Oil & Gas: A Case Study on Working Interest

Investors constantly seek ways to diversify their portfolios, grow wealth, and minimize tax liabilities. One investment type that continues to attract high-net-worth individuals is oil and gas working interests. In a recent Tax Smart REI podcast episode, Troy Eckard, CEO of Eckard Enterprises, shares insights into oil and gas working interests as a powerful asset class, particularly for its unique tax benefits and cash flow potential.

This post covers key takeaways from that discussion, including investment structures, tax implications, and the long-term wealth-building strategy this asset can offer.

What Are Oil & Gas Working Interests?

In the oil and gas industry, investors can participate as either mineral rights owners or as working interest owners. Mineral rights owners receive a percentage of revenue without bearing operational costs. Working interest owners, on the other hand, cover the operational expenses and take on the full business risk, which allows them to capture a larger share of profits.

Key Benefits of Working Interests

1. Significant Tax Deductions: The 1986 Tax Reform Act incentivizes domestic oil and gas drilling by allowing investors to deduct substantial portions of their initial investment. For example, investing $100,000 in a working interest can yield approximately $37,000 in tax savings for high-bracket taxpayers.
2. Immediate Income Potential: Once operational, these wells generate monthly cash flow that can continue for decades.
3. Tax-Free Income on a Portion of Revenue: The IRS allows a 15% depletion allowance, making a portion of revenue from oil and gas investments tax-free.

Due Diligence: The Key to Avoiding Pitfalls

Investing in oil and gas can be lucrative, but it is also a highly complex asset class. Many promoters market oil and gas working interests with inflated projections and hidden costs. Eckard highlights the importance of extensive due diligence to ensure transparency, fairness, and profitability. Investors should consider questions such as:

• Who are the people behind the project, and what is their track record?
• How are the deal terms structured, and do they allow for a reasonable return on investment?
• What risks exist, and how are they mitigated?

These questions help investors avoid inflated costs and risky deals that don’t yield a substantial return. For example, Eckard recounts a case study in which an investor was offered a working interest with a cost markup of 400%, making it nearly impossible for the investor to earn a profit.

Why Technological Advances Have Improved Oil and Gas Investment

Oil and gas investments have become less risky thanks to advances in horizontal drilling and fracking. These technologies enable operators to access reserves with greater accuracy and productivity. According to Eckard, today’s drilling techniques allow operators to drill into rock formations with precision, reducing the risk of dry wells.

Structuring Investments for Maximum Control and Tax Benefits

Eckard advises that direct ownership models (like a tenant-in-common arrangement in real estate) are ideal for oil and gas working interests. Direct ownership allows investors to claim direct tax deductions for drilling and operational costs. Additionally, this model provides transparency and flexibility, ensuring that investors retain control over their assets.

Investors should avoid partnerships where operators maintain control over expenses and obscure the actual costs, as this setup can often lead to excessive fees and diluted returns. By structuring investments as direct ownerships, investors not only maximize control but also reduce the risk of IRS audits by ensuring that their expenses are fully documented and justified.

Long-Term Wealth Building with Working Interests

While oil and gas working interests are effective for immediate tax relief, Eckard emphasizes that the asset class is best approached as a long-term strategy. By consistently reinvesting returns into new wells, investors can build a substantial revenue stream that compounds over time. Here’s how it works:

1. Year-One Tax Deductions: Investors can deduct up to 80% of their investment from taxable income in the first year.
2. Monthly Cash Flow: Wells typically begin producing revenue within 9-12 months, with monthly cash flows continuing for 20-50 years.
3. Deferred Taxes: Investors can reinvest earnings into new wells, continuously deferring taxes and compounding wealth through asset appreciation and additional tax savings.

This long-term approach allows investors to accumulate a portfolio of revenue-generating wells that contribute to cash flow, portfolio diversification, and substantial tax benefits.

Is This Investment Right for You?

Oil and gas working interests can be a rewarding investment vehicle, but they’re not suitable for everyone. Investors need high disposable income, a willingness to engage in due diligence, and a commitment to long-term investment. Eckard suggests that only a small percentage of high-income individuals should pursue working interests due to the risk and complexity of this asset class.

Conclusion

Oil and gas working interests offer unique tax and income benefits, especially for high-net-worth investors seeking tax-advantaged cash flow. With direct ownership and modern drilling techniques, this asset class has evolved into a compelling option for building long-term wealth. However, success in oil and gas investments depends heavily on working with experienced, transparent operators and adopting a long-term strategy.

For real estate and tax-savvy investors considering alternative asset classes, oil and gas working interests may be a valuable addition to a diversified portfolio. But as with any investment, the best outcomes are achieved through thorough due diligence, proper structuring, and a commitment to long-term wealth-building strategies.

Transcript

Case Study Overview: 1:16 – 1:52

Thomas:
Thanks for tuning in this week’s episode. This week we’re joined again with Troy Eckard of Eckard Enterprises. We’ll go through a case study on working interests in oil and gas. Over the years, we’ve had a lot of questions from clients on oil and gas, so Troy, thanks again for joining us. For anyone unfamiliar with your background, could you give us a quick intro?

Troy’s Background in Oil & Gas: 1:52 – 2:29

Troy:
I’ve been in the industry since 1985. I started investing in wells and representing high-net-worth clients as a licensed broker. I’ve been involved in this space for nearly 41 years. Today, the technology and structures are a lot more refined, making this a valuable, but also a risky asset class. I’m excited to share insights on how investors can navigate this space effectively.

