How to Invest in Oil Wells, Oil and Gas Industry

Investing in oil is a tremendous investment vehicle with an upside that can cause your investment to be 75% to 100% tax-deductible. However, there are certain risks associated with investing in oil. In this article, we will be discussing the fundamentals of investing in oil wells and the best way to invest in oil.

Why invest in oil?

Oil may be the most popular petroleum product, however, there are other products of petroleum that causes its high demand and supply in America and the rest of the world. Petroleum products include a variety of items such as bicycle tires, basketballs, paint, umbrellas, solvents, perfumes, deodorants, etc. There is a petroleum product for almost anything; whether as gasoline for your car or propane for your stove, and other household items. One interesting fact about petroleum is that it has no substitute. Oil and gas may be substituted by biofuels or renewable energy. However, the use of petroleum in other products may not be easily substituted. 

Despite the demand for biofuels and renewable energy in place of oil and gas, there still remains a wide demand for oil and gas for transportation infrastructure in the United States. 

Oil and gas can be regarded as a good investment opportunity for investors seeking to explore this field. Oil is a commodity that is limited in supply, with high demand. It is a non-renewable energy source, the supply will most likely be limited in the future and the demand for products made from petroleum will increase. By all implication, the price of oil will continually increase as it builds up towards reaching its supply limit. As this happens, oil investors will be the ones to benefit because their oil investment will be up.

Advantages of Investing in Oil

1.    Tax benefits. The most obvious benefit of investing in oil and gas is the tax benefits that come with it. Especially when you specifically own an oil and gas well. The tax benefits include:

• Passive income tax breaks
• Owners of producing oil and gas wells can get as much as 75% - 100% write off against their active income in the year that they invest.
• The possibility of a 10% - 15% yearly depreciation allowance that comes from the cash flow of producing wells or royalty interest. 

2.             Diversification. Investing in oil and gas can also allow investors to diversify their portfolio, using it as a tool to hedge against inflation. Generally, when oil and gas prices rise in the economy, it causes other stocks to tumble, with the exclusion of oil and gas stocks. Diversifying your portfolio with oil and gas stocks will protect your portfolio against economic slowdowns.

3.             Profit. There are also instances where oil and gas investments pay investors passive income and generate good returns over the long-term. It provides investors with consistent cash flow, like real estate.

Disadvantages of Investing in Oil

• Volatility. This is a major disadvantage with investing in oil seeing that oil is a global commodity and the slightest global tension can directly affect its price. In turn, this could affect investors’ cash flow, especially if cash flow is directly linked to the price of oil and gas.
• Liquidity. There may be difficulties in selling oil shares of smaller companies compared to those of larger companies. In a case where finding a buyer seems difficult, you can opt for redeeming your interest with the company directly or your limited partner.
• Minimum investment amount. Investing directly in an oil well can cost hundreds or thousands to millions of dollars to drill a well. Although there are other new ways to invest in oil and gas.
• Oil spillage. There are also liability issues that could arise in the case of oil spillage caused by any of the investor’s oil and gas wells during drilling. 

Types of Oil and Gas Investments

There are four major kinds of oil and gas investment. They are:

1.    Exploration: Investors in this category directly invest in oil wells. They are mostly institutional investors or companies that invest hundreds of thousands or millions of dollars in oil drilling. The process of oil exploration implies that striking oil is a matter of probabilities. The investment can generate returns 10 times over or even more if the company actually strikes oil. The reverse will be the case if the company doesn’t strike oil.

2.    Developing: This category of oil and gas investment concerns projects or companies that drill near proven reserves in an attempt to look for more value. This type of oil and gas investment is less speculative and there are hardly any guarantees that the results will be productive.

3.    Income: This category involves land acquisition through lease or purchase of proven oil and gas reserves while seeking to create a steady income stream above expenses. Some oil and gas investors consider this as the safest way to join in drilling and extraction operations of oil wells. It is mostly an income play than a speculative play. It may be the safest, but it certainly has a risk associated with it, the oil may run out faster beyond expectations. This type of investment is reserved for oil investors who seek a passive income stream and have a high-risk tolerance.

4.    Services and Support: The companies in this category do not directly invest in oil and gas exploration or drilling, but provide support services to oil and gas companies. Support services providers include pipeline companies, construction and rigging companies, drilling and refining hardware and equipment manufacturers, refiners, shipping and logistics, transportation, amongst others. Investing in these types of companies is like investing in any technology or logistics company. Their prices are not affected by the rise or fall of oil prices, so long as there is consistency in demand.

