The plunging price of oil has been one of the biggest economic stories of the past eight months or so. Falling oil prices impact many sectors of the economy, but oil production (not surprisingly) is the sector that is most directly affected.
Investors who own shares of major oil production companies like Exxon-Mobil, British Petroleum and Royal Dutch Shell have taken their lumps since oil prices started falling. However, there are benefits to investing in oil production that go beyond just the price of a barrel of oil or the share prices of oil production companies like these.
Specifically, investing in oil production can yield significant tax benefits. In fact, domestic energy production — and oil production, in particular — offers more tax benefits for investors than almost any other type of investment.
Deductible Expenses and Costs
For starters, the costs (both tangible and intangible) incurred by producers to drill for oil are 100 percent deductible, regardless of whether or not the well actually produces oil. Tangible drilling costs refer to the actual equipment that is used to drill for oil, while intangible costs include chemicals, labor and other materials that go into the drilling process.
Thus, tangible drilling costs for equipment must be depreciated over a period of seven years, while intangible drilling costs can be fully deducted during the year in which they were incurred. Intangibles account for the bulk of oil drilling costs — typically around 75 percent. The oil well must be in operation by March 31 of the year following the year you want to take the deduction.
Other expenses incurred in the production of oil that go beyond actual drilling are also fully tax-deductible. These include lease operating costs; lease and mineral rights purchase costs; and legal, administrative and accounting expenses incurred in oil production.
In addition, a special provision of the tax code known as the depletion allowance provides a special tax break just for investors and small oil producers. If an oil producer refines or produces 50,000 barrels of oil a day or less, or owns 1,000 barrels of oil a day or less, 15 percent of the gross income generated from the oil well will be tax-free. While the depletion allowance is often criticized as a needless tax break for the rich, energy experts say it is needed to reflect the steady diminishing of reserves (and asset value) within a given oil field. If you are an oil investor whose holdings conform to these guidelines, the depletion allowance is a powerful tax-cutting tool.
Additionally, if you have a working interest in an oil well (see below for a more detailed explanation of a working interest), you are considered an “active” investor in the well. This means that any investment losses you incur in the well can offset other earned income (such as capital gains and wages), thus reducing your overall tax bill.
These tax breaks are available to any investor, regardless of his or her income or net worth. This makes direct investment in oil production a potentially attractive option for affluent individuals and accredited investors.
How Direct Investment Works
There are several different ways to invest in oil production, but not all of them yield these tax advantages. For example, if you invest in oil production via a mutual fund or ETF, you cannot reap these tax benefits.
There are two main ways to invest directly in oil production. The first is to assume a working interest in an oil well. With this form of investment, you will fully and directly participate in any profits generated by the well. On the flip side, you will also be directly responsible for assuming a portion of all the costs involved in running the well — these include the costs of oil exploration, drilling and production. This is the riskiest way to invest in oil production, and is generally not recommended unless you are highly experienced in the oil industry and understand it very well.
A limited liability partnership (or LLP) is a better option for most investors who want to invest directly in oil production. With this type of partnership, your liability is limited to how much money you have invested in the project — in other words, you are not liable for the project’s debts. You will receive a K-1 form annually that indicates your share of the limited partnerships expenses and revenue.
Even when investing in oil production via an LLP, however, this remains a relatively risky endeavor. Therefore, many partnerships require that you meet the criteria of what is referred to as an accredited investor, which is an investor who is financially sophisticated and meets minimum annual income or net worth requirements.
Of course, energy prices are extremely volatile. This is especially true for oil and gasoline prices, which have already started climbing again after bottoming out in late January. Regardless of which way oil prices go, you might be able to reap attractive returns and take advantage of big tax breaks by investing directly in oil production. Just be prepared to withstand the high volatility that is inherent in this industry.