What are the Pros and Cons of Investing in Gas and Oil and what is a Direct Participation Program?

What are the Pros and Cons of Investing in Gas and Oil and what is a Direct Participation Program?

There are a number of questions that people often ask about investing in oil and gas. Amongst the most common are ‘Why should I invest in these commodities?’, ‘What are the caveats and risks?’ and ‘What is a direct participation program?’ Here are the answers to these frequently occurring queries: –

‘Why Should I Invest in Gas and Oil?’

There are a multitude of different reasons why people choose to invest in gas and oil. When petroleum is expensive and people are paying high prices at gas stations, some opt to invest in these resources because the returns that they can get from investing in them can offset this.

Others choose these commodities to hedge against interest or stock rate movements. Despite possessing similar levels of volatility, commodities and equities rarely fall in the same year and have a tendency to go in opposite directions to one another. Investors can dodge market volatility to an extent by investing their money in commodities, which is an asset class that is amongst the most volatile around. This sounds counterintuitive and doesn’t exactly conjure up images of the predictability that is sought by so many investors. However for long-term investors who wish to be insulated from unexpected fluctuations in the price of traditional assets like bonds and stocks, putting funds into a wide range of commodities might be a good idea.

Some people wish to invest in order to diversify their overall holdings. Diversification might not guarantee against making a loss but it is an important strategy utilized for the purpose of spreading risk. The goal of this is to invest in a variety of asset classes that each possess their own unique rewards and risks so that when an asset class falls out of favor, the others won’t directly correlate and will retain growth potential.

Another reason that investors opt for gas and oil is that they see that they are in finite and low supply but also see that demand for them is increasing. The prices of commodities have been driven up in recent years by a multitude of different factors, including increases in demand from India, China and other emerging nations that require steel, oil and other commodities in order to support infrastructure development and manufacturing. When demand is high and existing production or supply is strained, buyers engage in competition for what little supplies there are and prices go up.

Some investors are attracted to gas and oil by the potential payback that is associated with drilling programs. However payback rates vary depending upon the success, structure and price of the program and returns aren’t guaranteed. It is important for people who are considering investing in these resources to understand that their payout will come back to them throughout the years at the start of production. After this, returns will diminish every year. A lot of programs would be attractive from an economic standpoint if oil prices experienced a great fall, although return of principal would take longer. Ensure that you go through the sensitivity studies and offering memorandum with your advisors.

There is also the allure of the tax benefits that are available. The majority of gas and oil investments possess some benefits in this area. Details of these benefits are available online.

‘What are the Caveats and Risks?’

One risk involved with investing in these commodities is the fact that they can be volatile. Flow of cash varies according to two main variables: the amount of gas or oil that is produced and sold and the price that is received for the gas or oil. Both of these variables can fluctuate based on a range of different factors, for example the price of oil can shift due to political or economic issues or even due to the weather.

Gas and oil are depleting assets and the typical lifespan of an oil well is between twenty and thirty years. Returns can decline after the first couple of years. Sometimes the property or wells are made ‘for sale’ a few years down the line, other times they might not be. If there is an exit strategy for the investment that you are considering then ensure that you fully comprehend it.

If the type of ownership that you have is a general partnership and the expenses go beyond the income that the investment generates then a general partner might be forced to put in additional money for the purpose of funding the shortfall. This type of ownership is therefore not appropriate for all investors.

External political and external events affect gas and oil availability and pricing. There are varying levels of risk among energy choices. You should consider all energy choices to be high risk but royalty programs generally tend to be more conservative while experimental drilling programs are the most speculative.

It is possible to sell and resell some gas and oil shares in an auction-style set up. However, you should consider investments that don’t trade on major exchanges to be long-term and illiquid.

It is important to remember that your risks are directly tied to those of the company that is in charge of operating the wells. You should therefore ensure that you know the history and background of this company and carry out due diligence before you opt to invest.

There are a number of drilling-based issues and other complications that can crop up. Drilling programs adjacent to producing wells or in proven fields are known as ‘development programs’. They are considered to involve less risk than experimental programs.

What is a Direct Participation Program?

Direct participation programs, also known as a DPPs, are investment programs that are designed to allow investors to directly take part in the tax benefits and cash flow of the underlying investments. If investors purchase energy stocks then they are stockholders of the companies but the tax write-offs, net cash flow and actions are benefited by the companies themselves and not by the stockholders directly. The energy companies frequently reinvest profits into exploration, growth and development, which effectively gives control of the investor’s profits away. However this is not the case in direct participation programs. Pooled investment money get utilized for goals such as acquiring mineral rights or producing wells with royalty payments and extracting then selling gas and oil for cash flow. This is beneficial because you get the advantages associated with being an owner even though you have not had to taken the steps required in order to become an oil expert or set a company up, which is the function that the program’s sponsor performs. Whilst each program possesses a stated investment objective, it is not guaranteed that these goals will be achieved.

Direct participation programs generally tend to only be available to accredited investors – those investors that have a one-million-dollar plus net worth or who have had a £200,000 salary for a period of at least two consecutive years.