In the investment arena of oil and natural gas partnerships, you see a lot of general partnerships crop up in areas that are being drilled (particularly Texas). You might wonder: Why don’t these people form limited partnerships so that they can shield their personal assets from liability in the event that an oil well has a massive tort or contract fallout?
The answer is that there is an extremely lucrative tax deduction called the “income of intangible drilling costs (IDCs) that enables general partnership investors with working interests in oil and natural gas ventures to deduct all of the income that comes from intangible drilling costs. You can also become eligible for this tax deduction if you agree to become a general partner without a working interest, but this comes with the humongous risk of subjecting your household’s balance sheet to personal liability arising from issues with your oil and natural gas investments (typically, the only investors that would choose this option are those with the bulk of their assets in retirement accounts that wouldn’t be subject to forfeiture according to their state and federal bankruptcy laws).
The website Energy Tax Facts does a commendable job of explaining this tax benefit:
“The standard IDC tax deduction–which has been around in one form or another for 100 years–allows producers to recover those investment costs quickly and reinvest them in exploring for, and hopefully producing, new American oil and natural gas supplies. Since 1913, IDCs have allowed producers to invest literally hundreds of billions of dollars in finding and delivering new energy that might not have been available without them. For America’s 7,000 plus independent oil and natural gas producers (who drill more than 90 percent of the nation’s wells), IDCs can be deducted in the year they are spent or spread over 60 months. Independent producers are in the business of exploring for and producing oil and natural gas. The integrated companies (who have marketing or retail operations like gasoline stations) must amortize 30 percent of IDCs over 60 months and can deduct the remaining 70 percent in the year they are spent or spread them over 60 months.”
IDC costs cover every expense that goes toward drilling an oil well except for the drilling equipment (labor and chemicals count as intangible drilling costs, for example). Imagine a well costs $500,000 to drill and $400,000 is considered intangible. You receive a current deduction of $400,000 so long as the well starts to operate by March 31 of the following calendar year (note: the threshold for the deduction is not whether or not the well actually produces oil, but whether commences operations for oil).
In addition to this tax benefit, there is also a 15 percent gross revenue allowance for depletion that exists regardless of whether the ownership is through general or limited liability.
These types of benefits explain how Charlie Munger why Charlie Munger was able to refinance some of his Pasadena, California apartments and use the capital infusion to purchase oil wells in Oklahoma that were generating $100,000 per month. It provided the cash-generating base that funded his purchase of Blue Chip Stamps and enabled him to meaningfully join forces with Warren Buffett through Berkshire Hathaway.
For those of you not planning to become oil barons, awareness of IDC tax benefits is another reason to own stocks like ExxonMobil, Chevron, ConocoPhillips, and Phillips 66. According to Energy Tax Facts, it is estimated that these tax benefits have added a full percentage point to the returns of Exxon investors since 1970.
It may not sound like much, but ExxonMobil has returned a little over 14.5% since 1970. This means that a $10,000 Exxon investment in 1970 would have grown to $4.8 million. Without the IDC credits, those same ExxonMobil shares would have compounded into $4.2 million over the same time frame. Over the course of almost half-a-century, your $10,000 ExxonMobil investment raised your ownership of profits by about $60,000 which then get capitalized at a rate of about 10 that contributed an extra $600,000 to your wealth over the super long term.
This is why I think much of the investment commentary on major oil stocks is misguided. People want to talk about the dividend right now and the fluctuation in the stock prices. I think the focus should be on the fact that the commodities are non-renewable (have a finite supply), are subject to growing demand from industrializing nations, naturally hedge themselves to inflation, and enjoy generous tax benefits during the discovery and early implementation process. These factors all aggregate to make the large oil stocks excellent cash generators to include on your family’s household balance sheet.