Tax Benefits of Investing in Oil and Gas: A Detailed Overview

Oil and gas are a staple of energy production throughout much of the world, and their potential returns make oil and gas investments an attractive option. Tax incentives designed to encourage oil and gas production also help these opportunities stand out. If you’ve ever considered diversifying your portfolio with energy assets, it’s essential to understand how to invest and the potential tax benefits. 

What are oil and gas investments?

Oil and gas investments involve putting money into the exploration, extraction, refining, transportation, or sale of petroleum-based products. 

The first thing to understand about investing in this industry is the types of oil and gas companies out there. They can be divided into three primary categories:

  1. Upstream companies. Upstream companies deal with the exploration and extraction of oil and gas. This includes everything from drilling exploratory wells to operating platforms that extract the resources. These companies typically need a lot of capital, and investing in them can be high risk due to the effort and expense involved in locating oil fields, drilling wells, and providing the associated oilfield services.
  2. Midstream companies. Midstream companies transport raw materials to refineries for processes. They may construct oil and gas pipelines, ship, and store raw materials.
  3. Downstream companies. Downstream companies are involved in refining, selling, and distributing finished products. This can range from oil refineries to local gas stations.

There’s a range of investment vehicles in this space, including: 

  • Oil and gas futures contracts. These are legal agreements that involve trading a certain number of barrels of crude oil at a predetermined price on a specific future date. 
  • Buying mineral rights. These give you ownership of the mineral resources on a piece of land. You have the right to license those rights to others and can earn royalties based on what they extract.
  • Buying publicly traded oil and gas company stocks. This is one of the easiest ways to invest in oil and gas, as you can usually purchase stocks in oil and gas businesses in an existing brokerage account.
  • Exchange-traded funds (ETFs) and mutual funds. Instead of investing directly in the stocks of oil and gas businesses, you can take advantage of these indirect investment options. You can purchase EFTs and mutual funds directly via an investment platform or through your brokerage account.
  • Direct participation programs (DPPs). These programs allow you to pool your money with other investors to purchase ownership of shares in a company or an oil and gas well. DPPS are usually organized as limited partnerships, allowing investors to take advantage of investment returns and tax benefits without having to manage the business or project.
  • Private placement. This involves selling the stocks or bonds of an oil or gas company to a limited pool of investors rather than on the open stock market. 
  • Working interest. Owning a working interest in an oil or gas well gives you the right to a share of income from production after paying royalty income investors. You’re also obligated to share in the cost of developing and operating the well.

Tax benefits of investing in oil and gas

The tax benefits associated with oil and gas investments depend on the type of investment vehicle you choose. 

Investing in oil and gas by buying stocks, bonds, mutual funds, and EFTs offers the same tax benefits you’re likely familiar with from investing in other areas: long-term capital gains taxed at a lower rate than ordinary income.

The remainder of this article focuses on the tax benefits of direct investment in oil and gas properties—via either a working interest or a royalty interest—rather than in marketable securities of oil and gas companies.

These kinds of direct oil and gas investments come with an array of tax benefits that are hard to find in other sectors. These benefits are a result of government initiatives to encourage domestic energy production. 

Key tax advantages include:

  • Intangible drilling costs (IDC) deductions. These are costs associated with drilling that can’t be easily quantified or seen. They include things like wages, fuel, or supplies. They typically make up around 75% of the cost of drilling a well, and you can fully deduct these costs in the first year of investment, reducing your taxable income.
  • Tangible drilling costs (TDC) deductions. Costs of tangible assets, like drilling equipment, are typically around 25% of the cost of drilling a well. These can be depreciated over seven years.
  • Qualified business income deduction. Individual investors may qualify to deduct up to 20% of their income from a working interest in an oil or gas asset under Section 199A, otherwise known as the qualified business income deduction.
  • Depletion deductions. Depletion is similar to depreciation, but instead of writing off the cost of an asset over time, it accounts for using up natural resources by mining, drilling, quarrying stone, or cutting timber. As an investor in a producing oil or gas well, you can realize significant tax benefits from depletion, as the depletion deduction is still available even after your cost basis has been fully recovered. Depletion deductions can also offset royalties from oil and gas investments.
  • Loss deductions. A royalty interest in an oil and gas asset is considered passive income, but a working interest is considered active income. So you can use losses from a working interest in oil and gas assets to offset other forms of active income, including salary or wages or self-employment income.

Oil and gas investment tax breaks: an example

Let’s paint a clearer picture with an example:

Imagine you invest $100,000 directly into an oil drilling project. In the first year, 80% ($80,000) of that investment goes toward IDCs. Because you can write these off in the first year, you have $80,000 of deductible expenses that may go against your ordinary income dependiing on the project.

Additionally, 10% ($10,000) is spent on TDCs. You can depreciate this amount over seven years, leading to deductions of roughly $1,430 over the next seven years.

If you’re in the 35% tax bracket, these deductions can result in tax savings of roughly $28,500 in year one. That’s $80,000 of IDC deductions plus $1,430 of TDC deductions, multiplied by the tax rate of 35%.

In year two, the well starts producing income. However, you can continue to depreciate the TDCs and claim depletion deductions to reduce taxable income and enhance your return on investment.

How to get started as an investor in oil and gas

If you’re eager to get started in oil and gas investments, here are some steps to consider:

  • Education. Understand the oil and gas sector, market dynamics, and potential risks. While there can be benefits to investing in this sector, every investment involves some level of risk. It’s entirely possible that an oil or gas well will not produce enough oil for investors to get back their original investment, much less turn a profit.
  • Financial evaluation. Work with your financial advisor to determine how much you’re willing to invest. Oil and gas investments aren’t a mandatory part of a diversified portfolio, and investing in certain kinds of investments, especially oil futures, is often considered risky. As with any other risky investment, don’t invest more than you’re willing to lose.
  • Choose an investment vehicle. From direct investments to mutual funds or ETFs, choose a model that aligns with your risk tolerance and financial goals.

Remember, while the tax benefits are enticing, all investments carry risks. It’s crucial to perform your due diligence and understand the sector before diving in. But with the right approach and guidance, oil and gas can offer a rewarding addition to your portfolio, both in terms of potential returns and tax advantages.

Maximize your tax benefits from oil and gas investments

Tax laws and regulations can change quickly, so it’s important for investors to stay on top of the latest developments. A tax professional who is familiar with oil and gas investing can guide you through the nuances, help you optimize your deductions, and keep you informed about potential changes on the horizon.  

If you’re curious about how the tax benefits of oil and gas might impact your tax outlook, check out our ROI page to see if you’re a good fit for a complementary tax analysis.