In the wake of the recent financial crisis, many investors have struggled to generate the levels of returns to which they were accustomed through traditional means. The sluggish pace of economic growth and the reduced lending by banks has left the stock market struggling. Many other types of investments have similarly suffered, whether from the collapse of the real estate market or the massive volatility within the commodities market.
Through it all, one of the most consistent performers has proven to be the energy sector, with some oil companies posting record profits even despite the slow economic growth and slumping demand in the U.S. and among many other major consumers. However, learning how to actually tap into the massive profitability of this industry is the real key to investing in oil.
In the past decade, the number of ways for an investor to gain exposure to the oil market has grown substantially. Investors have had access to the futures market for years, while new index funds, both mutual funds and exchange-traded funds, have emerged to provide easier access without necessarily requiring constant monitoring.
And, of course, there has always been the option to invest in these successful oil companies themselves, many of which have seen dramatic growth in the past decade. Often smaller firms can provide larger returns, with higher risks.
However, while many of these approaches provide exposure to oil markets, none of them directly tap the potential profits involved in selling oil, but rather rely upon the fluctuations in market prices to provide a return.
There are several ways of accessing these more profitable ventures, all of which entail significantly more risk than do traditional investments, even compared to stock in smaller oil companies.
Some investors might choose to deal in drilling leases, which offer the right to drill for oil, but this approach involves the active management of properties, buying and selling leases in the hopes of earning a profit.
A simpler approach is to purchase an interest in an oil well, either in the form of a royalty interest or a working interest. Royalty interests represent ownership of the resources and are taken out of a well’s revenue before costs, but are often eligible for fewer tax incentives. Working interests claim a portion of the revenue from a project, along with an equivalent share of the costs, but have excellent tax incentives from the federal government.
Finally, a group of investors can form a partnership that will provide access to a portion of revenue, or units of production, which offers even greater control over the management of the project.
Argument for the Direct Approach
The biggest advantage of traditional forms of investment in the oil industry is that they are relatively stable. Even futures contracts, which can lose value quickly as prices fall, ultimately only sell for a lower amount. By comparison, every form of direct investment in oil wells holds the potential to be lost completely, in the event that the well comes up dry.
However, the risks entailed by direct investment are linked to correspondingly high potential profits. Because an investor is purchasing a stake in the wells production, the ultimate return is determined both by the price of oil, as with other types of oil investments, but also with the size of the oil reserves being tapped. Some oil wells can provide steady returns for decades, after quickly making up for the initial investment. Unlike with other investments, oil wells can also cut down losses by simply shuttering production at times of low prices, not to mention much of the original investment will ultimately be written off of federal taxes.