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Investment Risk – Oil and Gas Evaluations 

Understanding proper oil and gas (“O&G”) investment risk analysis is at the core of successful long-term investment strategy.  Truthfully, this can be complicated and intimidating…and as boring as watching grass grow.  So, what’s an investor to do?   

 Here is a macro look at the evaluation process and its importance in performing accurate risk analysis.  But prior to jumping headfirst into this processit is essential to understand two things.  First, this assessment process is usually long, capital intensive, and the last analysis piece that includes many technical (engineering and geologic) and financial (accounting and modelingassessment processes.  Doing these accurately is how oil and gas companies prioritize and allocate funds, projects areas, and ongoing development of these assets.  Second, no other industry has the varied exposure to so many different risk types that exist beyond just a single/simple economic evaluation of the assets only.  Quantifying and understanding these risks are crucial…done right…can save an investor much heartache. 

 Risk Analysis: Capital Intensity 

What makes O&G investments different from other industries is how capital intensive they generally are.  Within the industry, capital intensity can also vary tremendously by asset type like onshore or offshoreexploratory, developmentaldrilling, infrastructure, legacy well redevelopment, or processing facilities.  Most have multiple asset types in each investment project.  Because of this, O&G companies often rely on multifaceted risk analysis to ensure the right projects get funded.   

 According to Deloitte, during the last decade the industry registered net negative free cash flows of $300 billion, impaired more than $450 billion of invested capital, and saw more than 190 bankruptcies.  What gives? 

 Historically, oil and gas companies would diversify investment capital into multiple revenue streams and asset areas to offset market variations…while systematically and methodically developing and hi-grading those assets.  But the US shale revolution and oil prices over $100/bblthrew caution to the wind with massive capital inflows into the industryprompting inaccurate and euphoric project evaluations, fueled by inexperienced investors as well as O&G industry professionals.   

 As the industry experienced the incoming and outgoing tides of commodity variations, Warren Buffets infamous saying became a reality…”Only when the tide goes out do you discover who’s been swimming naked. 

 Risk Analysis: Quantifying Risk Types 

Today, those remaining in the industry are reverting to time tested methods and strategies to evaluating projects and quantifying risk, but with a new ESG twist.  Let us explore these different risk types. 

 Political Risk 

A projects political risk can be impacted by federal, state, and local forces.  Any change in government policies, regulations, taxes, permitting, and restrictions should promote a re-evaluation of economics, timing, and ultimately whether a project is worth doing at all.  O&G companies should demonstrate an understanding and history of identifying these risks and ways of properly planning for them. 

 Environmental Risk 

Environmental risk impacts include worker safety, local ecology, natural resources, and waste management.  This must be factored into a projects risk analysis.  Spills, worker incidents, accidents, property damage, and local water and habitat impacts are the biggest source of financial risk…second to none.  Any prudent O&G assessment should involve a detailed review of these impacts, proper insurance coverages and detailed plans of compliance measures in each jurisdiction like spill response (SPCC plans) and regulatory certification (Tier II & Quad O).  In the new age of ESG investing, methane emissions and flaring plans need to be disclosed and quantified.   

 Technical Risk 

Minimizing technical risks requires project teams to employ a diverse set of skills like Geologists, Engineers, Project Managers, Procurement Specialists, and Business Development.  Each discipline requires a wide range of tools and data used to develop interpretations of existing features like faults and legacy production or create exploratory predictions of new assets using seismic or taking physical cores of the rock.  This information is then used to estimate project costs, materials, and infrastructure necessary to implement and bring online a project’s hydrocarbon production potential.   

 Economic Risk 

Because the required O&G capital investment is so large, economic analysis on returns, capital & operating expenditures, and sensitivity analysis of oil and gas pricing needs to be highly understood and accurately modeled.  This modeling is complex, can be highly subjective, and can yield a wide range of non-unique outputs depending on the experience and background of the modeler.   

