043 | Investing in Oil & Gas: The Untapped Advantages You’re Missing

00:01 – Patrick Lonergan (Host)
Welcome back to the Vital Strategies Podcast. I’m your host, Patrick Lonergan. Today, I’m joined by Matthew Eich, Executive Vice President of US Energy Development Corporation, who has helped raise over $1.6 billion in capital. In this episode, we uncover how oil and gas investments can supercharge your wealth while slashing your tax bill. Matthew shares insider tips on making the most of these opportunities, navigating today’s market and maximizing your returns. Stay tuned to the end to hear his top strategy for securing your financial future. Let’s dive in with Matthew Eich. Today we’ve got Matthew Eich with us, who’s Executive Vice President of US Energy Development Corporation. He’s a member of the company’s board of directors and has overseen capital raise of over $1.6 billion since he joined the company. Matthew also has a background in real estate. Matthew, I welcome you here today. It’s exciting to have you. It seems like you like cash-flowing assets that have tax benefits, so thanks for joining us.

01:04 – Matthew Iak (Guest)
Thank you so much for having me. I hope to make this of extreme value for all your listeners.

I thought it’d be good to just thinking about the oil and gas space in general, like start to understand what that investment looks like, where the opportunity lies. From there I think we can start to geek out a little bit on the tax side of things. But can you give us an overview of oil and gas as an investment?

in general. So there’s a wide variety, much wider than people think of in terms of the mediums to invest directly into energy in the United States. So obviously you have your public securities, you have your stocks and you have your master limited partnerships and your royalty trusts, which are kind of the public exchange vehicles in the energy space. But there’s a massive, a plethora amount of securities that exist within the institutional space in energy, especially direct traditional fossil fuels, as well as renewables and you name it. There’s a lot of different structures that can be complex or simple but have a host of different tax benefits, return profiles, you name it. It’s really changed so much in the last seven years. It’s almost beyond description the transition that’s happened, not the energy transition, but the security style of investment and tax style.

02:14
So, if you really look back, 2015 was a major kind of inflection point in the US, especially in upstream E&P production, where Wall Street really dictated how public companies are going to operate and the cascading effect really affected all securities. For example, probably the single most common type of private investment was really private equity in oil and gas and the whole thesis of buying land, drilling a couple of wells and selling it to the majors had been the entire capital formation of the institutional space for decades. That really has a tombstone over it in his RIPs. You can’t get funding, it doesn’t exist. The whole thesis is gone and most oil and gas numbers had no idea how to transition or operate within that major change.

02:56
That happened right on 2016. And then there’s been a series of changes with tax law changes and the TCJA you name it but the world has really shrunk its investment opportunities into direct energy, especially in the institutional world, as ESG environmental social governance became so big and impacted investing. So what you actually see now is direct retail investors probably have 20 times the opportunity they would have had five and seven years ago because the endowments and pensions XYZ have been limited or prohibited from investing in oil and gas. It’s created an outsized artificial return risk-to-return profile as well as security structures. So that’s the backdrop, I think, to everything we’re talking about.

I love all of that. Can I have you expand a little bit on the outsized risk to return profile? Because if I’m an investor and I can look at, my downside is, let’s just say, 10,000 of whatever, but my upside is a million, like I’ll take that all day long If I can make a lot of those bets. I know that that turns out well for me. So can you just talk a little bit about that risk profile?

Yeah. So oil and gas to me and I’m an insider in this historically has been what I would consider the most fast moving risk reward ratios, where you get these boom bust cycles like huge wins, huge loss, huge wins, huge losses over decades and it’s refuted itself so many times until 2015. What normally happens is, when returns get really good, capital flows in. What normally happens is, when returns get really good, capital flows in, which makes it more competitive, margins shrink, you have a higher risk and a lower return profile Kind of has that market peace and then things crash. So normally these things in oil and gas have happened super rapidly Every three, four years.

04:38
Boom bust, boom bust, boom bust We’ve seen it all over the US for 40, 50 years. Boom bust We’ve seen it all over the US for 40, 50 years when Wall Street decided that the major E&P companies, which are 60% to 70% of all the production, are forced to operate within cash flow. So the whole paradigm has shifted in what you’ve seen as this outsized window where the returns are good but money’s still not flowing into the sector, which is keeping the return profile way larger than it should be at this point in the cycle. Just anecdotally, our company’s done so well in the last five years for investors. Normally we’d have to tell everyone hey, we got to ratchet down expectations, whatever they are. We got to ratchet them down because there’s a reversion to the mean. You can’t keep it. But when you’re not competing with capital, you can keep getting outsized returns and not increase risk.

05:23
Now the risk side has changed because the technology has become so advanced that when you’re drilling, especially in these major shale plays, your hit ratio is 99.99999% infinite. So the risk is going way down. The break-evens are still really low. So in 2018, when this happened the first time, your break-evens were $75 to $80 a barrel. You still had all the upside, but your downside became very apparent quickly. Right, and really 14 to 18 had a ton of upside but massive downside Post that you’ve had upside. Without the downside, your break-evens are still $40 to $50 a barrel, but you have the upside. That’s what I mean when I make that comment, and that’s abnormal in most industries.

