Oil and Gas Limited Partnership FAQs

FAQ’s: Oil and Gas Investments – Limited Partnerships

Welcome to Oil and Gas Limited Partnership FAQ’s.  We designed this site to give you unbiased information to help you better understand the many aspects of these investments.  Because of their complicated structures and tax consequences, before investing in any oil and gas partnership we suggest you contact an experienced oil and gas lawyer to assist you.

What is an oil and gas limited partnership?

An oil and gas limited partnership is a private investment vehicle formed to acquire, develop, drill, and operate oil and gas wells. As with any investment vehicle structured as a limited partnership, the investors put up the capital to develop and operate the project; they then receive cash distributions during the term of the partnership as well as allocations of favorable tax benefits. The sponsor of the project operates and manages the project on a day-to-day basis, and acts as the managing general partner of the partnership. The managing general partner or an affiliated company usually acts as the operator of the oil and gas project and oversees the drilling contractor.

Is an oil and gas limited partnership different from a master limited partnership (MLP)?

While private oil and gas limited partnerships and MLP’s are both structured as partnerships for tax purposes, there are important differences. Interests in MLP’s are usually publicly traded securities, while private oil and gas limited partnership interests are privately offered to a limited number of sophisticated investors. MLP’s are similar to real estate investment trusts (REITs) in that they invest in a portfolio of oil and gas properties, and seek to buy and sell properties from time to time as economic conditions warrant. MLP’s are intended to be ongoing businesses. A private oil and gas limited partnership, in contrast, is typically formed to drill and operate a specific property, with the intention of liquidating the investment at some point in the future, either upon a sale of the developed property or upon the depletion of the oil and gas resources at the end of the useful life of the property.

Most MLP’s invest in pipelines and other mid-stream assets, because MLP’s are required to distribute 95% of their taxable operating income every year, and thus need a stable asset base that can continue generating sufficient cash flow year after year to maintain distributions to investors. While there are a handful of oil and gas MLP’s, they are under constant pressure to raise new funds to be able to buy new properties as their maturing properties deplete their reserves over time. Thus, oil and gas MLP’s have an inherent investment risk that they will not be able to keep raising additional capital because of market conditions or poor performance. In this case, the MLP will not be able to maintain its reserve base at a level capable of sustaining cash distributions to investors. And if cash distributions drop, the price of the MLP’s shares will drop. This is known as the “feeding the beast” problem.

Private limited partnerships are designed to acquire, develop and operate a single asset, and unlike MLP’s do not have to be cobcerned with maintaining their asset value or stock price.

How do I make money with oil and gas limited partnerships?

Oil and gas limited partnerships make money for their investors in several ways.

Cash Flow

Most oil and gas limited partnerships distribute operating cash flow to investors on a monthly or quarterly basis. Unlike a corporation, partnerships are not separately taxed, so there is only a single level of income tax on the profits allocated to the investors. In other words, a limited partnership is a flow-through entity similar to a REIT, MLP or mutual fund.

Return on Capital

Oil and gas properties are depreciating assets, and their value goes down every year as the oil and gas reserves are depleted through production. Nevertheless, in a properly structured oil and gas investment partnership, the investment returns produced over the life of the wells that are developed by the partnership will be sufficient to return the investors’ capital investment plus a reasonable return on that investment. In addition, private investment partnerships often have a fixed term of 5 to 10 years, at the end of which the property can be sold (hopefully at profit) or refinanced to pay off the investors’ capital.

Tax Benefits

Properly structured oil and gas investments are also entitled to several types of tax benefits, and this is one of their main appeals.

What are the Tax Benefits of Oil and Gas Limited Partnerships?

IDC Deductions

There are a number of tax benefits that flow through to the investors in an oil and gas limited partnership. The most important of these is the deduction for intangible drilling and development costs (IDC’s). The cost of drilling and developing an oil and gas well can be divided for tax purposes between tangible costs and intangible costs. Tangible costs are the hard the costs of the physical elements of the well, such as the steel casing and tubing and down-hole pumping equipment. Intangible costs are the costs of the drilling contractor, engineers and other service providers, and other intangible costs relating to the project.

For a typical oil and gas well drilled in the United States, the IDC’s will generally constitute 70% to 80% of the total cost of drilling and developing the well. Without the special tax incentives, IDC’s would have to be capitalized for tax purposes. They would then be amortized over the life of the well, which could be 20 or 30 years or more. However, under a special tax provision, IDC’s maybe entirely deducted in the year the well is drilled.

