Wednesday, October 5, 2011

There will be tax breaks: Investing in oil and gas drilling | Reuters ...

Seated in the conference room of his wealth management firm in San Ramon, Calif., Rich Arzaga breaks out a few tools to explain the investment advantages of oil and gas drilling programs. He?s got a fine-point pen and a sketch pad ? but alas, no milkshake a la Daniel Day-Lewis in ?There Will Be Blood.?

?This is not wildcatting,? says Arzaga, founder and CEO of Cornerstone Wealth Management and an adjunct professor in personal finance at the University of California at Berkeley. Lewis? anti-hero in ?Blood? swindles and snakes for oil wherever he can find it, whereas Arzaga?(pictured) wants to discuss something much more civilized: qualified drilling programs that yield big tax savings for investors and, if you?re lucky, 10 or more years of financial returns.

Still, if that sounds a little bit Hollywood, Arzaga understands. ?Insurance companies, wire houses and banks don?t offer this type of alternative investment,? he says. ?It?s not their thing. You have to hang out with the independent advisers who do this.? You also need at least $25,000 to start, which explains why over the last five years, Arzaga has been limited to roughly a dozen clients in this realm.

Yet at a time when Wall Street sports the stability of a rickety roller coaster, and European turmoil dogs investors on North American shores, oil and gas drilling represents a niche so far outside the norm that it?s in many respects immune to common economic doldrums. And when oil prices soar, the prospects for this commodity look downright appealing? that is, up to a point. To be sure, once you give your cash over to the program, it stays there until the wells pan out, or don?t ??making it much unlike a liquid mutual fund, for example. This explains in part why the program works best for those trying to avoid a major tax hit on an appreciated asset, where the burden might be 40 percent.

What?s more, ?The number one risk is that there?s a certain amount of fraud out there,? says?Grant Rawdin, president of Wescott Financial in Philadelphia. Yet once you find a drilling company with a solid reputation ? Arzaga, like many in the game, uses Atlas Energy ? you don?t just sit back and wait for the black gold to pour in.

?Then you have to do your homework,? Rawdin says. ?You need to look at geological surveys, how other wells have done, what the drilling costs are going to be. And once that oil well goes dry, you?re done, so you have to amortize your investment over the life of the well.?

In the typical program, an investor immediately yields tax breaks as sanctioned by IRS codes, which are now more than three decades old. With a highly appreciated asset, you can put the money into oil and gas drilling and shelter it almost entirely from capital gains tax. If you invest $1 million and are in a 40 percent tax bracket, you will save about $350,000 right off the bat, Arzaga says. (The sheltering comes from how the program is structured; federal laws allow typically for 89-91 percent of the investment to be allocated to intangible drilling costs that can be written off entirely in year one.)

With that, though, come risks not found in the ordinary world of stocks and bonds. You start out in your first year as a general partner, meaning that if a worker gets injured or killed on the work site, for example, you?re a susceptible to a liability claim. Arzaga says that Atlas, a Pennsylvania-based company that is part of Chevron, carries about $50 million in insurance for these claims. This is supplemented by insurance from the drilling contractors and Chevron itself. Though the liability risks are small, they must be disclosed to investors.

This type of venture also has ethical issues, especially among the eco-friendly.

?There?s so much controversy around hydraulic fracking,? says Julie Murphy Casserly, principal of JMC Wealth Management in Chicago. That process, which uses pressurized fluid to release oil from rock, isn?t popular with environmentalists. So when Casserly recommended an oil and gas drilling program to a California couple with about $2 million to invest, those self-described ?socially conscious? clients asked questions.

?When it came to them having a $450,000 tax liability, they were faced with how green they really were when you have to put your money where your mouth is,? Casserly says. ?So you have to ask yourself: How do you feel about this personally?? As for that couple, ?They told me they were moving forward with it on a call a few days ago,? Casserly says. But of the $2 million, they plan to invest only $500,000 in oil and gas, the rest in causes that fit their social mores. ?It?s sort of like a carbon footprint offset.?

Once wells start producing, usually in the second year, an investor?s status switches to limited partner and checks start rolling in. Assuming a typical return of about 10 percent or more a year ? 30 percent of which is tax free for the first five years of production ? Arzaga estimates you can recoup your original investment in five to six years, having realized significant tax savings along the way.

Based on that initial $1 million up front, ?Within a five-year period, you basically get your capital back,? Arzaga says, ?whereas if you kept your capital, you would lose $400,000 to taxes forever.?

Of course, much of the math is contingent upon whether wells produce. ?You really don?t know the total worth of the investment until the whole thing plays out, until the wells stop producing,? says Scott Biggane, a client of Arzaga?s from Santa Cruz, California who is?the global account manager with?Emulex. ?It could be 10 years or more.?

Biggane is single and has the potential for huge tax liabilities each year, so he loves the oil and gas program for its sheltering capabilities. But he??acknowledges that after four-plus years of doing these deals with Arzaga, not every one has hit instant pay dirt.

To be precise: Biggane?s first two forays, which followed the qualified tax paradigm, are doing fine: They?ve?recouped more than 60 percent of the original $50,000 invested in each.?Then he branched out into a more speculative venture, looking for oil?and gas in the Gulf of Mexico with another company,?Ridgewood Energy,?seeking bigger returns but with bigger risks.?While Biggane?s satisfied with how Ridgewood has kept him in the communications loop, this deal hasn?t panned out yet financially.

?It hasn?t worked out so well,? Biggane says. ?We hit a number of dry holes that had some big dollars involved with them.??Though he believes the gulf wells will eventually yield, ?time?s wasting and they won?t produce. And Hurricane Katrina shut us down for six months, so the checks then were very small. Mine was one of the softest ones [return-wise]. Luck of the draw.?

Asked if he?s considering a fourth go, more along the lines of the first two, Biggane pauses. ?I haven?t yet decided. The gas returns would?ve been better except that gas prices have been really soft. That?s sort of hurt the investment.?

Then he reflects on the one gusher that no geological survey can thwart, and laughs:

?But the tax breaks,? he says, ?are tremendous.?

Source: http://blogs.reuters.com/reuters-money/2011/10/03/there-will-be-tax-breaks-investing-in-oil-and-gas-drilling/

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