 Evaluation Analysis: Modeling Risk 

So, how can you verify your O&G investment is a good deal?  O&G companies use a variety of ways to qualify their data to ensure their estimates are accurate including economic modeling and statistical sensitivity assessments. 

 With over 15 different inputs, economic forecasting and modeling is the foundation and most preferred approach to evaluating risk.  However, each input can have accumulating effects to predicting returns and are subject to how aggressive or conservative a company’s mentality is.  These inputs, over time, can also be escalated, held constant, or varied depending on these outlooks.  Each input is built on real data sets, which they themselves need to be processed, qualified, and risked.  A more aggressive company may treat one input set differently than another…which can lead to wide differences in project outcomes.   

 Running statistical sensitivity analysis takes economic models a step further by creating, quantifying, and testing risk parameters.  This concept is applied to every aspect of the risk process, data, modeling, time value of money, cash flow, and ultimately quantifying the project uncertainties and full implications of each action a company makes. 

 Good investment decisions start with quantifying the risk types, understanding the modeling, and evaluating how aggressive or conservative a company applies and tests its project ideas.  The complexity of O&G risk factors is intimidating but can be overcome by inquiring into each of these different facets of analysis.  Having a team witthe technical skill set and experiences to draw upon is essential to a profitable oil and gas investment.   

Your business is your baby.  You’ve sacrificed for years, nurturedendured sleepless nights and now it’s time to sell your business.  This means incomeand income means…well, taxes.   

The tax side of selling a business has many moving parts, and if you get nothing from this articleremember this!  ALWAYS consult a tax or financial advisor.   

Here are four tax-related issues to keep in mind 

  1. Are sales proceeds taxes as ordinary income or capital gains? 
  2. Is the sale assets or stock? 
  3. All cash deal or payment installments? 
  4. Can sale be treated as tax-free merger? 

 Remember these issues are relevant for federal income taxes…different states have different rules and may collect more or less taxes than the IRS on the same deal. 

How Are Business Sales Taxed? 

The IRS, with few exceptions, treat the business as individual assets, not one big sale.   

Those assets will be put into two buckets 

  1. Long-term capital gains (real or depreciable property) 
  2. Short-term capital gains at ordinary income rates (A/R and inventory) 

 

Pro Tip #1:  Plan +2 years ahead of selling your business to reduce ordinary income tax 

If you sell an asset that you’ve held for more than 12 months, the proceeds will be treated as long-term capital gains. The maximum tax rate for most taxpayers is 15%with the maximum rate at 20%. Proceeds treated as ordinary income are taxed at the taxpayer’s individual rate. Currently the top individual federal income tax rate is 37% more than twice as high as the long-term capital gains tax rate. 

Asset Allocation 

Obviously, sellers will want most of their assets treated as long term capital gains.  However, most times, during negotiationsthe buyer may want a different allocation, that in turn, can reduce the new owner’s tax bill.   

Pro Tip #2Negotiate on sales price, to receive a more favorable asset allocation  

It’s a potential conflict, as the buyer often wants as much of the price as possible allocated to costs that can be deducted or assets that depreciate. 

For instance, the IRS says that selling inventory produces ordinary income.  But selling capital assets held for more than a year creates a long-term capital gain. 

Deal Structure 

In addition to asset allocation, the deal’s structure can affect the tax bill. If the seller agrees to take the price in installments, for instance, they can defer paying taxes until the payments are received. 

Pro Tip #3Buyer competent?  Doing your due diligence can spread out your tax bill 

Buyers may end up paying more when they don’t have to pay everything upfront. And the seller may also be able to charge interest, in addition to saving on taxes.  Installment sales do add more risk, though, because the new owner must run the business well enough to produce profits to make payments. 

Corporate Stock Sales 

Sales of sole proprietorships, partnerships, and LLC’s are commonly treated as sales of separate assets.  However, when a corporation is sold the deal can be presented as a stock sale rather than a sale of assets.  This is important because if the corporation sells its assets, sale proceeds will be taxed twice. 

  1.  When the corporation pays taxes and 
  2. Again, when its shareholders file individual returns 

In contrast, a stock sale gets taxed once, saving on taxes for the seller. 