Suppose a well costs $1,000,000 to drill, of which $800,000 are IDC’s. This means is that the full $800,000 would be deductible in the year that the well was drilled. And since a partnership is a flow–through entity, the investors would be allocated their proportionate share of this $800,000 dollar deduction. And unlike real estate and most other investments, this deduction can offset income from any source, including the investors’ salaries.

Since 1984, the “passive activity” and “at-risk” tax rules eliminated the ability of taxpayers to offset most types of passive investment tax losses against their salaries and other active income. So, for example, in the typical real estate development deal, where substantial tax losses are generated in the early years, prior to 1984 these losses could be deducted against the investors’ active income from salaries and other sources. However, the 1984 tax act carved out a special exemption for qualifying oil and gas drilling projects. The upshot of these special rules is that in a properly structured deal, deductions form IDC’s that are passed through to investors may be deducted against any type of income, even salaries. Thus, private oil and gas drilling partnerships are one of the few remaining “tax shelter” structures that are still permitted under U.S. tax laws.

The investor must be a general partner as opposed to a limited partner in the year the IDC deduction is claimed in order to be able to offset it against salary and other active income. This is why most oil and gas drilling partnerships are structured so that the investors start out as general partners, and then may elect to convert to limited partners in a tax year subsequent to the one in which the IDC deductions are taken.

Depletion

Because an oil and gas well is a depreciating asset, the owner of the well is entitled to treat a portion of the cash flow realized from production of oil and gas as a return of capital. This portion is treated as a deduction for income for tax purposes. There are two types of depletion deductions that apply to oil and gas assets; in general, the investor is entitled to use the one that provides the larger deduction.

“Cost depletion” allows the recovery of capitalized costs (such as lease bonus and other lease acquisition costs, legal fees, and certain other capitalized, non-depreciable costs) of a producing property over its life by an annual deduction computed on the basis of the actual oil and gas sold each year in relation to estimated recoverable oil and gas.

“Percentage depletion,” if applicable, is an annual statutory allowance equal to a percentage of the gross income from the depletable property (but in no event exceeding 100% of the taxable income from the property before allowance for depletion), computed without regard to the costs associated with the property. Deductions resulting from percentage depletion can therefore exceed total costs associated with acquisition of the property. Percentage depletion may only be claimed by investors who qualify as so-called “independent producers,” and only with respect to a limited amount of oil and gas production each year. The availability of percentage depletion is largely dependent on the personal tax situation of each individual investor, and each investor must therefore individually determine his or her eligibility to qualify as an “independent producer” and must individually calculate his depletion deductions, if any.

Equipment Depreciation

Because most equipment and materials used in drilling wells, including casing, tubing, and bottom hole equipment, are salvageable, they are not eligible for treatment as IDC, but are accounted for as investments in tangible drilling costs. Oil and gas operations typically involve substantial pieces of equipment in surface operations as well, such as surface pumping systems. All of these may be depreciated for tax purposes over a relatively short period of time (typically seven years). These depreciation deductions will be passed through to the investor partners.

Organizational and Syndication Costs

To the extent that any organizational expenses qualify for treatment as deferred expenses subject to amortization, the limited partnership may make an election to amortize such expenses over a period of not less than 60 months. However, amounts paid to promote the sale or to sell partnership interests, such as selling commissions, must be capitalized and may not be deducted or amortized.

Capital Gains on Sale; Recapture Rules

On dissolution of the limited partnership, any remaining assets of the partnership may be sold, which may result in the realization of taxable gain to the investors. Distributions of cash or partnership assets in complete liquidation of the partnership will generally be treated first as a return of capital and thereafter as a capital gain, to the extent of the amount of cash distributed.

However, on sale of the property by the partnership, whether or not in connection with a liquidation, the portion of the gain that represents IDC and depletion that reduced the basis of the property will be recaptured as ordinary income and not capital gains. An Investor must likewise recapture certain deductions for IDC’s, depletion, and depreciation as ordinary income on disposition of his interest in the partnership. If the partnership disposes of property or an investor transfers an interest, the partnership and the investors may recognize ordinary income (instead of capital gain) to the extent such deductions for IDC’s, depletion and depreciation must be recaptured.

Are there other benefits of Oil and Gas Limited Partnerships?

Hedge Against Inflation

Oil and gas investments have traditionally acted as a good hedge against inflation. Many analysts believe that the huge amount of government debt and liquidity injected into the world financial system since the 2008 crisis will inevitably lead to inflation. Thus, an allocation to commodities, including oil and gas, should be a part of every investment portfolio.

Diversification

Numerous studies have confirmed that that oil and gas investments have a low correlation with stocks and other equities. Thus, allocating a portion of your investment portfolio to oil and gas and other commodities can provide significant diversification and reduce the overall risk levels of the investment portfolio.

