How To Invest in Oil Wells And Natural Gas
As the United States recovers from the Fiscal Crisis of several years ago, the job market remains uninspiring. The unemployment rate has fallen consistently, but so has the number of people looking for work. The so-called labor force participation rate is as low as it's been in 35 years. Individuals seeking employment have some options, and one option is to head to North Dakota.
North Dakota is home to the Bakken formation, an oil field discovered in the 1950s.  The available oil from this formation was not thought to be particularly significant at first. The advent of hydraulic fracturing - also known as fracking - changed that. The U.S. Geological Survey estimates that the Bakken formation, extending beyond North Dakota to South Dakota and Montana, offers an estimated 7.4 billion barrels of recoverable oil. That's more oil than the United States uses in an entire year.
Our annual demand for oil continues to increase, and so does our demand for natural gas. Electricity generation from natural gas has grown linearly in recent years, now exceeding 1.2 trillion kilowatt hours. The average American home uses about 920 kilowatt hours per month. Natural gas, therefore, creates enough electrical energy to power over 108 million homes each year.
Oil and natural gas are critically important to our country's economic well-being. Oil and gas are organic fuels, meaning that they are derived from the remains of animals and plants that decay in the ground over millions of years. Layers of sand, silt, and other composites put those decaying remains under pressure and heat. This changes the chemical composition of the carbon and hydrogen in the remains into what we now call Fossil Fuels: oil, natural gas, and coal.
The use of coal in the United States is falling, both as a result of political pressure and cost relative to natural gas. These pressures and relative prices are inherently variable. Political landscapes are only viable until the next election, and commodity prices are always subject to fluctuation. Still, coal production is not projected to increase over the next 25 years. So let's focus on oil and natural gas and the benefits of oil investing.
Oil and Gas Investments
Investors who see opportunities in the oil and natural gas markets have many ways to allocate funds and seek a profit. Some of these opportunities are available to the general public. For example, anyone can open a brokerage account at a company such as Fidelity or Scottrade and make investments in oil by purchasing shares of stocks in companies that make a profit in the oil industry. These include oil producers such as ExxonMobil, BP, and Chevron Corporation, as well as refiners such as Valero. Investors can also own shares in companies that process, store, and transport natural gas, such as ONEOK, Inc. and Enterprise Products Partners, L.P.
These companies often provide a decent dividend yield, and their shares of stock are very liquid - meaning that an investor can buy or sell shares of stock easily. In the case of the public companies mentioned above, their markets are extremely fluid. Millions of shares of stock change hands between investors every day. For most investors, that's plenty of liquidity.
Investors, however, may not be satisfied with the profit margins of these companies. ExxonMobil recently reported annual revenues of more than $390 billion, but a net income of $34 billion. That's a net profit margin of less than 10 percent, and that's typical in the oil business. Many investors would like to reap the rewards of investments that derive from much higher profit margins.
The value of a company depends in part on its projected profits and profit margins. Companies in the oil and natural gas business are subject to the ever-changing prices of the commodities they control, as well as the costs of extraction, transportation, insurance, personnel, specialized equipment, and other factors. For some investors, the prospect of making money investing in oil and natural gas requires taking a more direct path: directly investing in oil wells or making direct natural gas investments.
Investing Directly in Oil and Natural Gas
The allure of investing directly in oil and natural gas is understandable. The closer an investment is to the source, the higher the profit margin - and the bigger the opportunity.
By the time a commodity gets to you (as refined gasoline or as natural gas that you use to heat up your breakfast), it has been marked up by many participants in an economic chain. Every time the price is marked up, there is less room for additional profit. This is due, in large part, to the fact that the consumer can only bear a certain price.
So if you want to invest directly in an oil or gas drilling project, what should you look for and what should you look out for?
What to Consider in Gas Drilling Projects
It's an unfortunate truth that there are scams in virtually every industry. The oil and gas industry presents enticing opportunities for scam artists to prey upon the unsuspecting, or the merely greedy. The Securities and Exchange Commission (SEC) offers some guidelines for investors looking to place funds with oil or gas drilling companies.  Most of these guidelines are common sense.
For example, you should get to know the person who is selling you the investment. Ask him or her for references and follow them up. You should also research any company that you're going to invest in. It's likely that the company will have an SEC filing that details financial statements and disclosures. You should read and understand them prior to investing.
You should also understand that any investment in oil or gas drilling has risks, including the risk of your principal. Any salesperson who claims that the investment is a guaranteed success has to be viewed with more than skepticism.
If you receive a "can't miss" fax, or any unsolicited business proposals, it's highly unlikely that they are true opportunities. People who have true opportunities generally don't broadcast them to the world hoping for someone they've never met on the other end of a fax machine to jump in. Set those sorts of proposals aside and do your own homework to find the right opportunities.