Ways to Invest in Oil

When it comes to investing in oil and gas, you could either directly invest in oil wells or try other options such as stocks, mutual funds and ETFs, futures contracts.

Stocks, mutual funds, ETFs: This is the most basic and fastest way to indirectly invest in oil and gas. Unlike directly investing in oil wells that require a huge amount of money, investing through stocks and mutual funds will allow you invest with a much or little amount of money you have. Investing in oil and gas companies through stocks is like investing in other public-traded companies. A major advantage of this type of investment is that investors can capitalize on the dividends these companies payout to shareholders. The best oil and gas companies to invest in are large-cap companies such as Exxon Mobil (XOM), Chevron (CVX), Conoco Phillips (COP) and British Petroleum PLC (BP). 

Oil and energy mutual funds also operate in a similar manner like regular mutual funds. Such that if you do not want to invest in individual stocks of any company or are quite unsure about the company stocks to buy, you can opt for mutual funds. Some top oil and energy mutual funds to consider are:

• Fidelity Select Energy Portfolio (FSENX)
• Vanguard Energy Fund (VGENX)
• BlackRock All-Cap Energy (BACAX)

For investors that are looking for an investment option that is closely related to the price of the commodity, they can opt for investing in an oil and gas exchange-traded fund (ETF). Oil and gas ETFs moves closely to the actual price of oil and gas in the market. It is a more volatile kind of investment and it doesn’t give dividends unlike many of the individual stocks.

Futures Contracts and Options: Another way to benefit from oil and gas investment is by purchasing oil and gasoline futures contracts. However, there’s much risk associated with this type of investment, considering that futures contracts expire frequently without any value. The same applies to options. It is better to have a proper understanding of how options and futures work before getting involved with them. 

Master Limited Partnership (MLP): For investors who would still like to directly invest in oil wells, Master Limited Partnership or MLP presents a more direct approach to investing in oil wells. Typically, the MLP is publicly traded like stocks, however, there are key differences. With MLPs, investors can tap into the advantage of a private partnership, in that they will only pay taxes on distribution. Yet, buy and sell with the liquidity of a public company. All investors in MLPs are considered “partners” even though not all of them will have active roles in the venture. Another advantage of MLPs is that they are not as volatile as commodities. A downside is that they do not usually appreciate in value.

How can I invest directly in oil wells with little money?

While investing indirectly through stocks, mutual funds and ETFs; futures and options can be an easy and fast way of investing in the oil and gas industry. You can still invest directly in oil wells through a Direct Participation Programs (DPPs). With a DPP you can seek a prospectus or private placement memorandum (PPM) of the target company. The private placement memorandum of the company would show you all the necessary things you need to know about the project such as contracts to be made, costs involved, and projected returns. It also states what you are buying. For example, a working interest (WI) of 2% and net revenue interest (NRI) of 0.50%. The memorandum spreads across both new drilling sites and rework programs.

The DPP also includes other monthly costs and charges like pumper fee, operator fee, administration costs and filing fees, etc. Once you have properly gone through the memorandum presented by the company and have run a background check on the company you can proceed with your investment.

Note: Before you can directly invest in oil wells you must be an accredited investor. That means you must have an individual or joint net worth of at least $1 million at the time of purchase or have income exceeding $200,000 in the last two recent years (or a joint income with a spouse exceeding $300,000). You must also have a form of insurance to cover your investment.

What to consider before investing in oil and gas wells?

What kind of projects are involved? The two common types of projects you will mostly find are the wildcatting project and developmental drilling. The wildcatting project has to do with the exploration of “green” field. Usually testing a new field in search of oil. This type of project is based on the probability of whether the company finds oil or not. There are high possibilities of losing money under this type of project. On the other hand, the developmental project has to do with the drilling of oil wells very close to existing or productive oil fields. Many times, this type of project is 100 percent successful.  

What is the company’s success rate in drilling? This is another useful observation that should be taken cognizance of while running a profile check on the company. This would help you compare the company’s number of wells drilled to the number of wells producing/ Alongside, the company’s performance to the state’s averages. 

What is the size of their reserve? The size of the company’s reserve can also give you an insight into its capabilities. Some companies allow them to be open to interpretation, while others reveal an estimate of their reserves sizes.