Oil and Gas Properties: Investing Essentials

The Chinese are largely credited for drilling the world's first oil wells in the year 347. They used bamboo poles to drill nearly 800 feet below the Earth's surface. The oil was burned so that brine could be evaporated to produce salt.

Since then, drilling for oil and gas has become more complex and widespread. The valuable natural resources below ground are used to fuel modern economies, which is creating a lot of value for those that explore and produce oil and gas. That being said, the exploration and then development of oil and gas is an expensive venture, which is why the industry has turned to investors to raise capital to find and develop these properties.

What are oil and gas properties?

Oil and natural gas is found in subsurface pools typically called reservoirs. But these are not pools in the traditional sense as the hydrocarbons are found in porous or fractured rock formations. In order to extract the oil and gas, energy companies lease acreage above the reservoir to obtain the subsurface rights. The energy company then drills wells into these rock formations to produce the oil and gas. These leases along with any associated wells are commonly known as oil and gas properties.

The San Ardo Oil Field in California. Photo credit: Flickr user Loco Steve

Conventional oil and gas properties that use vertical wells to extract the oil and gas can have many wells drilled very tightly packed across a few thousand acres. Meanwhile, unconventional properties where horizontal drilling techniques are used might space wells a few hundred acres apart. In addition to that some oil and gas properties are only prospective for drilling as the subsurface leases have been obtained, but drilling hasn't yet commenced as it's a new exploration area or thought to be an extension of a currently producing area.

What is the history of oil & gas properties?

American exploration and production companies have been buying and selling oil and gas properties for more than a hundred years. Oil and gas exploration is risky and expensive. In order to fund the exploration and reduce risks, energy companies will sell oil and gas properties to competitors or financial investors. This fresh capital is then recycled back into the business to develop the best prospects as well as to continue to explore for new prospects.

The onshore shale boom in the U.S. has created a whirlwind of activity around oil and gas property sales. Shale focused drillers acquired millions of acres worth of subsurface leases early on in the boom. One way drillers chose to pay for drilling on these leases is to sell mature producing oil and gas properties for cash that can be used to drill new wells. In fact, since 2007 about $40 billion worth of oil and gas properties have changed hands annually as energy companies restructure their portfolios.

Photo credit: Flickr user Kool Cats Photography

How many oil and gas properties are there?

At any given time there are literally hundreds of oil and gas properties for sale in the U.S. Both buyers and sellers of these properties can be private individuals, exploration and production companies, investment funds, master limited partnerships as well as a range of other investor types.

In recent years among the more common buyers of oil and gas properties were upstream MLPs and private equity funds. MLPs in particular are focused on buying mature properties with proven reserves and production along with low-risk drilling opportunities in order to support stable distributions to unit holders. In any given year a midsize MLP will screen hundreds of opportunities to purchase oil and gas properties, but typically will close just a handful of deals each year. Meanwhile, private equity funds or other institutional investors are building oil and gas companies from the ground up by purchasing oil and gas properties instead of starting exploration from scratch.

Why invest in oil and gas properties?

Oil and gas wells tend to produce a lot of cash flow. Once drilled a well can produce oil and gas for several decades before depleting. In many cases an energy company can recoup its initial investment within a few months and then continue to collect the cash flows from the wells for years to come. It's the strong returns and cash flow that draw investors into oil and gas properties.

Further, oil and gas properties do have some special tax advantage. For example, small independent producers and royalty owners can take advantage of Percentage Depletion, which was added into the tax code in 1913. Similar to the depreciation deduction, this allows for the deduction of a percentage of the depletion of oil and gas reserves. It's one of a small handful of tax credits or deductions specifically in the tax code for oil and gas properties.

Photo credit: Flickr user Steven

Meanwhile, some MLP investors can enjoy tax advantaged income from owning oil and gas properties. Upstream MLPs typically buy mature oil and gas properties and pass nearly all of the income through to unitholders. This income has two advantages. First, it avoids the double taxation of dividend income paid by a corporation and thanks to the heavy depreciation charges the income is generally tax deferred as in many cases as it's a return of capital.

The compelling combination of cash flow and tax advantages are why oil and gas property investments are popular with investors. Given that oil and gas companies will continue to flip oil and gas properties for cash to fund exploration drilling, it's a sector that should continue to grow as MLPs and investment funds will continue to be on the other end to scoop up these properties. 


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