The North American Securities Administrators Association has some additional suggestions.  You should ask and confirm that any investment will be held in a separate escrow account that's not to be combined with other funds. Moreover, the funds may be used to cover company costs such as advertising and salaries. It's important to ask how much is going for these types of costs as opposed to actual drilling operation costs. Knowing who has control of the funds is critical, and this person or group has to be highly ethical.
It's important that you avoid oil investment scams at all costs. You can help accomplish this by ensuring that you speak with the principals of the operation and avoid high-pressure salespersons who don't give you sufficient time to research the investment and understand the risks. You can also help others by encouraging them to do the same.
The Basic Framework of Oil and Gas Investments
Having covered some of the hazard areas of investing in oil and gas drilling, let's examine the things that you should look for and how investments can be structured. First, let's cover some basic terms:
- Reserves - An oil or gas investment can be described in terms of its reserves, which refer to the amount of oil or gas present. Reserves are categorized as proved, probable, or possible. Only proved reserves have been assessed and can be assumed to be recoverable from known reservoirs with current methods. More proved reserves equates to a bigger potential revenue source.
- Reserves to production ratio - This addresses how long it will take to produce all the proved reserves. The reserves to production ratio will be measured in terms of years. The higher the reserves to production ratio, the better it corresponds to a longer income stream for a given rate of production.
- Basis differentials - Not all hydrocarbons are created equal, at least in price. Sometimes there are things called basis differentials, which affect the price that operators receive when they sell their product to the market. You should be aware of any basis differentials that an operator must deal with in order to have a relative estimate of the revenue that can be generated, based on the production rate and the proved reserves.
- construction risks
- mechanical risks
- natural disaster risks
- pollution risks
- commodity price risks
- risks on the actual amount of reserves
- other risks on business interruption
- Obtaining a notarized copy of the lease for the area where the drilling will take place and understanding this lease.
- Reviewing the AFE and knowing what costs are expected.
- Avoiding brokers.
- Making sure the operator is listed with Dunn & Bradstreet.
- Avoiding high-pressure sales techniques and offers that come unsolicited.
- Reviewing the operator's insurance.
- Knowing the principals, getting references, and following them up.
- Not risking capital that you cannot afford to lose.
Understanding the Lease Terms
When you consider a gas or oil investment, it's vital that you examine the legal basis for how the resources are going to be acquired. This is typically done by a lease agreement on the property. You need to know when the lease was signed and its terms. For example, the person selling the lease might have retained an interest in the profits to be acquired later. This could affect your bottom line as an investor. It might also be okay, but you need to know about it.
Ask about the current status of the lease and get a notarized copy. How long is it valid for? Is it in default? Are there any liens involved? Make sure you inquire about any distribution of profits that will go to others before going to investors like you.
It's also important to know how the leased property is positioned relative to other properties in the area - particularly others that have leases for oil and gas drilling. You should find out what the terms of those leases are, if possible. There will also be a geologist's report for you to examine. If you aren't able to understand the terms and details of these documents, you should consider hiring someone who can assist you and ensure that all the documents are in order and point towards a favorable investment.
Seismic and Other Risks
Surfers always talk about "local knowledge" - the information that locals know will help them be in the right position at the right time to catch the right wave. It's similar in the oil business. Those who are unfamiliar with a certain area would be unaware of certain risks without local knowledge.
Arm yourself with knowledge about the local project's drilling laws. They vary by area. For example, in Ohio, there are now regulations about drilling near fault lines or areas where seismic activity has been detected.  These regulations require seismic monitoring. Seismic events over magnitude 1.0 necessitate a pause in activity until the event is investigated and explained. You should have an idea of the frequency and magnitude of seismic activity in the area you have in mind for an investment.
The drilling operator is going to have insurance, so ask for a copy of the operator's insurance. Read it. Know what it covers and how much it covers. There are:
It's important to make sure there is enough coverage for these risks and also that there's not too much coverage - you don't want to pay for something unnecessary.
Know Your Costs
When you're thinking about your costs, you should request an authority for expenditure, also known as an AFE, and see what these costs entail. The AFE is a budget document that itemizes all the expenses that are associated with the drilling project. It takes into account the depth of the well, geological circumstances, and the cost of completing the well or abandoning it.
It can be difficult to create a reliable AFE.  Part of the difficulty comes with estimating costs from a long list of factors. The expected drilling time may be off by many months, particularly if something occurs that interrupts business. The cost of drilling fluids and equipment is likely more reliable, but can vary based on equipment reliability and unexpected drilling conditions.
Operating costs are divided into tangible and intangible categories. Tangibles are things that have a salvage value when you're done with them. The intangibles are everything else. Tangibles include items such as oil well pumps, and pipelines. Intangibles include the costs of labor, fuel, and supplies.
