consult their own tax professional for advice. Viper Capital Partners LLC offers no professional tax advice.

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