Subsurface interests are often referred to as mineral rights, including interests in oil and natural gas.
There are two types of mineral rights for an investor to consider: royalty interest or working interest.
With a royalty interest, owners do not have the right to enter the land to extract oil or gas on their own accord. Instead, they are entitled to a percentage of any extracted minerals. A separate entity is generally contracted to enter the land for exploration and drilling.
With a working interest, the owner is given exclusive authorization to enter the land to extract oil and gas, which also allows owners share in development and operating expenses.
Both investment programs have advantages similar to many DST/TIC investments, such as monthly cash flow potential, tax deferral and a 15% depletion allowance.
There are other potential advantages to consider when deciding on diversification outside the traditional real estate sector:
- Many oil and gas programs have no mass closings or closing costs.
- They are not dependent on real estate values or rent collections.
- Participants benefit from a virtually unlimited product demand.
- The ability to diversify from 100% real estate can appeal to many high net worth individuals.
However, direct investment in oil and gas requires a great deal of due diligence. Even though product demand is practically unlimited, the market price can vary significantly because of changes in supply and demand and unpredictable geopolitical events. While they can offer higher rates of return, they should be considered more risky. Before proceeding, you should consult your financial advisor to consider your overall portfolio diversification and goals and whether this is suitable for you.
Many oil and gas programs are designed to meet the qualifications of “like-kind” replacement property, making them eligible for 1031 Exchange purposes.
Risks of Oil & Gas Investments
| Commodity Price Volatility | Oil and gas pricing will fluctuate. |
| Production Risks | Production levels will fluctuate. |
| Lack of Operational Control | Operators are not obligated to drill or keep wells in production. |
| Revenue Delay | Distributions may not begin until months after the close of the offering. |
| Illiquid Investment | You may not be able to sell your investment. |
| Regulatory Changes | Could impact current tax treatment of Royalties. |
| Loss of Investment | May not recover original investment over life of reserves. |
| Reserve Depletion | Assets will deplete – estimates could be off. |
| Loss of Production | Natural disasters or shut-in wells could decrease or halt production temporarily or permanently. |