Tax-Free Corporate Mergers 

If one corporation is buying another corporation, the deal can be done by exchanging strictly stock. Under the right circumstances, this can mean no taxes at allas long as no cash is involved. 

The Bottom Line 

No matter the size of your business, consult a financial and tax advisor as taxes can eat into the cash you were hoping to get out of your business.  All this is governed by a complex set of IRS rules, which may not always be straight-forward.    

 

INVITO

As major investment firms promote their virtuous investments that maximize societal value, while seemingly scrapping their goal of maximizing shareholder valueone must ask:  Is woke capital truly committed and capable of delivering on its heroic quest, or is it simply pandering to social progressivism for profits and PR? 

 

We live in a day where the undercurrent of mistrust towards institutions is at an all-time high.  Whether it is Wall Street, the Government, or Hollywood…everyone has an agenda, and pointing fingers seem to be the solution for a problem as vague as the umbrella of solutions offered.  Elevated as the root cause that threatens all of humanity’s prosperity…man created climate change…and the fuel propelling us off this cliff of human apocalypse…fossil fuels?!? 

 

Poverty & Human Development 

It is hard to arguesince the dawn of humanity, that no other energy source has plucked humanity from abject poverty to the precipice of human flourishingdevelopment, and into enlightenment as fossils fuels have.  It has afforded our society the luxury to focus on values that are non-survival related and have enabled more progressive focus on values of equality, social justice, and environmental stewardship.  But tell that to almost half of the world that lacks such luxuries and would kill to enjoy a fraction of America’s energy abundance, and the 1st world values that come with them.   

Countries like Indonesia are moving away from clean energy projects. Credit: Getty Images

 

Rising energy consumption is tightly correlated with rising income and living standards, historically lifting humanity into the modern world.  Access to cheaper forms of energy is the necessary steppingstone for proper human developmentand not a process that should be skipped with more modern expensive options 

 

Humanity has flourished over the past two centuries with the average life expectancy increasing from 30 to 70 years, due to the use of machines (technology) coupled with the harnessing of energy (mainly fossil fuels) with these technologies.  But linking historical human development with environmental risk requires a more targeted approach.  Humans suffer from far more immediate local environmental risks, such as indoor air pollution, water pollution and water-borne illnesses, and malnourishment than more long term global environmental risks, such as climate change, ozone depletion, and ocean acidification. 

 

Over the decades, investment into business, specifically energy and energy technologieshas been a worthy, sustainable, and profitable endeavor whose local impacts can be certainly verified.  In particular, the vision, commitment, innovation, and sacrifice of the fossil fuel industry and the millions of talented employees, has been the irreplaceable and beneficial engine of progress for America.  Doing far more good than harm.  Thus, it is unjust to poorly treat and vilify an industry of people that do not deserve such ire.  Just imagine where the world would be without fossil fuels! 

Two possible agendas can explain this demonization and woke capital mindset.   First, to deflect the public’s perception of Wall Street greed (power and control) and poor performance, it is much easier to usa popular cover narrative (climate change) and perpetrator (fossil fuels) than to accept responsibility.  And why notwhen doing so additionally elevates your status and virtuousness.  Second, distracting an investor from reality is profitableand words like sustainability” and “ESG” and phrases like “saving the planet” are powerful images and again…profitable. 

 

Economy & Investment 

Recently the behemoth investment firm, BlackRock, which manages $7 trillion in assets, committed to a multitude of ESG initiatives including substantially increasing its so-called ESG funds, pushing clients to adhere to the UN’s Sustainable Development Goals, and aligning itself with “Climate Action 100+” aimed at improving business strategy with the goals of the Paris Agreement. ESG investing today is estimated at over $20 trillion in AUM o¼ of all professionally managed assets globally.   

