Owning production in oil and gas is an excellent asset class to be in, argues Paul Anthony Thomas, a Certified Professional Geological Scientist, oil and gas producer and Registered Landman.

Owning production in
oil and gas – a hot topic in this era of shale gas development through
technologies such as “fracking” – is an excellent asset class to be in, argues
Paul Anthony Thomas, a Certified Professional Geological Scientist, oil and gas
producer and Registered Landman. He has over 30 years of experience in the
sector, and is also a principal at Ledger Petroleum, based in Abilene, Texas. 

This publication is
pleased to share part two of the insights of such an experienced figure on a sector that is
getting a lot of media attention right now (view part one here). As always, while the editors of
this publication don’t necessarily endorse all the views of such contributors,
we are delighted to share the views of such experts and value any reader
reactions.

To view the first part of this feature, click here.

Favorable tax
treatment

Due to its core commodity status and the risk required to
find, exploit, and produce oil and natural gas, today the oil and natural gas
production business is blessed with some of the most favorable tax treatment
from the Internal Revenue Code available to any global investor.  Some of the ways in which this favorable
treatment can be realized include:

1, Intangible drilling/workover costs: The expense of
drilling and completing (installing the well) or working over (repairing) a
well may be expensed by the owner as “Intangible Drilling Costs” in the year
that they occur.  If you are a working
interest owner (a partner that pays the bills), these expenses may be taken
against the ordinary active income of the taxpayer;  

2, Dry hole costs: All exploration expenses, including
leasehold costs, may be expensed in the year spent if a dry hole is drilled;

3, Capital depreciation: On producing leases, leasehold
costs are generally capitalized along with the “tangible” portion of the
installation or workover process such as recoverable pipe, pumps, surface equipment
and other equipment that may be salvaged when the well is plugged.  These items are depreciated using short term
(5 or 7 year) depreciation rates, depending on the class of asset;

4, 15 per cent of gross income is excluded from income tax:
Once a well is put into production, only 85 per cent of the gross income from
oil and gas production is taxable as income. 15 per cent is not subject to any
form of income tax because it is considered depletion of the producing asset
(known as the ‘depletion allowance’). 
For working interest (bill-paying) owners, this income is offset by any
expenses of producing the oil, liquids, and natural gas (known as operating
expenses), severance or property taxes, and required maintenance/workover
costs. Intangible expenses (non-salvageable portion) are written off in the
year spent while the tangible costs are depreciated;

5, Percentage depletion allowance allowed every year:
Another benefit not found in any other asset class is that the depletion
allowance (15 per cent of gross income) is available every year of production.
Regardless of the owner’s basis in the property, the owner may take 15 per cent
depletion allowance off the top of the gross income for 100 years if the
property produces in paying quantities for 100 years.

New era

The era of cheap oil is behind us.  It is common knowledge that, over the next
100 years, oil and natural gas will give way to other energy sources such as
solar, wind, waves, and nuclear as they become affordable and manageable. The
media would have one believe that the new horizontal shale production made
possible by the use of hydraulic fracturing (“fracking”) will sustain the
supply for oil and gas for the foreseeable future. In fact, horizontal drilling
has been an industry standard since the 1970’s and the first reported fracking
was conducted in 1865 with the Roberts Torpedo. 

It is true that shale production has unlocked many new
producing hydrocarbon zones, but the truth is that the storage capacity of
those reservoirs is extremely limited when compared to historical oil and gas
production.  The simple fact remains that
a large percentage of the “easy” and cheap oil has already been discovered,
with future production being more expensive to the extreme.

An example of this fact is the East Texas Field which
produced 5.2 billion barrels of oil from 1930 through 2000 and continues to
produce today. This field was the largest oil deposit discovered in the world
until the giant fields of Saudi Arabia (estimated 77 billion barrels) and the
Prudhoe Bay field in Alaska (estimated 25 billion barrels) joined the
discovered sites. The East Texas field
produced 5.2 billion barrels from 148,000 acres (an estimated 37,000 barrels
per acre). In contrast, the newly developing Bakken Shale/Dolomite (including
the Three Forks formation) of North Dakota and
Montana
covers 128,000,000 acres and has estimated recoverable reserves of about 7
billion barrels. 

Although the extent of the recovery from the Bakken/Three
Forks will not be known for a few more decades, it is currently estimated that
the recovery will be about 50 barrels per acre. 
The difference between these two fields illustrates definitively that
oil and gas will be harder and more expensive to produce in the future than
they were in the past by several orders of magnitude.

Supply and demand is
the ultimate regulator

With regards to natural gas, one historical fact that seems
clear is that “cheap energy prices are the cure for cheap energy prices.” As
natural gas prices remain low, oil producers move to the higher priced liquid
and oil products. As operators move away from natural gas, the supply
diminishes and prices rise. Another factor affecting this scenario is
commercial demand.

As the price of natural gas lowers, electric utilities and
commercial users move to natural gas as a cheap fuel causing increased demand.
More natural gas vehicles are built. As demand grows and supply lessens due to
lower production due to less drilling caused by the sustained low price, the
price rises, causing oil and gas operators once again to explore and drill for
natural gas, increasing the supply and, hopefully, stabilizing the price.

In conclusion, the factors that drew our family to invest in
producing energy are compelling.  Energy
is a required core asset with a predictable, hedgeable, and protectable value;
little reliance on the “psychology” of the global or local marketplace; an
inherent indifference to interest rates or public market sentiment; possessing
a natural hedge against inflation; providing favorable tax treatment; and with
an uncertain supply and a continually increasing demand.  These factors support our family mantra,
“There are no greater assets to own, in certain or uncertain economic times,
than producing energy in the ground.”

Thomas has personally drilled or supervised the drilling of
over 200 oil and gas wells and currently owns an interest in over 225 producing
oil and gas wells throughout the US. 
He served for five years as the US EPA Region 6 alternative
energy/recycling coordinator, working with the Department of Energy on
alternative energy generation profitability and technology transfer.  He was editor of “Human Psychology in the
Stock Market,” 1969 © EP Thomas Ph.D., Bruno’s Press, and most recently
“Winning With Private Equity,” 2010 © Paul Anthony Thomas. 

He is working on the publication of “Twenty Five Ways to Make Money In the Oil
and Gas Business” due out this year. He can be contacted at 325-695-1329 or at paul.a.thomas1110@gmail.com.