We have seen oil prices go up and down, up and down over the 100 years my family has been in the oil business. My great grandfather, AP Young, worked the West Texas oilfields until his work boots were sloshing because of all the sweat. Some years, he would sit under a tree and hope someone on the rig got hurt so he could replace them, so he could feed his twelve kids.
With the hangover of the COVID-19 pandemic decreasing the need for oil, our daily consumption to fulfill the country’s oil demands will not go away. We’ll need oil production for years to come and will be struggling to keep up with production because today, the total rig count (the number of wells drilling oil) is down over 70% from one year ago.
The bottom line is the U.S will start looking for oil and it simply will not be there. This is why oil prices go in cycles. Pretty simple. It is basic supply versus demand.
Let’s discuss some current market factors impacting economic performance of oil and gas investments:
1) Supply & Demand
When it comes to natural resources, oil remains one of the most hunted assets on the planet. It’s fundamentally linked to the economies of the world and can simultaneously be an indicator for economic health and a driver of it because of our dependence on it.
Prior to the COVID-19 pandemic, in February, oil production in the United States was approximately thirteen million barrels per day. When the pandemic hit in March, production decreased significantly due to a larger number of wells being temporarily shut, ceasing to produce. Additionally, many current drilling programs were suspended. As of August 17th, the production in the United States was around ten million barrels of oil per day.
The United States is the #1 oil producer in the world due to number of active rigs drilling for oil and gas. Pre COVID-19, per the Baker Hughes published United States active rig counts, the total number of active rigs in the United States was approximately 650 on February 28th. As of August 14th, the total rig count is less than 200. With lower daily production and the steep decline in rig count, oil prices will be required to increase as the nation’s and world’s demand rises.
In March, JP Morgan stated the country would experience negative oil prices. Then, for the first time in the history of the oil and gas industry, a negative oil price was encountered as of April 21, 2020. A WTI (West Texas Intermediate) contract for May 2020 traded at a negative $37 per barrel. Today, JP Morgan predicts prices could reach $190 per barrel in 2025.
What does this mean? If an oil company owns oil and gas minerals acres situated in a basin that requires a break-even price of $45 per-barrel to develop the prospect, prudently the drilling must be delayed or placed on hold. The economics are pretty simple. What are the drilling and development costs of a well in comparison to the time frame oil and gas can be produced to recover the well drilling and development costs?
For example, assuming well costs are $8 million to drill and complete, and ultimate oil recovery equals 160,000 barrels of oil over the lifetime of the well, an oil price of approximately $50 per barrel would be required to recoup the cost of the well. This simple analysis ignores the time value of money and daily production rates. If the economics for drilling and development are not achievable in comparison to the ability for the well to recoup the cost, the well development program would not be initiated. Oil and gas commodity prices significantly impact the magnitude of active new well development and development of oilfields.
2) Buy Low, Sell High
What does this mean for a potential investor and how can their investment portfolio benefit the most when oil prices are low?
The most obvious advantage to investing in oil and gas when commodity prices are low is the ability to negotiate lower well development costs with the oilfield service and supply companies. These lower costs of development provide the opportunity of buying low with the potential upside of selling high. The period of recoupment of the lower well development costs obviously will have a diminished duration period and thus be more economical.
3) Income Tax Advantages
Investors seeking optimum return on oil and gas investments desire to select an investment structure which allows for the pass through of oil and gas income tax incentives. To stimulate active domestic production of oil and gas, Congress has passed income tax legislation to promote domestic exploitation of the United States available oil and gas reserves.
Examples of available income tax deductions enacted by Congress are as follows:
a) Deductions for tangible drilling costs:
Tangible costs related to drilling — such as the costs of equipment used for drilling — previously were 50% deductible in the year place in service with the remaining 50% being depreciated over seven years. With the passage of the Tax Cuts and Jobs Act (TCJA) passed in December 2017, tangible cost is currently 100% deductible when placed in service.
b) Deductions for intangible drilling costs (IDCs):
All intangible drilling costs, including labor, are deductible when incurred. In specific situations which require the prepayment of intangible drilling costs, these IDC deductions are available in the year of prepayment providing the well is spudded (drilling commenced) within ninety days of the end of the previous taxable year. Applicable IDCs normally range between 65% to 80% of well development costs. This percentage of current deductions could be significantly beneficial to an investor seeking income tax favored investments. The structure of the oil and gas investment must allow the investor to participate in such deductions. The normal method of such participation is offered by direct acquisition of oil and gas working interest or participation in a partnership which acquires oil and gas working interest as an asset of the partnership.
Intangible drilling costs can include expenses associated with employees, mud drilling, supplies, chemicals, the fracking process, crews, and most expenses except for the actual drilling equipment (which is considered a tangible cost).
c) Depletion allowances
Depletion allowances represent the method or recovering the cost of oil and gas mineral leases. On an annual basis, the greater of percentage depletion or cost depletion can be claimed as a deduction. Percentage depletion is calculated as fifteen (15%) percent of the gross oil and gas revenue and cost depletion is calculated by multiplying the oil and gas mineral lease cost by a percentage of annual production divided by the projected recoverable reserves remaining as of the end of the calendar year.
Drilling programs, such as described above, provide tax-advantage deductions by passing through to the investors IDC deductions, depreciation and depletion allowances.
Because of lower oil prices, excellent opportunities exist right now for an investor to buy low and sell high once oil and gas commodity prices recover from increased demand.