THE oil and gas IDC TAX DEDUCTION…An attractive lure. but is it dangerous for investors?

The development of Oil and Gas assets is a capital intensive business. Inside the CAPEX matrix of development are expenses classified as Intangible Drilling Costs (IDCs). The are not only critical in creating wells, but also for the significant tax benefits they represent for investors. But are the benefits good enough? Are they worth the risk? Why is such a tax deduction such a shiny lure for investors? Let’s dig into those questions and more as we find out.

What are they?

Intangible Drilling Costs encompass a spectrum of expenditures necessary for the development of OG wells. These costs are indispensable for drilling wells and developing a field with scalable value. They include expenses such as survey work, ground preparation, wages, fuel and other expendable supplies, geology services, engineering services, drilling services, fracing services and more. Even drill bits…we don’t actually buy the bits. We pay rent them. That expense is a qualified IDC. So, despite the term "intangible," these costs represent tangible investments in the preliminary stages of drilling projects.

Before we get any further, here comes the disclosure + disclaimer: I am not a tax professional, nor have I played one on TV. The information in this blog is sourced from our research and experience as an Oil and Gas development company. We rely on our own tax professionals for advice. And this blog has not been reviewed by them. Every person has a unique tax situation. Consult your tax professional for tax advice.

Now let’s roll the clock back a bit to see where this all started. In the US, oil became a commercial business in Pennsylvania in 1859. John D. Rockefeller bought into the space in 1866 (the same year oil was discovered in Texas), and over the next decade-ish built one of the largest companies in the world. Standard Oil. In fact, the company had created so much economic value so quickly, it’s operating influence leading the industry made petroleum trade a springboard for the US as an emerging economic power globally. In 1901, Spindletop (a mound near Beaumont, TX) hit…one of the largest oil discoveries in history. South Texas was the epicenter of the next boom in the industry. This boom rippled throughout the national economy, and the government did what they do when they want to spur a capitalist economy.

So in 1913, the United States tax code was amended to include incentives for investments in OG development by allowing deductions for IDCs. This provision, which can now be found in National Archives eCFR.gov site, specifically here in 1.612-4a, aims to mitigate the financial risks inherent in drilling ventures and stimulate investment in energy exploration. Under the current tax framework, IDCs are fully deductible in the year they are incurred, providing an immediate tax benefit to investors. This stands in contrast to many other tax deductions, which are typically amortized over several years (also an option in OG, if preferred).

And in large part, one could conclude that the tax incentives made possible by the government have been instrumental in stimulating the industry and the broader national economy. To this day, it serves as an enticing lure for investment in oil and gas exploration by making projects more financially viable, especially in the early stages of development. Additionally, the deduction stimulates innovation and technological advancement in drilling techniques, further driving the growth of the sector.

Furthermore, the availability of tax incentives for IDCs promotes domestic energy production and reduces dependence on foreign sources. This aligns with broader energy security objectives and contributes to the economic growth and stability of the nation. There’s nothing more American than being an Oil and Gas developer.

Side, but related, notes: there are other valuable OG-related tax deductions for investors including depreciation. Additionally, distributions can be free from income tax while the LP entity operates from a financial position of a high CAPEX-driven loss. We’ll look to publish more on those opportunities in another blog.

So what’s it worth to an investor?

The short answer is that 100% of IDCs are deductible. Of that 100%, 60-80% of the total invested amount can be deductible in correlation with the relative IDC portion of the total use of your investment. But the development company must know how to execute. Always consider the IDC deduction track record of the management team in this part of any due diligence.

And here’s another good part…by allowing for immediate deductions of IDCs, investors can reduce their taxable income, including and especially W2, in the year of investment. If you want an example of how the tax deduction actually works, email me psnell@petrovybe.com. It’s not as simple as applying the deduction to your gross income. The example makes consideration for an effective tax rate (high net worth individuals pay a blend of multiple rates depending on the income level), and for other common deductions. In our example, the math delivered a value of 21% cash-on-cash-equivalent ROI. Pretty good in my book.

BUT back to our original question…is the deduction really worth it?

Not necessarily. Certainly it is not worth it on its own. In my time in the business, people have proven more emotional about winning on taxes than they’d like to admit. Look, no one wants to keep more of his money in his own pocket, and out of the IRS abyss, than me. And while most accredited investors nod in agreement and say to themselves, “of course the tax deduction is not the only qualifying criteria”, people still OVER-value the deduction anyway. The “keeping more of what’s ours”, the satisfaction of victory in paying less tax…it just gets emotional. And that’s why it’s a dangerous lure for investors.

It’s easier than one would think to justify the other investment fundamentals to achieve the instant gratification of the tax deduction. Yes, the deduction is part of the upside equation. Just make sure you do your due diligence on the ENTIRE value of the project…OBJECTIVELY. The management team, their track record, and the project forecast. All are critical elements to evaluate in conjunction with the tax deduction opportunity. Now lean in for this one: The most important due diligence questions you can ask any development team are the following…

1) What is your track record on delivering tax deductions to your partners? (already addressed above).
2) What is your track record in picking profitable drilling locations?
2) What is your strategy to defeat the decline curve?

We honestly don’t have time to answer number two in a meanigful way in this blog. So we are going to table it for another article. Just know that the lead Geophysicist of any project should have a supportable number for his track record. For example, PetroVybe’s Geophysicist has a 75.2% career hit rate on profitable location selection. In a few words, that’s so baller level…especially in light of having limited technology for the first half of his 48-year career.

The third question, about the strategy to defeat the decline curve…we will address that now. First, we need to define the decline curve. It is an OUTPUT from a decline curve forecasting algorithm - an EUR (Estimated Ultimate Recovery) for the production of a well to determine the estimated recoverable production of hydrocarbons (oil and natural gas) over time. Among dozens of data inputs, the algorithm considers volume and rate of depletion in the reservoir.

While there is much data and information, including the decline curve, that goes into a the broader project proforma, the development team must have a clear understanding of the biggest hurdles facing any project, and they must have strong science, a proven strategy, and a strong track record for overcoming them. And the decline curve is really enemy #1 because location selection feeds directly into that formula and it’s output. Without the right technology, data, and expertise to interpret that data, the decline curve is very difficult to accurately predict.

But it is possible to defeat the decline curve from an investment perspective…in a big way. Look no further than the super majors (Exxon, BP, Shell, et.al). But many independent developers have done it too. Sorry, Jed Clampet does not count. Unfortunately, the track record of most development companies that recruit accredited investor partners is terrible. It’s one of the reasons I started PetroVybe…to change the industry narrative by deploying a strategy that has proven to work by development companies that use PE and institutional money.

If the investment centers on a well bore assignment or multiple wells, but does not include a critical-mass strategy (maximize the ROI capital through reinvestment), return of originally invested capital is unlikely…ever. So as part of the due diligence, ask how their forecasted decline curve compares to the 10 nearest already-producing wells. Also ask for a 5-year P&L forecast that shows commodity pricing, EBITDA calculation, and distributions. Full transparency. Additionally, make sure the strategy doesn’t rely on an exit to deliver the forecast. An exit is part of every development company’s strategy. But exits are low probability for direct-investment OG projects. If the forecast heavily relies on it, beware.

Hope you found this read fruitful in your OG education journey!

Until next time,