Oil and Gas: Complexity, Risk, and Reward
The laws of supply and demand tell us that when the demand for goods falls, prices drop. Unfortunately this is not always the case, particularly regarding oil and gas, a complex and potentially risky sector of the investment world. On a more practical level, consumers may stare at the gas pump confused as to why gas prices are rising when oil prices are falling and wonder how they, as investors, can capture returns in this volatile market. Marketers of oil and gas investment vehicles can take advantage of this confusion by utilizing sales tactics to lure such individuals into investments that are clearly not in the best interest of the investor. When it comes to oil and gas investments the buyer should beware, as in most cases there is far more complexity to the investment than meets the eye.
The world of oil and gas investments is quite expansive with multiple investment vehicles offering various combinations of risk and reward. This Viewpoint will discuss two of the more common investment vehicles targeted to consumers and describe Truepoint’s approach to capturing the returns from this segment of the broader investment market.
The direct investment
A direct investment in a specific oil and gas exploration venture via a partnership offers investors with a high appetite for risk a means for speculating in oil and gas. The income tax benefits are often the driving force behind a direct investment unless you are one of the producers and promoters of such a deal and, thus, privy to the best returns. The U.S. tax code supports the exploration and drilling for oil and gas on U.S. soil and has therefore afforded investors in these projects special tax benefits for taking on the risk associated with exploration. The ability to write off much of one’s initial investment on a tax return in the first few years of a project provides investors with a tax benefit that, in limited circumstances, is worth the risk involved. While an investor may hope for a big return, they should be willing to face the reality of a low performing or dry well and recovering little to none of the initial investment.
What is a Master Limited Partnership?
Another common oil and gas investment is the Master Limited Partnership (MLP). In recent years investors have been courted by MLPs with the promise of steady income payouts and ease of liquidating one’s investment. An MLP is structured as a limited partnership that trades on the stock market. This vehicle provides investors with the ability to easily sell their shares, while enjoying tax benefits of a partnership structure. A successful MLP will pay out a steady stream of dividends which are considered a return of capital and are not taxed. The taxable income reported by the MLP will likely be much less than the cash distributed due to deductions for depreciation and depletion. While this appears to be a great answer for the investor, when the MLP is sold the gain will likely have a large ordinary income (not capital gain) component resulting in more taxes on the back end of the deal. An additional concern with MLPs is that the tax reporting is quite complex throughout the life of the investment and will require the involvement of a knowledgeable tax preparer and possible extension of one’s annual tax filings.
Gaining exposure to the oil and gas market
So how does a Truepoint client gain exposure to the oil and gas market? While we don’t recommend an explicit or concentrated allocation to any individual oil and gas investment, our clients gain access to the sector through the passively-managed securities in their portfolio. In fact, our core U.S. stock holding, the Vanguard Total Stock Market Index, is a size-weighted fund, and therefore holds all U.S. companies in proportion to market value. As such, oil and gas receives an allocation of approximately ten percent within Truepoint’s recommended equity holdings. Some of the larger oil and gas companies included within these funds include Exxon Mobil, Royal Dutch Shell, BP, and Chevron, all of whom are industry-leading companies with established positions in the oil & gas sector through their leading portfolio of resources, technology, and disciplined investment approach.
Outside a unique set of circumstances likely involving a compelling short term tax advantage which may make a direct oil and gas investment attractive, from an investment perspective, we believe that strategic allocation within a low-cost, tax efficient portfolio increases the likelihood of earning expected returns while minimizing the risk involved with this industry.