Why Energy Production Should Be A Core Asset In A Diverse Portfolio.

As seen in With energy demand on
a continued growth
By Paul Anthony Thomas trajectory, here is
why it’s good to
own oil and gas
producing
assets.

ASSETSCore

1 1RERAELAALSASSESTESTASDAVDIVSIESRER| |NOCVETMOBER 2014

My father was an investor, invest- money, and lost money. Throughout these
ment adviser and publisher decades of my financial education, we would
who purchased his first public research and invest. We would write about
stock in 1926. Thereafter, he our experiences with these investments in
was hooked on investing as a profession. my fathers’ newsletter, New Horizons for
Investors. He would write, and I would read
He studied the markets, read every book and ask him questions. This publication was
and The Wall Street Journal, went to school to a monthly newsletter sent to 10,000 paid
study investing, and continued to invest his subscribers throughout the world. There was
own money throughout the Great Depres- a section dedicated to “Hot Stocks,” includ-
sion and the 55 years following. He bought ing fundamental analysis and the “new fad”
and sold raw land, coins, precious metals, of technical analysis, one section dedicated
currencies, art, real estate, commodities, cars to our past recommendations and our cur-
— any form of investing, he would study rent portfolio performance, one area about
the markets and trade. He went on to study commodities, one section about upcoming
engineering and geology, graduating from currency trends, and another page about pri-
Oklahoma State University with a master’s vate programs on which we were working.
degree in civil engineering, and then from These private programs included: prospect-
Louisiana State University in 1940 with a ing for oil; investing in oil and gas leases; res-
Ph.D. in geology. idential and commercial real estate; mining
for coal, copper, gold and silver; pipelines;
He was a master investor: studious, intel- natural gas/oil arbitrage; art; coins; precious
ligent, knowledgeable and experienced, metals; and currencies; among others.
with a vast amount of knowledge gained
from first-hand investing activities during a What follows is a more in-depth exami-
60-year career. From all his investing expe- nation of the key reasons to consider energy
rience, his life motto became: “There are no investing.
greater assets to own, in certain or uncertain
economic times, than producing energy in CORE ASSET
the ground.” Producing energy is a core asset. What
defines a core asset? From cellular divi-
During World War II, my father’s contri- sion, which is fueled by nourishment, to
bution to the war effort was in finding oil the growing of food, the cleaning of water
along the Gulf Coast of Texas, Louisiana and the building of shelter, energy (in the
and Mississippi. He was good at it, iden- form of oil, gas, coal, wood, fire, sunlight,
tifying prospects that routinely found new waves or wind) is required for every living
fields and astounding discoveries in one of
the most treacherous geologic settings in the If the economy fails, humans
world, the highly faulted Gulf Coast. He
was a staff geologist working for a major oil will need four things: shelter,
company when the company was finding,
on average, a salt dome oil field a week. food, water and energy.

Unbeknownst to me, he started my invest- thing on earth to survive and prosper. If
ing career when I was about 13 by showing the economy fails, humans will need four
me how to contour geologic maps. Imagine things: shelter, food, water and energy. If
a young person wanting to draw lines and the economy prospers, energy is the core
pictures on a big piece of paper. requirement and the driving factor in every
process known to man. In my discussions
Between geologic learning sessions, we with audiences about energy, I challenge
read The Wall Street Journal together and
discussed common stocks, bonds, commod-
ities and currencies, their merits and pitfalls.
Together we read books and edited his pub-
lications. We purchased all forms of public
instruments and private assets, traded, made

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every participant to think of a single item on US ENERGY CONSUMPTION
the planet that does not require some form
of energy to be produced, grow and survive. Courtesy of the Energy Information Agency (EIA)