That’s fantastic. There’s a couple of things you mentioned there that I think are worth discussing. Dry wells the technology has gotten so good that I’m not drilling a hole unless I know where the oils have. So I want to couple that with. Maybe we can use a US CDC example or just an example in general. Like when I make an investment, am I investing in one well or am I investing in multiple wells? Like how spread investment? Am I investing in one well or am I investing in multiple wells? How spread out is my risk? Because you didn’t say 100%. So there’s still a chance that I could find a dry spot and not get any oil out of it. So can you just talk on those points for me?

Yeah. So for people in the know, in the industry, exploration is dead. The E in E&P doesn’t really exist. People aren’t exploring for reserves in that capacity. There’s no reason to.

06:46
When you can drill into shale plays, your risks can still be cost overruns, downhole issues, operational. There’s still things they can have. Prices can drop you name it. There’s still risks, but finding the reserves is no longer the majority of the risk, which it always was. I guess we’re trying to find the next set of reserves. People will still do it.

07:07
I just don’t know if there’s a reason to do it. As an investor I don’t need to do it. I don’t think a retail investor ever needs to take that risk anymore when they can just go and get involved in an area that they know has no geological risk or little to no geological risk. It doesn’t mean you can’t scrub a well by drilling it too high into a water table. There’s operational stuff. But geologically you know the oils. The shale is where foil emanates from. The problem has been shale. Is this source rock? That is very impermeable and the problem is you have to create a condition in these little particles to let oil get to a level where it come up. You know it’s there. It’s creating the conditions to get it up. And that’s where horizontal fracking has really reshaped the world and that’s why 99% of all operators have success in drilling, because they’re only drilling those areas. You’re not going back to the vertical stuff or taking any risk. In today’s world, there’s no reason to.

That’s wonderful. So, going back to if I’m making an investment in an oil and gas fund, we’ll call it, am I investing in one well or if I have a dozen wells, how does it typically work?

This is where the risk of who you choose to invest through and with and whatnot, can be dramatically different. Our personal goal is to not have that risk, is to not have what we call a concent concentrated asset, where you have a bell curve of returns and you can be on either side of that bell curve. What you want to do theoretically from my standpoint, this is in everyone’s is you want to reduce that risk by having as much well-worn diversification as you can, and each as well as 10, 12 million bucks. So it’s got to be a really big investment process where you’re doing a part of a capital stack that might be a billion to $3 billion and you’re taking a small piece of it as an investor to fund. That’s the best way, because then what happens is if you look at that bell curve, all the averages come together and you get the average out of a hole. Even if you don’t get an average on a well, you can still invest in single well projects.

09:03
I think what happens is your risk and reward ratio goes higher. Where you can make more or lose more. There’s farther away from the average as you get less and less diversification. So from my standpoint, you get to 40 to 50 wells in whatever vehicle you use, really reduce the risk of a single well being good, bad or indifferent. You get down to five, seven, 12 well wars in a package. Whatever the fund style is doesn’t matter. You start to dramatically increase that it could be really good or really poor and you increase what I would call cash flow risk, because a lot of times operations even in great wells, you might be shut down for three, six, 12 months based on everything from weather to offsetting frack jobs or your frack defense. So what you can earn is cash flow, even if the investments are solid and phenomenal. If you’re drilling an adjacent field and you have to shut it all down Again, it’s like the more diversified, the less of that it impacts month to month, year to year on what you do.

Great, I love it. There’s two sort of hot topics, I think, that are coming up regularly in our conversations with our clients about oil and gas, and I’ll let you pick in what order you want to talk about these. But the first is the elections, the second is electric vehicles. If everybody gets an electric vehicle, for this value of this investment is the cash flow just dry up. So can you talk about those? For us, we have seven hours till you get lit.

So I would say the majority of people in the actual oil and gas business not the investment business like us that are real oil and gas operators. They’re usually massive stewards of the environment. I don’t think I know any company that the C-suite isn’t 80% hunters and fisher and we all care so much. And in the US there’s just such a high standard of care and diligence. I don’t think people recognize it, that we’re not anti the environment. So I just want to make that statement.

10:48
However, evs are actually a net positive for oil and for natural gas. It sounds weird so I’ll walk through that. You can do the pretend math or the real math. And the real math basically says when you get your EV, you’re somewhere between 10 and 12 years from consuming less oil than your traditional ice vehicle. So the consumption, the building of it, the diesel used to get all the rare earth elements you name it. Not only is its carbon output much larger, but the EV vehicles are much larger consumers of oil, even though they’re not using fuel to fuel it. The construction of it use more oil. So from that standpoint, you’re not reducing the commodity amount. You’re actually dramatically increasing the next 10 years of usage through a transition Beyond 10 years you really think about.

11:29
There’s only one real source of energy in this country to source all the electricity needs that we would need, and the answer is it’s natural gas. So I think what it means is the future of natural gas as we go from 300 million to 500 million humans in this country. I think you do want more. Especially, inner cities should have more EV for pollution and smog, not necessarily for carbon and all the ways as we state it. It’s a modern marvel, it’s freaking awesome. And are there parts of this country that really do need it for efficiency? So from that standpoint, I think you’re going to have a massive increase in consumption five, seven years from now in natural gas, not today but at that point in time the grid will rely on gas for its consistency.

