Tuesday, May 18, 2004

How to Like High Oil Prices

It's simple to like high oil prices: own oil wells! (well, percentages of some, which I will go into below) And when oil prices go up, the checks from oil wells go up much more than what you pay at the pump.

The basic problem is that people are unfamiliar with how to do this, and then there is the problem of acquiring these investments.

First, I'll list several different ways to have ownership in an oil well:
Royalties - This is the best type of ownership to have and the hardest to get. As the name implies, this is a percentage of everything that comes out of the oil well, without any burden of the costs to manage, operate or maintain the well (as with anything, there are taxes on it). Royalties are usually given to the land owner where a company is going to drill a well, but the oil company drilling the well usually carves out a percentage or two for itself.

Working Interest - This is ownership in a well where you get a percentage of everything that comes out, but you pay a percentage of the monthly operating expenses to maintain and operate the well (including taxes). This is usually a pretty good deal, but if the well operating costs are high, or if oil prices are too low, you may find yourself paying out more each month than you are getting in. So you end up rooting for higher oil prices.

The benefits of a working interest is that if the well's total costs exceed its total income in any given year, those excess costs can be written off your ordinary income. The downside is that your liability as a working interest owner is unlimited. If the well needs a major overhaul, you may see bills that are much larger than you ever expected.

Limited Partnership - This is a structure that most people are familiar with since it is also used for other investments. There is a general partner who overseas the investment with limited partners who have no say in the operations. The downside in the investment is typically limited to the original investment.
So these three investment options are fairly straight forward and may appeal to some investors. The problem is getting into these investments. You can't call your broker and ask him to pick up a few oil royalties for you.

These types of investments are largely sold by small oil companies and operators, and only to "qualified individuals". In other words, the average person on the street couldn't qualify as an investor by SEC regulations, so the way in is to know someone in the business who can get you in on a deal (which is more or less how I got mine).

There are also a LOT of unscrupulous people and companies who have used these types of investments to scam people. Whether it was selling 500% of a deal, selling interest in wells that weren't drilled or in production that didn't exist - it has all been done. So even if you are qualified, you have to know that the people and company you are dealing with are honest.

In addition, these investments are incredibly risky. While I have all three of the investments above, I'm not mentioning the two dry holes I was involved in. This risk can be mitigated by buying existing production rather than investing in new oil wells. In essence, by buying production you are buying a bond that will fluctuate on oil prices, but there is still the risk that the production will go dry before it has paid off the investment, that oil prices will go down, or that Kerry will nationalize U.S. oil production (hey, it happened in Mexico).

This means the average investor has basically one way to hedge his portfolio against rising oil prices: buying stock in oil companies. This, however, has its own pitfalls. While ExxonMobil has appreciated 20% over the past year, Shell didn't due to accounting irregularities, which has punished the stock.

So the best bet is to buy a basket of oil stocks in order to hedge your finances against rising energy prices (there are also energy indexes, commodities, futures, and other options, but I am trying to keep it simple).

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