Oil & Gas Investment Structures: 2:29 – 5:36

Troy:
There are two main types of investors in oil and gas. Mineral owners are like landlords—they own the land and get a percentage of income but don’t manage operations. Working interest investors, on the other hand, are like the tenants—they take on the operational responsibilities, pay the bills, and keep a larger share of the income. As working interest owners, investors can benefit from significant tax deductions under the 1986 Tax Reform Act, which encouraged domestic drilling.

For example, investing $100,000 can yield $37,000 in tax savings if you’re in the top bracket. But whether the well is successful or not, the tax benefits apply. My goal is to defer taxes by investing in profitable wells, using the IRS’s incentives to expand my capital and increase my net worth.

Due Diligence in Oil & Gas: 5:36 – 12:14

Troy:
Due diligence is crucial in working interest investments. Many promoters rely on investors’ lack of understanding to inflate prices or hide costs. You need to know the team behind the project, their experience in oil and gas, and how the deal is structured. Ask detailed questions like, “How many wells have you drilled?” or “What’s your rate of return?” Without these answers, walk away. You should understand the strategy, economics, and risk-reward balance of any oil and gas investment.

Case Study: A “Dead on Arrival” Deal: 12:14 – 15:54

Troy:
A potential investor showed me a deal offering 3% interest for a $125,000 investment, with the projected total revenue going to the mineral owners. The promoter set the cost at $27 million per well, inflating prices four times over, leaving the investors with a slim chance of any return. This kind of markup is common, but by paying attention to these numbers, you can spot deals that are essentially dead on arrival.

Horizontal Drilling & Fracking Advances: 15:54 – 20:37

Troy:
Modern drilling has reduced the risk of dry wells significantly. We drill horizontally, targeting massive oil reserves with precision. Using water and sand to fracture the rock and release oil, we’re able to turn historically risky ventures into highly productive wells. This has drastically reduced the risk in working interest investments, as we now see around a 95% success rate.

Ryan:
With these technology advances, the government tax incentives have remained strong, but the risk profile has improved. Troy, do you see the government revisiting the tax write-offs as technology has made dry wells less of an issue?

Troy:
There’s been talk about it, but the counterpoint is if the tax incentive went away, we might see a substantial decrease in investment. Even with reduced risks, this industry is still high-stakes, given the volatility of oil prices and the global market’s impact.

Working Interest Returns and Long-Term Strategy: 20:37 – 27:08

Troy:
Investing in working interest wells is a long-term strategy, providing monthly revenue once the well is producing. You get significant tax deductions in the year you invest, with income flowing in 9-12 months after the initial investment. Wells are projected to last 25-50 years, providing tax-free income on 15% of revenue due to IRS depletion allowances.

Thomas:
So, if an investor commits over several years and reinvests the income, they’d build a sizable number of wells over time. Is it realistic to say that, by year five, they’re in a position where these investments could pay out almost indefinitely?

Troy:
Yes, absolutely. By spreading the investment over multiple wells and years, you can create a strong income stream that could last 20-50 years. You’re building a long-term wealth foundation through continued reinvestment.

Eckard’s Performance Metrics: 27:08 – 30:54

Troy:
Our wells take an average of 168 days from drilling to production. Year-to-date returns are around 17.5%, and average returns have been 80%, with annual yields around 32.7%. This transparency and performance consistency are important for investors to expect when evaluating potential operators.

Ryan:
That’s really interesting, especially as it’s tough to find investment vehicles that yield double-digit returns while also offering substantial tax benefits.

Direct Ownership vs. Partnership Models: 30:54 – 37:20

Troy:
Direct ownership is crucial because it provides tax deductions and more control over the investment. You should own the well itself rather than being a limited partner (LP) in a company structure that doesn’t give you direct asset ownership. Always verify costs against a transparent budget, and avoid partnerships where the operator hides true expenses with markups.

Thomas:
This reminds me of real estate where owning directly as a tenant in common (TIC) allows similar benefits, versus entering a general partnership where control and transparency diminish.

Troy:
Exactly. The direct ownership model ensures you get full control and transparency, making it ideal for experienced, high-income investors.

Investor Suitability: 37:20 – 43:09

Troy:
Working interests aren’t for everyone. They are better suited for high-net-worth individuals with disposable income who understand the long-term commitment. Spreading your investment over several wells and years increases your success rate and compounds wealth through tax-deferred reinvestments.

Thomas:
So, it sounds like for people just starting, oil and gas working interest should be approached with a clear, multiyear strategy, and it’s not ideal as a one-time tax tool.

Troy:
That’s exactly it. One-off investments might yield some benefits, but it’s the sustained strategy that compounds wealth in this asset class.

Closing Remarks: 43:09 – End

Thomas:
Thanks again, Troy, for joining us on the Tax Smart REI podcast and breaking down working interests in oil and gas. As a reminder to listeners, always do your due diligence, especially with alternative investments like oil and gas. Remember, it’s not just about the tax savings; it’s about the long-term viability of the investment.

Outro: Upcoming Opportunities and Resources

Thomas:
If you’re looking for a CPA firm that understands real estate and alternative investments, or if you’re a CPA seeking new opportunities, request a discovery call here. Also, check out our book Short-Term Rental Tax Secrets, available in paperback and Kindle. Thanks for tuning in! We’ll see you next time on the Tax Smart REI Podcast.

Speaking to a tax professional before implementing any strategies is crucial.

Disclaimer: This podcast summary and transcript were partly generated and may contain some errors or miss key points from the audio recording.