12:10
So I think both are really positives for the industry, even though everyone thinks they’re negatives. They’re not, and I always want to make this one statement for everyone to understand Throughout all of our human history, energy has been the reason that we advance as a society. It’s the reason we have everything we have. We don’t use less of anything. There’s one source of energy we use less of now than we ever have in history. It’s not coal. Everyone thinks it’s coal. We use more coal, constantly more Even under carbon neutrality. We use more oil, gas and coal in the future than we use now, not as a percentage, but as a gross amount. We still use more. It blows everyone’s mind to realize that the only thing we use less of now is whale blubber. That’s it.

We’re not lighting our candles with it anymore. Yeah, sorry.

We’re only the 10 billion humans who consume energy. Well, it’s not an energy transition, it’s an energy addition. So AI and its massive consumption is going to consume more electricity, more natural gas. The answer is we need all of the above, but this isn’t a horse and buggy. It’s not going away. You just need more energy for the world to grow. The world can’t grow on fossil fuels. There’s not enough capacity for the world to grow on fossil fuels. We need everything else so we can keep growing, not to replace what we have.

I love that. I think a lot of people think, well, the next president’s going to make or break oil investments. But I think we’ve seen over the last four years oil investments have done really well to all the things you talked about. I think about the economy and people get awfully hung up on like, oh, the president’s going to make break whatever it’s like. The president can pull a few levers, but there’s hundreds of levers in the economy and I think we give a little too much credit and a little too much blame to the current administration for some of these things. But yes, is the president going to make or break my oil and gas investment? I love this conversation.

Again, I don’t have a crystal ball per se, but we can kind of leave the tea leaves and tell you what’s going on. There’s a potential for effects not mega-lake, but definitely effects. This is going to sound weird, but under a blue government you’re probably going to get much higher oil prices. So I know everyone’s going to wait. How does that make sense? Well, the reality is you have restrictions, you have costs, you have infrastructure issues. In essence, they’re trying to make oil so expensive and natural gas so expensive that renewables can compete. So they’re offering enough subsidies to keep them alive to allow renewables competing against fossil fuels, which they don’t naturally compete. So ultimately, the more they hurt the infrastructure of oil and gas and the more they make renewables, in the short term it’ll push oil and gas prices up. Oil especially not necessarily gas, but oil especially will go up. In the short term, unfortunately, it can be way up, like 150 and 200, and that’s bad for the economy. So if that happens and I would only say that’s going to happen under a blue sweep so under a blue sweep, what you’re probably likely to see is a really big up and then, three years from now, a really big down, like a massive volatility of the industry. So great for all investors kind of sucky for us as consumers not really optimal.

14:56
Trump is more of a manipulator. He wants to keep prices lower, whether that’s through the drill bit or through market manipulation, because one of his core philosophies is to bring manufacturing back. We need to have cheap taxes and we can’t compete on labor and healthcare, so we need cheap energy. But keeping it down is still over-profitable for us. $60, $70 a barrel is massive. So ironically, I like the lower-priced environment because it keeps money out of the space. It keeps investors doing extremely well, like they had last five years.

15:25
I don’t like the market volatility, but I think under a mixed government nothing happens of any materiality either way. But I do think there’s some manipulation that you could see for four or five years. Long term you can’t change global supply and demand. What I don’t like is if the US isn’t producing enough. Ultimately we give the power to Iran, to Saudi Arabia, to the world’s worst actors, and I think geopolitically that’s unstable for us not to produce 13, 14 million barrels in this country. I think you put the world at risk in more wars, which eventually has cascading effects. So I am much more concerned about that in the next four years than a president, but the president will affect that.

So we’ve talked a fair amount about oil and gas and how it just works as an investment and some of the opportunity. Is there anything else we should touch on there before we get into I’ll call it all the different structures of how we can put an oil and gas investment together and the tax benefits that can come out of that.

I’ll just mention this. There’s three terms that the industry talks about when it talks about oil and gas. There’s what’s called upstream and upstream. What it means is the actual guys and gals who are lifting the oil and gas out of the earth. They call it exploration and production. So it’s the front-facing side, midstream, which is the transportation Usually you think of pipelines, the midstream transportation of those fuels and then downstream is more the utility. That’s the actual conversion into petrochemicals or electricity or fuel. So there’s different parts of those capital stack. Most of what investors have access to, the regulated stuff, is downstream. They don’t really have a lot of access to that. That’s a utility. It’s the midstream or upstream that there’s a bunch of different vehicles that investors can invest through in multitude of tax strategies, entrance points, partners, you name it, and that’s really where the universe exists in those two parts of the stack.

That’s wonderful and I want to just give a disclaimer is the right term. But we work with US CDC but we don’t get compensated for any of the work we do with your firm and we just think it’s a fantastic opportunity for our clients from a cash flow perspective and also brings tremendous tax benefits. So I like to get that out there, because if you don’t know people’s financial incentives, you don’t know why they’re shading their vice one way or the other. So I think that’s an important piece to sort of lay as a foundation for some of these things. I’m awfully interested in if we could just start with, let’s say, maybe a tax 101 with the intangible drilling costs depletion, depreciation Can we just start there and help understand how some of those tax benefits get to the investor?