The planner you choose to work with should be skilled in making these estimates while ensuring that the overall operation is safe, conducted at reasonable or even minimum cost, and that the end product of the effort is a successful well. Safety is expensive, but it must be the highest priority. Oil and gas operations are dangerous and the crew will be completing tasks that can result in the loss of life or serious injury.
Know Your Partners
As with any investment that places you in the position of being a partner with others, you need to make sure you know your partners. It's likely that you'll be a limited partner in a business partnership. Being a limited partner offers some protection that general partners don't have, but you also have less direct control of what the partnership will do.
This means you must be confident in the principals of the business. Learn about their past experience and, most importantly, their past successes. Successful people often tend to be repeat performers.
Even with a strong track record, you should also get investor references. Ask the references if they've made money with the business principals. Ask about the concerns they have and how many times they have invested with the principals. If there have been any circumstances that caused concern, you need to explore those circumstances and follow up with the principals to understand what happened and what was learned. You want to ensure those problems do not arise again.
Business rating services, such as Dunn & Bradstreet, can provide independent assurance that the business operators are above board. If an operator isn't listed with Dunn & Bradstreet, move on.
Finally, make sure your investment is with the drilling operator directly. You'll want to avoid broker/dealers who might act as middlemen in your investment. Commissions to intermediaries can exceed 20%. You'll want your investment capital to fund the project, rather than the retirement accounts of the intermediaries.
Revenue and Net Profit
When investing in oil and gas, you'll want to invest in a working interest or a royalty stream. You'll want the net revenue interest to be more than 70% to the 100% working interest. Net revenue is the "share of oil or gas production that is calculated after deducting any burdens from the working interest." 
These "burdens" include the rights of other owners, such as a mineral rights owner or someone who has a royalty interest. These people get the first revenues. Of the remaining working interest, it's best if you have the significant majority.
Tax considerations are also important. Current tax policy offers benefits to domestic oil and gas producers. For example, investors can deduct a substantial part of their investment from their income.  Limited partners can deduct against passive income.
Investors also get tax preference by sheltering a percentage of income based on a percentage depletion allowance. The concept is similar to depreciation in real estate.
As with any tax matter, you should consult a tax expert to ensure that you're taking advantage of every benefit that the U.S. government offers. You'll want to report all your information in accordance with the law.
Distributing Your Risk
There's a saying in stock market investing that 'diversification is the only free lunch the market offers.'' Diversification means distributing your risk across multiple assets that are not perfectly correlated. As some assets go up, others go down - but hopefully all do not go down at the same time.
Mathematically, diversifying allows you to achieve the same return on investment but with less volatility in your portfolio. It's the same when making oil and gas investments.
Don't limit yourself to one oil or gas investment. Distribute your investments across multiple wells. Some will do better than others. Some may be a total bust. By distributing your risk, you can have more confidence that you'll come closer to the overall expected return on investment.
The Time to Invest
Oil and gas investments offer many advantages to a seasoned investor. As commodities, oil and gas can offer diversification to more traditional stock and bond investments. There are many tax advantages for oil and gas investments that are not found in other opportunities. What's more, the upside potential when investing in oil and gas, particularly in limited partnerships with drilling operators, is considerable. It can last for many years as the well produces its product.
It's important, however, to ensure that you distribute your risk across multiple opportunities and that you deal directly with scrupulous partners. Any time there's a potential for high returns, there's also a potential that someone will attempt to take advantage of investors seeking those returns. Oil investment scams are an ongoing problem, but they can be addressed directly by following the steps indicated previously and working directly with people who have a history of successful operations.
One of the drawbacks to oil and gas investments can be a lack of liquidity. It may be difficult to sell your interest in an oil or gas investment. They are often not available to the public and you may have to sell your interest back to the limited partnership. If you need complete liquidity and want to invest in oil and gas, try investing in publicly traded companies rather than owning an interest in an oil or gas well.
Another drawback is that oil and gas investments quite literally have many "moving parts."" There are many unknowns in any oil or gas drilling project, and there will always be risks of loss that derive from equipment, personnel, legal, and other issues. You need to be certain of what legal liability you're accepting for these risks when you make an investment.
If you're considering investing in oil and gas, the most important next steps include:
Investing in oil and gas offers many unique opportunities for the right investor. If you follow the guidelines identified here, you can save time and money while you search for that next gusher.
To learn more, contact our team today for free expert advice on oil and gas drilling investments. We know the do's and don'ts of oil and gas investing, and we'll help you make the best decision.
More Tips on How to Invest in Oil:
- Get a consultation from a real operator who is willing to educate you about how to invest in oil.
- Invest in oil using small amounts of money into several deals versus a larger amount into one deal.
- Always speak directly to one of the principals and/or partners of the operator.
- Calculate the price of oil at 20% less than it shows on West Texas Intermediate.
- Contact us if you are trying to figure out how to invest in oil or any other crude oil investing tips.