PREDICTABLE INCOME 140.00
Predictable income is a common charac-
teristic of the producing energy business. HEATING AND QUADRILLION B’ 120.00 2.8
Once an oil and gas field has been estab- ELECTRIC POWER 100.00 3.4
lished and defined, the future income 80.00 4.1
of the property can be estimated using Oil Products
analysis of the production decline curve. Oil Transportation 23
The production decline curve shows the Natural Gas
amount of oil and gas produced per unit Coal 60.00 23
of time for several consecutive periods and, Nuclear 40.00
if projected, will furnish useful knowledge Hydroelectric
as to the future production of the well. Other 20.00 27
This analysis helps in valuing a property. In
special situations, volumetric calculations 0.00 13
(total storage capacity of the reservoir times
the recovery factor per acre) is also used to 1950 1960 1970 1980 1990 2000 2010 2020
estimate energy reserves. In the wind and
solar energy business, future production received for the produced commodity — be POTENTIAL FOR GROWTH
of energy can be modeled using histori- it oil, natural gas or electricity — the inves- As the above chart shows, demand for
cal studies conducted for decades prior to tor may protect future profits by hedging energy is endless. Due to constant growth
installation of the generating facilities. the production price. For oil and gas, over- in global demand and dwindling supply of
the-counter oil and natural gas commodity oil and gas, which is limited and uncertain,
HEDGEABLE contracts and/or options (“puts” or “floors”) the demand for energy continually rises.
One of the drawbacks of investing in any are used, where the counterparty is the mar- Because of its “core” commodity status, the
type of real estate is the ability to hedge ket. For electricity generated from solar or demand for energy is omnipresent, regard-
wind power, this hedging is accomplished less of the economy or the psychology of
price fluctuation, which can greatly using futures contracts on electricity, with the marketplace, without concern to inter-
impact the value of real estate, as the counterparty being the actual distributor est rates or government spending, irrespec-
seen during the market crash of of the electricity, such as an electric utility tive of what happens to the value of the
2008. The price of producing company or, in the case of large commercial dollar. We always have a demand market
energy has the ability to be users of electricity, a manufacturing plant or for oil and gas. If it can get to the market-
hedged against loss of mining operation. ing point, the commodity will sell.
value and, thus, loss
of capital. By NATURAL INFLATION HEDGE With regard to supply, finding sufficient
protecting Unlike luxury items, demand for energy oil and gas (exploration and drilling) is
the future is not materially affected by inflation. If the riskiest portion of the energy business.
price inflation becomes an issue in the economy, As a result of his 60-year global investing
luxury items suffer greatly and demand for career, my father placed extreme value on
A large percentage these items declines. However, because of a world-class oil and gas prospect, a pro-
its core status, producing energy reserves spective lease where chances favored the
of the “easy” and contain a natural hedge against inflation. production of hydrocarbons in commer-
When money loses value, as has occurred cial quantities. He knew that the key to
cheap oil has with the U.S. dollar over the past many finding profitable oil and gas production
years, the price of energy automatically was the quality of the prospect. Given the
already been adjusts to compensate. When the buying discovery of commercial hydrocarbons, the
power of the dollar drops 10 percent, the production process becomes a predictable
discovered. price of energy rises 10 percent, in keeping and required activity.
with the laws of supply and demand. In
the oil and gas business, there is a theoret- FAVORABLE TAX TREATMENT
ical break point where energy can become Due to its core commodity status and the
too expensive to purchase, but as inflation risk required to find, exploit and produce
occurs and the value of the currency fluctu- oil and natural gas, today the oil and natu-
ates, the value of energy compensates, and ral gas production business is blessed with
this theoretical break point has remained some of the most favorable tax treatment
undiscovered and unproven. from the Internal Revenue Code available
to any global investor. Some of the ways in