So the three main tax benefits of the upstream business, drilling, the production, what they call IDCs, which means intangible joint costs, tangible depreciation and depletion allowance. If you imagine a well and you see the wellhead above the well, that’s like the tangible and that’s maybe 20, 30% of the cost are the tangible costs, the physical costs, those depreciate.

18:23
So whatever’s happening in Congress, whether you have bonus, depreciation or maker’s, depreciation or whatever you have you’re able to depreciate that part of your investment like a real estate property, but in a much shorter window, usually one to five years, sometimes seven on the makers right, but it’s usually a pretty rapid depreciation. The majority of the capital in the upstream space is on the intangible costs, at least on a federal level and a lot of different states have different roles. But on a federal level you’re normally able to deduct those. And how investors take it against ordinary or passive or capital gain will depend on the medium that companies use to structure them. What type of fund wraps that up and how do they flow that through to investors?

19:03
But that can create insane amounts of tax planning because sometimes investors and I’d say probably the largest entrance in oil and gas for the last 30 to 40 years are these things called drilling funds where investors participate in between one and 150 wells depending on the sponsor, the area, everything you asked me earlier right. And those costs for investors in the first year can be 70 to 90% of what they invest can be a deduction for them, either against passive or ordinary income, depending on the structure of a fund. So investors will use that in a host of tax planning. Reduce my adjusted gross income. Try to gift money to my heirs, offsetting Roth conversions, getting money out of retirement plans during your five-year window in an inherited IRA. There’s a thousand reasons why people have unique tax situations and if you like the oil and gas investment, the company you work with, the underlying investment, the cash flow, all the good stuff, the charity on top is, you can usually do some really cool tax planning with that part of the code.

That’s wonderful. There’s a couple of things I want to just touch on that I think really, really matter. I’m not interested in making tax moves if it doesn’t contribute to wealth building. So to spend a dollar to save 37 cents, it never made any sense in my mind. I don’t like it, and that’s why we’re big fans of real estate. That’s why we’re big fans of oil and gas All the reasons we talked about just a few minutes ago with how oil and gas can be a tremendous investment. If oil’s anywhere above 40 bucks a barrel, we’re doing well, so we like the cash flow that comes off of these assets. And then, when I think about a few other factors, I get the tax benefits. That’s wonderful.

20:44
And then the other piece that I don’t think is acknowledged very often we do a ton of tax planning, lots of different strategies, and there’s three levels of tax planning. Level one is the IRS gives us guidance, but it doesn’t take any investment. This is good administration and bookkeeping. Level two is the IRS gives us guidance, but we have to invest dollars, and this is typically like IRAs 401ks. I’ll put oil and gas investments in that bucket there, and these are fairly low cost to administer.

21:12
And then we have level three tax strategies where we’re combining sections of the code to create efficiency, and these usually have a third party administrator and we have to start weighing the cost of putting money into this thing with the cost of setting it up. Or I’ve got a tax over here and if my setup cost is the same as the tax, I’m not really gaining anything. So we just need to be aware of all those things. The thing I love about oil and gas is there’s no cost to set this strategy up. I just make my investment and I get fantastic cashflow rate of return back on it, which is really nice from my perspective, just thinking about somebody that’s working on tax strategy all the time.

Yeah, I’ll tell you what I love about our industry is the last five years and I don’t know why it took 40 years to get here. You’ve finally seen a marriage, and I’m not saying this selfishly. I do think our companies helped set the bar really high because we performed really well and had the tax strategies. But I think you’re seeing not one, but an industry shift where companies can marry what you just described the oil and gas already exist in code under a product, that there’s not a lot of work or set up costs, and that wasn’t really true historically, I would say, unfortunately.

22:16
I’ve been in this industry for a really long time. I’m a second generation owner of this company. What’s really interesting in your last 40 plus years of what you’ve seen is it used to be the really good tax guys were a horrible investment in the oil and gas space and the really good tax guys were a horrible investment in the oil and gas space. And the really good oil and gas guys, who actually were really good operators and made good returns, didn’t understand the taxes and investors never got to benefit from them, and we worked really hard to marry that where you’re able to do both, and it’s not just us.

22:41
I see the whole industry having shift to getting good products and good returns and that high bar listen to getting good products doing good returns and that high bar listen to take money away from someone like us who’s probably the largest capital raise in the US in oil and gas. You have to be better than us and that’s awesome. I want the industry to keep raising the bar Because now investors look at this asset class and they go this is a legit entire asset class where there’s options to choose from that are not this high risk crazy, doesn’t work. Doesn’t work. Or I just did it because I didn’t want to pay taxes. No, and that shift is relatively recent in the long-term oil and gas history.

I love that You’ve talked a little bit about structure. So can we talk about what these structures look like? And for most of the oil and gas investments we need to be an accredited investor, which has a few different rules. There’s some income limitations, whether you’re married or single, and then there’s net worth limitations as well. So these are people that have substantial income or substantial net worth north of typically a million dollars or $250,000, I believe, for single and 500 married. I have to look at those, we’ll put it in the show notes, but you need to be accredited investor to be a part of a lot of the oil and gas opportunities. So what we don’t want is somebody going, hey, that sounds like a good idea and taking every dollar they own, throwing it in, and there needs to be a level of sophistication.

