Over the last week, I have had several calls and emails about the impact of lower prices on the profitability of oil and gas drilling funds that have recently begun drilling or producing. The answer is much more complicated than the question. The best way to frame the question is “how will the profit margin be affected?” To answer that, we need to look at both revenue and expenses.
Most financial advisers and investors that have significant experience with this asset type know that oil and gas wells generally provide “flush” production over their first one to five years. If a fund takes six to eighteen months to drill the wells, that means that one would hope to see a 100% “cash on cash” return – irrespective of any tax benefit (which is how unfortunately many poor performing funds are sold) in the first five years of production. Since most funds take about six months to start distributions, that translates into having all of the initial investment back in five and a half years. I like to think of most drilling funds as an opportunity to “reverse dollar cost average out of oil and natural gas”. What I mean by this is that a principal sum is invested, and the returns depend on competent drilling and production. The variable is the price over the time of production. One hopes for higher prices through the period of flush production, and risk is dispersed by the range of the flush production period.
Although there may be a lag of six to twelve months, falling prices also usually mean falling expenses. As prices fall, some oil in tight formations or narrow pay zones cannot be economically produced. Less oil production results in less demand for steel, concrete, labor, leases and drilling rig rental rates. Further, since many independent operators have debt on their business, when prices fall and revenues drop, they may be prone to sell assets like leases as well as their services at a discount in order to make loan payments. AOG Wealth Management does not use any drilling funds that utilize leverage, so in this scenario, “cash is king” and a savvy sponsor can get bargain prices on leases, equipment, steel, concrete, rig rates and other supplies. Lower oil prices can reduce profits, but if accompanied by lower costs, the margin can remain attractive.
One of the best ways to hedge risk and opportunity on drilling programs is to spread investments across several programs and several years. This is also compatible with the AOG philosophy of using programs over several years to maximize the tax benefits. It is impossible to predict demand and pricing in advance. One can prognosticate that fossil fuels will be in demand for at least the next five years. An excellent strategy is to build an “energy ladder” as part of an overall diversified portfolio that includes smart tax management, investment in assets classes and programs that have low or even negative correlation to the stock market, and planning in advance to reinvest tax savings and distributions in out-of-favor assets that have solid future expectations.
Oil and gas exploration, development, and production activities inherently involve highly speculative activities in which results cannot be exactly predicted and which necessarily involve risk of loss of one’s entire investment. Investment in the partnership is suitable only for “accredited investors” within the meaning of Regulation D defined by the Securities and Exchange Commission under the Securities Act of 1933 and amended by the The Dodd–Frank Wall Street Reform and Consumer Protection Act which requires investors to possess the financial ability and willingness to accept the high risks and lack of liquidity inherent in the partnership. All of the information furnished in connection with a partnership is derived through the use of scientific or other techniques associated with the oil and gas business, and, as such, should not be relied upon as statements of fact. Any reserve estimates, price calculations, price forecasts, exploration potential, predictions, or similar information contained in the material furnished in connection with a partnership are, or may well be, estimates only and may not be indicative of actual results. Legal and Tax professionals should be consulted before any investment is considered in a project.