The Investment Scientist

Tax advantaged oil and gas investments? Be very skeptical

Posted on: January 15, 2013

pump-jack group

Oil and Gas Investment Scam

In the last month alone, I’ve gotten calls from two clients asking me if they should invest in tax advantaged oil and gas investments being pitched to them?  Both of these clients are physicians.

The pitch is that oil and gas investments are like IRA accounts, but without the contribution limit. Whatever amount you invest can be written off right away.

The pitch is quite alluring to high-income professionals like physicians who are facing higher taxation. But it sounds too good to be true, so I did a study.

It turns out what is being pitched as “tax advantaged” is in fact the riskiest part of an oil and gas investment.

A full 75% to 85% of oil and gas investment goes to what is called “intangible drilling costs.” These costs are 100% deductible because once the money is spent, it is gone regardless of whether the well is dry or wet.

The rest is so-called “tangible drilling costs,” such as drilling equipment that can be depreciated over seven years.

There is no tax advantage to an oil and gas business relative to other businesses. It’s just that other businesses typically don’t burn through all their investment in one year for ONE shot at success.

The other problems with these type of investments are asymmetric information and moral hazard. There are economic terms to describe the fact that the two sides in a deal often have different knowledge levels, and the side with more knowledge will take advantage of the side with less knowledge.

To put it in layman’s term, if the well to be drilled is a sure bet, do you think it needs to be pitched as an investment option to physicians who have no clue about the oil industry?

Use some common sense. If something needs to be pitched by a salesman – be it a life insurance policy or an oil and gas investment, it’s probably not worth buying.

But then, common sense is the least common of all senses when it comes to investment. That’s why I still have a job.

Get my white paper: The Informed Investor: 5 Key Concepts for Financial Success.

4 Responses to "Tax advantaged oil and gas investments? Be very skeptical"

Usually these kinds of things are pitched to a client so wealthy that the write off is more valuable than any potential profits. The amount of tax not paid, due to the write off, becomes and is counted as part of the return. My common sense question would be, “Which way am I better off? Pay the taxes on my income, or invest and take the deductions and any small cash flow from the investment?”

If I invest, I hand over all of the cash; say $100K. Even if all of it were intangible write offs, I have lost the use of 100K and saved the tax, so the out of pocket is $100K, plus accounting fees at filng time, and the benefit is the savings of tax. On the other hand, if I decide to keep my cash I will have to pay the effective tax rate, which may be lower than brackets indicate. Whatever tax I pay, I would still have 60-80% of my cash to use.

The bottom line is, not only are wells risky, they may be dry, or world prices of oil may be below break even; in addition to that, the investor must have so much cash that money to spend is of little value to him/her. Most of us are not in that category, even Doctors.

Well said.

Your story reminds me of the scene in the movie Boiler Room where the salesmen were purposely cold-calling doctors to pitch their lousy penny stocks.

Allan,

A lot of that are still going on, but have becoming more sophisticated.

Michael

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



You may also get his monthly newsletter, or join his Facebook page for regular wealth management insights. Michael's email is info[at]mzcap.com.

Twitter: @mzhuang

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