It should almost always be an intermediary. So you guys representing the client to make sure that they’re not just finding a good investment that’s inappropriate for their portfolio or doesn’t give them the benefits it gives somebody else. You can’t just say that’s a great investment In this asset class. You really want someone looking at it on the client’s benefit to keyhole into a bigger puzzle. Yes, it’s just a great investment period, but it’s unique and it’s illiquid. It’s meant for accredited investors. Sometimes some of these investments I’ll mention now are only for quips. So there’s a big swath of a lot of the midstream offsets, kind of the pipelines and whatnot. The only way to render them are through quips. You can’t actually even as a retail investor get involved unless it’s even a higher standard. Some of the private equity style investments that are in oil and gas can only be done by quips. But it’s accredited and above super accredited. That’s really that audience, which is great because it also they tend to benefit from all the taxes more too, absolutely. I’m going to end with what I started the drilling and I’m going to give you a bunch of the others that are out there.

24:52
There is a host I mentioned this of private midstream. They’re more like traditional private equity where they have high watermarks, a return profile. You enter in. They’re building out midstream, almost always in the Permian right now, because it’s the major formation in the US where almost all activity is, and you’re transporting a toll road asset, you’re getting paid for all the oil and gas volume regardless and that’s a really hot investment for institutions and endowments, especially on the natural gas side because it’s ESG and natural gas. So you have a big world in that side, these toll road and midstream, and those are pretty much exclusively private equity style funds. You have private equity and upstream, which are these total return funds that’ll drill out a bunch of locations and then flip the properties. So that’s more of a buy cash flow, sell type of model. Those have really shifted in the last five years. They used to be buy land cheap, drill out a bunch of wells, flip to the majors. I told you that’s dead, just completely RIP. Now it’s just drilling for real returns and cash flow, where each well is about the economics and then selling the package of wells. That’s kind of shifted and those are really for cash flow buyers who want to exit a vent in a specified 3, 5, 7, 10.

26:01
From there it gets more fun and these are the parts that people don’t know. You and I have talked about this before, but 1031 exchanges are huge in the US and most people are unaware that there’s multiple parts of the capital stack that are 1031 exchange eligible, because oil and gas is real property. So you could sell a building in California and exchange it to an oil and gas property in Texas as a real like-kind exchange. And there’s two different parts of the energy.

26:26
There’s a very passive part of it where you can be the landowner and just collect royalties, which is really cool because there’s no activity. You just collect checks on what’s currently and future existing and the positive is that’s what most of the families and endowments in the US own. I think that’s been outsized returns the last couple of years because if you look back at Harvard and Yale and all these major institutions, they went from 13% to 14% of their portfolios in that to almost zero, and that’s by charter of anti, which has created better returns for us as buyers. When there’s more sellers than buyers, you get an outsized return.

26:58
So that’s a weird part of the stack that’s huge, and then you can actually buy wellbores the physical wellbores that are on location instead of the land and those usually have much higher cash flow but deplete over time. So investors who want higher cash flow but don’t care about the backside as much, they may buy what are called working interests, and the investors who want cash flow but appreciation or flat, they typically buy the land side 1031s. So both of those exist. One big negative I would tell everyone on those that exist out in space, they’re usually unlevered, so they’re part of a 1031. For the cash they’re not really something you’re going to go to the bank and lever up, they’re kind of all cash. But they do exist and they are pretty cool in that 1031 world.

That’s great, because part of the 1031 rules are I have a debt replacement piece and I don’t fully understand all of that. So I assume it’s somebody that has maybe paid off a property. They’ve owned it for a long period of time and then they’re like hey cool, I’m just going to exchange it into this oil and gas opportunity.

Yeah, I mean, look at the two markets, right, you say, okay, we have cap rate compression in real estate, you have four or five caps you have, Whereas in oil and gas and I’m not going to speak for the industry but you probably have 8% to 12% yields on an asset versus 4% to 5%. It’s a different risk return, you name it, but it’s, I think, probably an arbitrage right now that exists between the two worlds. I love that. So, technically, ones are newer for people.

28:19
The other one that I don’t think most of the world is aware of, and my favorite tax law so I’m super biased is the opportunity zone law. But opportunity zones overlap with oil and gas in an immense way. In fact, the majority of the Permian Basin is an op zone. So everything you’re going to drill anyways just gets that tax benefit, and I’m not going to go into deep in it, but basically it’s only for investors who have capital gains. So that’s the one, but it’s basically a mega Roth. Anything you put in there, not only the yield can usually be generated tax for your own life cycle, but the backside, whatever you sell it for 1X, 2X, 5X, 20X it’s all tax. It’s literally a mega Roth for investors who have cap gains. And the cool thing is in oil and gas it just overlaps. You don’t have to go chase anything, it’s just already there.

29:01
So very awesome overlap that most people are unaware of and it kind of beats all the normal issues that people have how do I pay my taxes? In a couple of years it has tons of cash flow. Do I worry about gentrification? No, you don’t have to substantially improve. Does everybody drill the well? That’s the original use. All the hanging chads that you think of. Is there good inventory? There’s trillions of good inventory.

You don’t have to chase anything.