The U.S. Energy Information Administration publishes a wide variety of data an analysis on the oil and gas and other energy sectors.  We highly recommend that you read the current version of the EIA’s Annual Energy Outlook, which provides a wealth of information on all aspects of the energy markets, including 30-year projections of prices and of supply and demand figures.

What are the Risks of Investing in Oil and Gas Limited Partnerships and how can they be Addressed?

Oil and gas investments have a number of risks.  The private placement memorandum or other disclosure documents accompanying the investment should have a section entitled “Risk Factors,” which you should read carefully before investing in any oil and gas limited partnership.  In this case, the assistance of an experienced oil and gas attorney is recommended.

Risks Associated with General Partner Status

Investors who elect to invest as general partners in order to take full advantage of the available tax benefits will be directly liable for the liabilities of the partnership. If they invest as limited partners, their liability will be limited to the amount they invest; however, their ability to use the IDC deductions to offset income from salaries and other non-passive income will be eliminated. In addition, a general partnership interest cannot be owned directly or indirectly through an entity that limits the investor’s liability. The risks must be to the individual investor.

In order to mitigate these risks, an oil and gas partnership typically will provide insurance against certain risks. However, there are risks that the partnership will not be able to insure against and, therefore, these risks will be borne by the investor general partners and the managing general partner jointly and severally. Also, the partnership requires additional capital to complete the drilling, if the partnership elects to borrow to pay for the additional costs, an investor general partner may be liable for the repayment of such debt in the event that the cash flow is insufficient to cover the repayment of the obligation.

Commodity Prices

Volatility in commodities prices represents perhaps the biggest risk in oil and gas investing. In recent years, oil and gas prices have been subject to wide fluctuations. This risk can best be mitigated by investing during periods of low commodity prices, which will provide for upside potential as oil and gas prices rise. In addition, the cost of drilling a well can be up to 40% less during periods of low oil prices, as demand for oil rigs and service personnel drops significantly at these times.

Geological/Reserve Risk

Reserve risk refers to the risk that oil and gas will not be present in commercially recoverable amounts. The oil and gas industry has developed a system of classifying oil and gas reserves by risk category, which has been adopted by the SEC and other regulators. It is important for investors to understand these reserve classifications. In general, “reserves” refers only to that portion of the physical oil and gas in place that may be economically recoverable at current oil prices and with existing technology under existing operating conditions. “Reserves” are further divided into three risk categories: “Proved,” “Probable” and “Possible.” These can be determined by either deterministic or probabilistic methods. Proved reserves are those quantities of petroleum which, by analysis of geoscience and engineering data, can be estimated with reasonable certainty to be commercially recoverable, from a given date forward, from known reservoirs and under defined economic conditions, operating methods, and government regulations. Investors should make sure that the promoters of the limited partnership investment have provided a independent reserve evaluation from a reputable petroleum engineering firm and that they understand the level of reserve risk that they are undertaking.

Operating Risks

Investors should make sure that the manager of the investment has retained qualified contracts to drill the wells and operate them after they have been drilled. Like any complex business, oil and gas operations are subject to a number of operating risks, and it is crucial that qualified professionals be involved in all aspects of the business.

Drilling and Mechanical Risks

“Mechanical risk” refers to the risk of a physical breakdown or other problem with a well. It is not unusual for wells to break down and require periodic servicing. When this occurs, a workover rig must generally be brought out to the field to pull the rod string and pumping mechanism from the hole in order to make repairs. Sometimes repairs are required to the casing (the steel lining of the wellbore) or to the cement that binds the casing to the bore. Investors should make sure that the cash flow projections provided by the sponsor of the investment include a sufficient amount for repairs and work-overs. In addition, during the drilling phase of the wells, there is always the possibility of a substantial problem, such as the loss of a tool down the hole or an unexpected problem that requires re-drilling a portion of the well bore. Some of these risks, such as the loss of a drilling tool, can be insured against. However, there should always be an adequate contingency in the drilling budget to cover unexpected cost overruns.

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We hope that these FAQ’s have helped explain some of the more important aspects of investing in oil and gas limited partnerships.  Before investing your herd-earned money, we recommend that you consult with an experienced business attorney, such as the one whose YouTube video can be reached by clicking the link.  This firm, located in Beverly Hills, CA and serving Los Angeles and Southern California, can answer any additional questions that you may have.

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IRS CIRCULAR 230 NOTICE:  To ensure compliance with requirements imposed by the Internal Revenue Service, we inform you that any U.S. tax advice contained in this article (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).