 

If BlackRock and its sustainability-allies are true virtuous climate believers, why then has it been expanding its firms holdings in serial polluting Chinese investments?  As a result, millions of untold investors, through asset managers and their ESG vehicles are helping fund and strengthen the Chinese Communist Party (CCP), and their atrocious record of human rights violations and increasing polluting policies.  Shifting this “new standard for investing” reeks of hypocrisy, misleading shareholder stewardshipand disingenuous profiteering. 

 

Trends show energy consumption will continue to rise globally in the 21st century.  Modern economies are becoming less materially intensive and more service and knowledge focused, while economy growth rates exceed slower environmental impact rates.  In part, fueled by the cyclical effect of affordable fuels and technologies that enable reducing environmental impact in the first place.  This decoupling effect of human development from the environmental impacts is predicated on more efficient human activity driven by energy, technologyand demographic trends, like urbanization of the planet…not unproven investment theory based on poor scientific, economic, and societal history. 

 

How can the woke sophisticates in the financial services world and beyond who knowingly underwrite China, and other implied nefarious companies, claim to be genuine progressive ESG loyalists, let alone proponents of justice of any kind? 

 

Energy & Natural resources 

The history of harnessing energy through technologies is an intertwined dance between the patient process of human activity, fueled by economic investment, but relative to the increasing ability to use natural resources more efficiently.  Americans should know this better than anyone.  The history of harnessing natural resources in this way has afforded America these current modern energy opportunities.  Again, one cannot simply skip steps on its way to maximizing human activity.  Diversifying investment products should favor those with the most eco/cost efficient solutions, relative to the specific stage in that localized process.  Understanding that applying general global policy to local ecosystems, does not protect the very natural resources they aim to address.  Ordering targeted solutions for energy sources should favor the benefits to human development firstthen focus on efficiency of those waste streams and use of natural resources. 

 

But to suggest that the idea of sustainability investments is the only conceivable path forwardis to infer that historical ones were not.  Not true.  Moreover, little evidence exists that human population and economic expansion will outpace the capacity to grow food or procure critical material resources in the foreseeable future.  And ironicallyall modern so called renewable energy is truly neither renewable nor sustainable.  All require exploiting natural resources and underlying technologies.   

 

This sleight of hand woke capital is trying to pull off is fundamentally nothing more than an attempt to profit and take control of an energy transition.  But victoriously parading around their own virtue and value is good marketing…even though it may be hard to swallow.  Modern so-called sustainable options are simply not affordable…yet…nor remotely as efficient and helpful as advertised.   

 

Summary 

For this purposelet us not pretend that demonizing an undeserved industrywhile wrapping itself in the virtuous robe of climate change, is in of itself noble or accomplishes something that it has not done in the first place.  In the last few decades, humanity has seen exponential progress towards once unfathomable human development.  As a proponent of the oil and gas industrysupporting a diversified, efficient, and agnostic energy policy is the most complete historical and economic investment strategy.  Insofar as it uses natural resources efficiently, reduces poverty and increases modern living standards, and progressively balances capital/energy/labor economically, the virtue of investment and economic stewardship should be judged on what it has done and what it continues to do.  Throwing the baby out with the bath water solely on the perceived merits of perception or progressivism is neither responsible nor woke.  Efficient reduction of monetary and environmental waste has and will continue to propel humanity towards the summit of prosperity.  Only then can the luxury of progressive societal values truly permeate humanity as a whole and transform our planet, our ability to steward, and ourselves.  

 

– INVITO 

As Tax Day approachesand before the ink dries on your check to Uncle Sam, we take a moment to look back at the history of taxes in America...you know…to make you feel better.  So, get your tea bags or some prohibition-style libations, while we reiterate the age-old saying…. nothing is certain except death and taxes. 

But before we dive in, it is important to note that taxes were not always levied on Americans such as federal income tax, the alternative minimum tax, corporate tax, estate tax, the Federal Insurance Contributions Act (FICA), and so on.  Neither did the founders of America desire and intent to design such an arrangement.   

The early colonists had to deal with the British, which imposed a bevy of taxes on the colonists including a head tax, real estate taxes, and the infamous tea tax that led to the Boston Tea Party.   