It’s just a unique overlap of that tax law that people don’t really get or think of.

Yes, and I want to just highlight what I think is genius about the way Texas handled this, and you can correct whatever I say here. That’s wrong. But the governors were given the opportunity to designate the opportunities homes. So some governors went hey, okay, we’re going to pick our inner city rough areas, investment comes in there and works. Texas went no, we’re going to put it out there in the oil fields and just create. Well, texas is so diversified I feel like it could be its own country.

Well, it’s just oil, it’s wind, it’s solar. But what Texas chose and a lot of the red states did I’ll just kind of define this the blue states have harder time using energy, even renewables, because they chose the inner cities. So the governors were considered the CEOs. They get to choose 18% to 20% of the land mass in their state. They had to hit the census tracts, they had to have economically depressed areas, the whole goal.

30:18
The difference is in the lower red states they chose a lot of rural areas which overlap an immense amount of oil and gas activity. The blue states they chose so you can’t really drill up oil or gas while in the middle of the city. In fact that’s one of the big differentiations. For us Ops zones, the returns are way outweighed in oil over natural gas. I love natural gas. I don’t drill out of it today because the prices aren’t justifiable, but long term I love natural gas. There’s really only East Texas the Haynesville Shale, the Marcellus and the Utica, those big formations that run through New York, ohio and Pennsylvania and all the other western areas. That is very hard to find good op zones, even though they have good gas reserves. So it is weird, state by state, I do think some of the brilliance of some of the governors to choose both rural and urban areas has benefited the op zones much more in red states than blue states.

That’s fantastic, and I want to go back to something you mentioned earlier. You talked a little bit about depletion. Like the wells will sort of taper off over time. What is that timeframe? Is that like a 20-year timeframe? Is it a five-year timeframe? Is it somewhere in between? Is it hard to tell? What does that look like?

So every formation in the US has a very different production profile and even within that formation there’s different verticals that you’re drilling into, so you can’t give any answer. But in the shale world they’re very long life but very heavy upward production. I think one of the coolest things about oil and gas. Most investors don’t understand this terminology so I apologize why I use it. It’s much more of an institutional term. The IRR of oil and gas is probably one of the highest in the sector of the world. The ROI on a well isn’t necessarily the highest, so what that means is this If I take a dollar, I can very rapidly turn it into two, but it doesn’t really get to three.

31:57
So where oil and gas is really unique is the cash flow, the time value of money. It comes back so heavy, so quick. Now again, that’s not true in every reserve. The Eagleford Shale is a much slower, longer decline. Poor vertical wells have much different production profiles, but the majority of what you see today being drilled, these big horizontal plays, have massive upfront cash flow with a rapid decline, which is this depletion that you’re talking about. And I don’t want to speak for anyone in fund structure because a lot of funds will just keep stacking those and growing the value and a lot of them will cashflow them out to investors. They can design them however they want, so you can go for an end value that’s greater than the starting value or you can go for more cashflow now at a low value. That’s fund structure. But the well itself provides most of its return in the first three years and that’s fun from an investment style because it either gives the company or investors the optionality of what they’re doing and how to compound those returns.

I love it and for whatever it’s worth. I’ve got a USEDC investment that started in 2017 and I’m still getting paid, so it’s like all right, there’s still money coming to me.

Oh, I didn’t answer your actual question. The answer is forever. These wells will produce at lower rates. What starts to happen over time? If you’re an oil jar like we and I don’t want to speak for all industry when you have more oil and gas, your oil depletes more rapidly because it’s hard to get those heavy molecules to the well, even if there’s a lot of them trapped in there. You’re only getting 11% 12% of the reserves in an area to the well. The gas is more mobile and you will get gas production. I mean we have wells that are producing for 70 plus years. The gas side of the world produce much, much, much longer. So even an oil well, nearly 95% of the time you’re getting a lot of gas with it. That will go on infinite item. The oil will more rapidly decline. You look at the first 10 years. It’ll produce longer. That’s the real meat and potatoes of it from an oil side. So it does shift. You are correct.

Good, I don’t want to jump too far off course here, but we’ve had some clients that we’ve been looking at. They’ve got this cash flowing business and then they’ve got these passive losses that they have no way of soaking up. Is there a way, if I invest in oil and gas, to have some of those passive losses soaked up through? We’ll say gain that can come to me as a passive gain versus an active gain.

So I call it pigs right Passive generators. So the oil and gas patches I mentioned has a huge amount of production. So one of the ways to enter into that, there are funds that specifically buy production. As an example, there’s just one. Well, when you buy production, you’re not drilling this, you’re not getting the IDC, so you’re generating a ton of revenue. That’s a passive income stream and the offsets might be like 30% depreciation and 70% income.

34:35
Well, for a pig investor, that vehicle could be the ultimate because they might be receiving 8%, 10, 12, 14% cash flow. That, to them, is all tax-free. That’s the beauty, I think, of oil and gas patch, where if you have an investor, have a need, you can find a great partner who has a right structured fund. It may not always be me, maybe somebody else, it may never be me, but there’s someone out there that you can get the right risk and reward. It designs something in the tax world that it perfectly exists with that client and that’s what I love.

