There are advantages and disadvantages to any business investment that people make and it is the same with investing in oil and gas. Contrary to the popular belief that oil and gas investors are plain lucky, investing in such a business requires precise skills.
To begin with, an investor must have his research in place and also have a keen sense of intuition to know where exactly to invest. It is true that this form of investment is lucrative and promises break-even points in less than a year; however the risks involved are as high as the promise that this investment holds. This article attempts to analyze the advantages and risks for oil and gas investments and also explores the factors that go into making such an investment.
Understanding how oil and gas investments work:
Oil and gas investments are similar to all other unit investment trusts. Every trust is fragmented to small individual units that are sold to investors at a pre-determined price. Every unit is representative of an undivided equivalent interest in all the properties of oil and gas that belong to the trust. Every trust has a maturity date; on the date of maturity the relevant profits or losses resulting form the sale of the oil and natural gas assets are dispersed to individual unit holders.
It is important to know that unlike other UITs the investments made by the oil and gas trusts are direct. The investments are either in production or in drilling assets.
Advantages and risks for oil and gas investments:
As is the case with all investments, oil and gas investments have their own set of advantages and risks. While the advantages are more than just of a financial nature, the risks are purely financial risks. The analysis that is to follow will reveal certain facts pertaining to these advantages and risks.
• The most obvious advantage is that of investors in oil and gas being eligible for pass-through tax status. This means they can get privileges similar to those that limited partnerships enjoy and also enjoy depletion deduction options
• Deductible operational expenses also enjoy a pass-through
• Easy and quick recovery of intangible costs such as labor, drilling costs in the first year itself
• Straight line depreciations can be opted for as well for over seven years or over the life of the well
• Risk of losing out on money owing to losses from these trusts is very minimal as the demand for oil and gas will hardly cease in the near future
• Cash flow can last investors for more than a decade with the right well
Just like other investments have their risks, oil and gas investments have their minor share of risks as well. They are not riskier than mutual funds but they can also not be replaced until the maturity date. Here are a few other risks that individual unit holders in these investments can face:
• The possibility of hitting a dry hole – investing in new wells is a big risk; it is a better idea to invest in a well that is already producing
• Depletion curve – the oil is bound to run out someday, just the way any performing investment will run out of its flesh some day. This will prove risky
• Unpredictable ROI – depending on the performance of the well per drill, the return on investment will differ; this brings in unpredictable risks
• Rise and fall of energy prices and fluctuation in value of fuel is another risk
• As oil and gas assets are wasting assets, there is only so much that one can earn them
• An unsuccessful development is a looming risk for any investor
• Income also needs to be spent on maintaining and operating the well head
• Price rise of overheads such as part replacement, pumping fee, electrical works etc.
• A lot of paperwork and legal clauses to deal with
Investor qualifications to invest into oil and gas
Not everyone can invest in oil and gas investments. There are certain qualifications and standards that investors need to meet in order to invest in oil and gas. Here are a few qualifications that are common to most investments in the oil and gas sector:
• Investments usually happen through a broker or a small or mid-sized oil company
• Accreditation is a common criterion set by most companies. Typically, companies that have a million dollar net worth or those which have made about 200,000 in the past 3 years can qualify
• Options to fund entire projects are extended to investors with very high net worth or other investors can invest in multiple units
• Some non-accredited investors may qualify to invest in oil and gas depending on the displayed interest and knowledge in the oil and gas sector
Choosing the right oil and gas investment
Choosing the right investment option is as important as the money invested. There are many aspects that need to be considered while choosing a trust that deals with oil and gas. One must check the level of risk involved in choosing the trust. Aggressive trusts usually invest only in producing wells; these carry lesser risks for investors. Choosing exploratory properties are also acceptable as they ensure greater tax benefits. The rule of the thumb is that investing in mature operational oil and gas fields is a better option to investing in high risk ones. However, the truth is that one can also invest in the high risk ones in a small way to begin with and as experience and insights from the property are gathered one may choose to further the investment.
Advantages and risks for oil and gas investments – In conclusion
In conclusion, one may say that despite oil and gas UITs being similar to other investments that invest in stocks, they carry different risks and benefits. It is good to explore this investment after thoroughly understanding the pros and cons of the properties under consideration and also gradually proceed with the plan rather than rushing through an investment.