After the Revolutionary War, the Congress granted the power to impose taxes on the public. States were responsible to collect and pass those to the government, mostly excise taxes imposed on specific goods like alcohol and tobacco. The government also tried direct taxation—taxing things an individual owned. That was not popular, and the feds went back to collecting excise taxes.  And in 1791, Alexander Hamilton’s proposed excise tax on alcohol was enough to prompt the Whiskey Rebellion in Pennsylvania. 

 

The Civil War led to the country’s first income tax and the first version of the Office of the Commissioner of Internal Revenue—the earlier version of what we now call the Internal Revenue Service (IRS). This office took over the responsibility of collecting taxes from individual states. Excise taxes were also added to almost every commodity possible—alcohol, tobacco, gunpowder, and tea…but this time…without the party.  Interestingly, income tax rates used to apply to everyone based on income regardless of status—single, married, and heads of households. 

The first estate tax was enacted in 1797 to fund the U.S. Navy. It was repealed but reinstituted over the years, often in response to the need to finance wars. The modern estate tax as we know it was implemented in 1916. 

Other taxes as a corporate income tax were enacted slightly earlier in 1909. 

 

Wars are Expensive 

In 1913, the States ratified the 16th Amendment, instituting the federal income tax where the actual form and directions were a mere four pages…today the total an intimidating 106 pages.  Income tax rates ranged from 1% on income of $0 to $20,000 up to 7% on income over $500,000. 

However, to finance America’s participation in World War I, Congress passed the 1916 Revenue Act and then the War Revenue Act of 1917.  From 1916 to 1917 the tax rate jumped from 15% to a whooping 67%then finally settling at 77% in 1918. 

Wars are Expensive!  So, after the war, the federal income tax rates took on the steam of the roaring 1920s dropping to 25% by 1931.  The gift tax came about in 1924.  Sales taxes were first enacted in West Virginia in 1921. Eleven other states followed suit in 1933.  

 

The Great Depression 

The Great Depression was a worldwide economic downturn that began in 1929 and lasted until about 1939.  It was the longest and most severe downturn experience by the Western world, causing fundamental changes to economic policy, theory, and institutions.  But by 1933, the American recovery was in full swing.  But Congress raised taxes again in 1932 during the Great Depression to 63% on top earners…potentially lengthening this recovery progress.  Federal excise taxes on gasoline were implemented in June 1932 under President Herbert Hoover as part of the Revenue Act of 1932.  FDR signed the Social Security Act in 1935. The government first collected Social Security taxes in January 1937.  Dividend taxes were enacted in 1936 but only lasted through 1939. 

 

WWII and Beyond 

As mentioned before, war is expensive.  In 1944, the top rate peaked at 94% on income over $200.000.  By the end of the war and through the 1970’s, the top federal income tax rate remained high, never dipping below 70%.  Investment dividend taxes reappeared in 1954 and have persisted ever since.  The alternative minimum tax (AMT), a type of federal income tax, was not enacted until 1978, as a way to ensure everyone paid their fair share. 

It was not until The Economic Recovery Tax Act of 1981 that the highest rate was reduced from 70% to 50% and indexed the brackets for inflation.  The Tax Reform Act of 1986 expanded the tax base and dropped the top rate to 28 percent for tax years beginning in 1988.  The idea was that the broader base contained fewer deductions but brought in the same revenue. Further, lawmakers claimed that they would never have to raise the 28 percent top rate…this promised lasted three years before it was broken.   

By 1991 the top rate jumped to 39.6%.  However, the Economic Growth and Tax Relief and Reconciliation Act of 2001 dropped the highest income tax rate to 35from 2003 to 2010. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 maintained this rate through 2012. 

The American Taxpayer Relief Act of 2012 increased the highest income tax rate to 39.6%. The Patient Protection and Affordable Care Act added an additional 3.8 percent on to this making the maximum federal income tax rate 43.4%.   