35:05
You’re not sacrificing returns to find your, you’re just finding the best structure to match that client. You and I have this example today, right, you mentioned to me you have a client with a capital gain For them. The op zone fund might be the best a style of that, whereas for another client they need a drilling fund because they need the IDCs or another fund I’ll use. As I mentioned, they need a passive income generator, as long as the underlying investment is really good and the company you’re with is really trustworthy and you know it’s going to perform. Find that best medium to get the best benefits of the client.

That’s fantastic If we can spend a minute talking about how this can work inside of a qualified plan. So I know the structure changes a little bit and it’s owned by, let’s say, an IRA. Can we hop into what a Roth conversion looks like with oil and gas when we start combining some of these things like depletion with the qualified account?

So there’s two parts of it. I’d say the really good companies out there understand there’s excise business tax rules. You have to worry about certain items from a tax perspective on the income side and return side. So most of good private equity companies will design a blocker corp, an LLC, in the middle to first of all handle qualified money so that if it’s coming in, whether that’s of an endowment, a pension, a charity, you don’t have this excise tax issue, ubti, unrelated business tax. That’s kind of step one. Just keep that in mind that those units are kind of meant for that world.

36:34
Beyond that, a lot of these private equity companies understand that there’s an arbitrage to be had. Both the SEC and reserve valuations you name it typically give a lot of discounts for things like minority and marketability interest or reserves that are early in production or you name it. And some of the negatives that an investor might perceive hey, if I put a dollar in and my value shows less because it’s not marketable, it’s not liquid, the PV values have to be discounted, you name it. That could be seen as a negative for investors. I put a dollar in and it only shows up at 70 cents man or 50 cents. That’s scary, right. But a lot of clients will say, well, if that happens, I’ve invested in my IRA. And if that happens?

37:12
I’m going to convert during that year to my Roth IRA where, instead of paying conversion on a dollar, maybe I only pay conversion on 50 cents. When that happens I owe taxes, but only on half the money. So those arbitrages in private equity and it’s not unique to oil and gas, that could be someone who’s doing another private equity fund in tech but the smart companies that know how to design these really will take advantage of those opportunities and the clients will strike when the iron’s hot. By the way, clients could do this with stocks too, right? If I have a portfolio full of stocks and two of them are way down in value this year, I could separate them with their own IRA and convert those stocks to the lower value. It’s really no different, except in this fund.

37:52
You know, there’s certain things that the world might have discounts automatically because of marketability, minority or valuation right. So you can almost pre-plan. Because of marketability, minority or valuation, so you can almost pre-plan. You’re not certain. It’s possible oil goes to 120. No matter what you do, you can’t get it discounted, but it’s likely that a lot of the private equity companies should do this and this can happen in upstream and midstream. I kind of see this as a much bigger opportunity for really smart planners and clients to take advantage of those arbitrages.

38:19
Again you can never walk into something and know it’s going to be down 50 cents 100%. But you can say, historically this happens a lot, so I can take that. But this goes back to the original point. You’re originally going to invest because you love the investment. Right, I put a dollar in. I want to make two bucks, I want it to come back quickly. That’s the main purpose. This is the cherry on top of that.

Yeah, I totally agree, because there’s risk, like if my investment valuation is cut in half and then the cash flow doesn’t show up like okay, that’s real risk. So it’s like, well, that wasn’t a great strategy. I would have been better off leaving the dollar at a dollar versus having it come down to 50 cents and stay at 50 cents. So I don’t want to position it like it’s somehow financial alchemy, but there is, from our perspective, real opportunity to go. Okay, we know the values have a likelihood of being less. We can do the conversion at the right point in time and then the cashflow is going to come back in and help us replace that.

Well, I love that part of oil and gas. So let me take this to a bigger level. Your last point. Let’s just say this was a private equity investment. You know it’s a black box and you’re going to do it anyways, but you’re going to allocate it to your IRA and the likelihood is, in the first three years, because it’s private equity it’s going to have a very low value and if the company that’s running that fund values it properly and it goes really low, you’re going to convert it Okay, In oil and gas.

39:35
I think the main difference is that may happen. But the really cool part is you’re getting a ton of cash flow back In oil and gas. You’re not waiting for some exit event so you’re able to use that in your Roth IRA so many more times and come up. That’s where the added value of oil and gas is is the heavy cash flow that comes back provides re-investment opportunities that most securities. It’s more of a buy and wait. You don’t really have to wait very long in today’s day and age. Oil and gas I love it.

We’ve talked about all these awesome things that come with oil and gas investment. I think there’s something to acknowledge too about I’ll call the illiquid nature of the investment. It’s fairly illiquid. I put a dollar in Amazon stock. Whatever that price is tomorrow, I can liquidate it and get it back. I put money into an oil and gas investment. This is where I think the accredited piece comes in. It’s like okay, I’m putting my money in. It’s going to return itself eventually at some point in the form of cash flow, but I can’t make a phone call and go hey, send me my money back. Is that a fair statement? And if you, do.

odds are, the penalties are so severe you won’t want to. So it’s a very rare occasion in private securities that you’re forced to exit. Even if you win economically, you lose because the penalties are so. So I might put a dollar in and make $1.50 out, but I’m giving up another dollar because there’s heavy penalties. These are operating companies. These are not trading securities.