3 REALASSETS ADVISER | NOVEMBER 2014

which this favorable treatment can be real- nuclear SUPPLY AND DEMAND IS
ized include: as they ULTIMATE REGULATOR
become With regard to natural gas, one historical
1. Intangible Drilling/Workover Costs: affordable and fact that seems clear is that “cheap energy
The expense of drilling and completing manageable. The prices are the cure for cheap energy prices.”
(installing the well) or working over (repair- media would have one As natural gas prices remain low, oil pro-
ing) a well may be expensed by the owner believe that the new hori- ducers move to the higher priced liquid
as “Intangible Drilling Costs” in the year zontal shale production made and oil products. As operators move away
that they occur. If you are a working interest possible by the use of hydraulic from natural gas, the supply diminishes
owner (a partner that pays the bills), these fracturing (“fracking”) will sustain and prices rise. Another factor affecting
expenses may be taken against the ordinary the supply for oil and gas for the foresee- this scenario is commercial demand. As the
active income of the taxpayer. able future. In fact, horizontal drilling has price of natural gas lowers, electric utilities
been an industry standard since the 1970s, and commercial users move to natural gas
2. Dry Hole Costs: All exploration expenses, and the first reported fracking was conducted as a cheap fuel causing increased demand.
including leasehold costs, may be expensed in in 1865 with the Roberts Torpedo. More natural gas vehicles are built. As
the year spent if a dry hole is drilled. demand grows and supply lessens (due to
It is true that shale production has unlocked lower production following less drilling
3. Capital Depreciation: On producing many new producing hydrocarbon zones, but caused by the sustained low price), the
leases, leasehold costs are generally capitalized the truth is that the storage capacity of those price rises, causing oil and gas operators
along with the “tangible” portion of the instal- reservoirs is extremely limited when com- once again to explore and drill for natural
lation or workover process, such as recoverable pared to historical oil and gas production. The gas, increasing the supply and, hopefully,
pipe, pumps, surface equipment and other simple fact remains that a large percentage of stabilizing the price.
equipment that may be salvaged when the the “easy” and cheap oil has already been dis-
well is plugged. These items are depreciated covered, with future production being more In conclusion, the factors that drew our
using short-term (five or seven year) deprecia- expensive to the extreme. family to invest in producing energy are com-
tion rates, depending on the class of asset. pelling. Energy is a required core asset with a
An example is the East Texas Field, predictable, hedgeable and protectable value;
4. Percentage Income Exclusion from which produced 5.2 billion barrels of oil little reliance on the “psychology” of the
Income Tax: Once a well is put into produc- from 1930 through 2000 and continues to global or local marketplace; an inherent indif-
tion, only 85 percent of the gross income from produce today. This field was the largest oil ference to interest rates or public market senti-
oil and gas production is taxable as income; 15 deposit discovered in the world until the ment; possessing a natural hedge against infla-
percent is not subject to any form of income giant fields of Saudi Arabia (estimated 77 tion; providing favorable tax treatment; and
tax because it is considered depletion of the billion barrels) and the Prudhoe Bay field with an uncertain supply and a continually
producing asset (known as the “depletion in Alaska (estimated 25 billion barrels) increasing demand. These factors support
allowance”). For working interest (bill paying) joined the discovered sites. The East Texas our family mantra, “There are no greater
owners, this income is offset by any expenses field produced 5.2 billion barrels from assets to own, in certain or uncertain
of producing the oil, liquids and natural gas 148,000 acres (an estimated 37,000 barrels economic times, than producing energy
(known as operating expenses), severance or per acre). In contrast, the newly develop- in the ground.”
property taxes, and required maintenance/ ing Bakken Shale/Dolomite (including the
workover costs. Intangible expenses (non-sal- Three Forks formation) of North Dakota Paul Thomas is a principal at Ledger
vageable portion) are written off in the year and Montana covers 128 million acres and
spent while the tangible costs are depreciated. has estimated recoverable reserves of about Petroleum LLC, based in Abilene, Texas.
7 billion barrels.
5. Percentage Depletion Allowance Allowed
Every Year: Another benefit not found in any Although the extent of the recovery
other asset class is that the depletion allowance from the Bakken/Three Forks will not be
(15 percent of gross income) is available every known for a few more decades, it is cur-
year of production. Regardless of the owner’s rently estimated that the recovery will be
basis in the property, the owner may take 15 about 50 barrels per acre. The difference
percent depletion allowance off the top of the between these two fields illustrates defin-
gross income for 100 years if the property itively that oil and gas will be harder and
produces in paying quantities for 100 years. more expensive to produce in the future
than they were in the past by several orders
The era of cheap oil is behind us. It is com- of magnitude.
mon knowledge that, during the next 100
years, oil and natural gas will give way to other
energy sources such as solar, wind, waves and

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