40:52
It is absolutely critical that investors who invest in oil and gas outside of the public markets do not need liquidity on assets or they’re going to pay a severe penalty to get up. Unquestionably, I couldn’t agree more. That’s why it really is for a credit. It’s not just that the taxes benefit them more. Take the taxes out. The reality is what you just mentioned. The illiquidity premium is significant in private securities, but it’s the only reason they work is they’re given the time to grow an asset and perform those, to go drill a bunch of wells. Could you imagine going to Chevron and trying to invest with them and say, oh, I need to have my money back right now? They would laugh at you. You need to actually go deploy that money in a well. It’s physical, money’s already spent. What are you going to sell it to? So 100% yes.

Yeah, I think those are fantastic things to acknowledge. There’s always a few strings like, okay, I can’t put my dollar in today and get it back tomorrow and have all these other benefits.

I think it will change. Just so you know, I am starting to see the theoretical design of funds in this next iteration. I think in the next couple of years I can’t tell you when that you will start to see more of a non-trader repricing models. So the bigger this industry gets because people will realize this the performance has been bad prior to the last five years of the oil and gas industry. Just making this clear it’s been spotty at best. Some big wins, lots of big losses.

42:12
The last five years has really shifted this to being a main asset class that performs consistently and is really a great part of portfolio management. And with that you start to see progression of new funds that do things like offer quarterly liquidity and X Y, z. So I think that’s the next iteration that you’ll start to see in the private. It’s not here yet, but I do hear the whisperings of rumors. I’m at a lot of different PDSA boards and whatnot. Where do you see the designs coming up from a lot of good companies that are going to have that type of stuff out there.

I love it. So I’m going to recap some of the things that we’ve talked about. We’ve talked about the cash flow that comes out of an oil and gas investment. We’ve talked about how that happens from an outsized risk reward perspective. If we’re above $40 a barrel, we’re in the positive, which is fantastic. And then we’ve also talked about all the different structures. We can offset We’ll call it active income through the intangible drilling costs depletion, depreciation. We can offset passive losses through structuring the investment in a different way. We can do 1031 exchange. We can do qualified opportunity zone capital gain offsets. We’ve got Roth conversion as an option in there. So such a versatile tool. Anything else that we need to touch on from a tax perspective, I think we’ve hit lots of it. My goal is somebody is interested, they reach out to us. We can get them plugged into your team and we can start talking about the specifics of their situation and how this can apply. But this has been great.

To me, that’s the end goal, right, the understanding of the space is fantastic. There’s a lot of really good opportunities for you to find a medium that works in your portfolio and I can’t emphasize this enough. You guys as an intermediary is the most essential business, because if you go to any sponsor, including my firm, what would happen is the guys who work there are biased, we’re biased, we understand, we love, we’re passionate and unintentionally they’re just so passionate that they think it’s for everybody. The intermediary is there for a specific reason To look at the portfolio and say, as great as this is, it doesn’t fit for you.

44:16
You can’t afford illiquidity for three years. Your kids are going to college X, y, z, right. So I cannot express enough that even if the returns and the taxes are so powerful for you, it doesn’t make the investments right, and the job of great sponsors and oil and gas companies is to offer the best funds, not to find out if it’s appropriate for you. You need to have someone watching out for your benefit, and I’ll give you a great example of this.

44:37
We’re probably the only firm I know that helps advisors use tax planning, where we actually will bring third-party CPAs in. But outside of that, let’s say you go and you think you’re getting a tax benefit but for some reason in your state or your specific situation, you can’t use it. How mad are you going to be, even if security works out great, if you were planning on a massive tax savings and you didn’t get it because you didn’t do the planning around your specific case and then maybe because you gave too much to charity or used an easement or who knows what? Everybody’s situation had different ramifications. You have to examine the whole situation to find out what that best piece is for you.

You’re absolutely right. That’s what we’re doing for our clients. We’re looking at their entire situation and going hey, from a liquidity perspective, here’s how many dollars we think you should put in. From a diversification perspective, same thing Tax perspective. Like we’re factoring all those different things, like we have an incentive to go find the best operators. We’re not getting paid by you, so it’s my job to do the best thing for the client, so let’s find the best.

If I’m not the best, you might have me on a podcast and never use me. Right, that’s right. I have to be good. What your incentive is? The client’s doing best and I love that standard of care because I have to keep earning. Even if I was best last year, it doesn’t make me best next year. I got to keep earning it and your job is to find the best of who’s best for your clients. I don’t know it’s going to be me, that’s okay.

46:02
Yep, I love Matt, earlier there’s some incentives out there isn’t there for making investments sooner rather than later. Yeah, you guys can use the institutional fund. You guys have the incentive for longer where we do that 20% per year support nation and we do interest rate on those kinds of money as if they’re in cash, even though we spend it day one, and it allows you to invest more. Like if you put 100 now, you put another 100 in your end, even if the fund’s closed.

Great Well, matthew. This has been a wonderful conversation. I appreciate all of your wisdom and insight into not just the oil and gas industry, but all the tax benefits that we can explore as well. So thanks for joining us here today.

Love spending time with you.

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043 | Investing in Oil & Gas: The Untapped Advantages You’re Missing

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