Today, the highest federal tax rate is 40.8%.  In context of this articlewhat’s the big deal?  Seems like a historically low tax rate.  But the difference between today and the past is the wide range of things that ARE taxed.  Actually, it may be easier to list the things that aren’t taxed…like…uhm…air?  LINK  However you split the baby, understanding America’s history on tax will cause you to cry and lash out in a violent rage or you will find ways to cope and develop strategies to take advantage of the complexity.  Either way, certainty is usually a valuable thing these days…and since death is inevitableinevitably taxes only get worse when Congress meets. 

Happy Tax Day! 

 

Invito Energy Partners

“…but in this world, nothing can be said to be certain, except death and taxes”. What Benjamin Franklin was suggesting regarding tax, is as old as civilization itself. Take a long gaze back into history, and inevitability staring back at you is the long imposing face of the tax man. From every war, to every ruler, to the birth of Jesus himself; looking at history through this lens may shape the way we think, and feel, about ourselves and the cultures, as we understand them today.

 

Historically, tax is power to rule and affect human behavior. Limit that power and the effects on that behavior have massive implications.

 

Take the window tax, introduced by King William III, in England during the 18th and 19thcenturies. It was designed to impose tax relative to prosperity; the more windows you had, the more prosperous you probably were.

These simple property taxes resulted in changes to the daily lives for millions of Britons. Working conditions, architecture, and physical and/or mental health standards radically changed while folks developed ways to avoid the governments long arm into their pockets.

 

The American revolution, at its core, was a revolt over the oppressive taxation of the people. “No taxation without representation” was the cry. Every conflict from Iraq to the Roman empire was made possible by various taxes in some form.

 

The modern world today enjoys some of the highest tax rates in history with the average American paying 35% in taxes (UK 45% and France an astounding 55%). As a result, navigating the U.S. tax code has turned into an Olympic gymnastics event. So, what are we to do? If history is any indication, we will do what humans have always done…conform for “the betterment of society” or contort around and away from the long arm of the tax man.

 

– Invito Energy Partners

 


This report was prepared for use by advisors as a source of recommendations and a tool to effectively communicate with clients the many methods available to invest in oil. I have advised oil and gas executives for 28 years and our team has over 100 years of collective experience in energy. I hope you find this report useful in your daily practice.
I have addressed each structure beginning with the more straight forward structure (ETF’s) to the more sophisticated structure of Direct Investing which offers the greatest overall benefits to investors.  ETF’s are a simple and passive way of gaining oil exposure. MLP’s generate good yield and are a moderately hedged way to play oil. Royalties provide excellent tax-advantaged yield, are a more direct play on oil prices which can create good opportunities for capital gains.  Lastly, Direct Investing gives investors  significant tax write-offs against their income, tax advantage cash flow, direct exposure to oil prices and the most upside potential of all the structures. There is no right or wrong way to invest in oil, but there are many circumstances which make one method superior to another depending upon the client’s needs.

ETF’s

Oil ETF’s are not created equal – but they all can have a place in a portfolio depending upon the client’s objective. We focus on 4 basic types of oil ETF’s: Oil Price, Upstream, Downstream and Oil Field Services (OFS).

OIL PRICE ETF’s

Oil price ETF’s own paper contracts, not physical oil or shares in energy companies and therefore have no long-term place in a client’s asset allocation and should only be used for short-term trading opportunities. Oil price ETF’s can vary widely from USO, which uses very short-dated futures contracts, to DBO which invests in much longer dated contracts.  The shorter the contract, the higher the volatility and potential for large daily price swings.  Depending upon your goal, each ETF (or a combination of the two) can be useful if used properly and in moderation.
Recommendations & Explanations:  
USO: Even though USO has been maligned by the press for its dramatic 84%+ fall in less than 4 months earlier this year, it did what it was designed to do-which is track West Texas Intermediary (WTI) in a normal WTI price environment.  However, when the markets swiftly dislocated, USO was unable to effectively track WTI physical price movement and traded at a steep discount to physical oil.  Investors need to be aware this can occur with any oil price ETF that invests in short dated futures contracts.  USO is the largest and most liquid oil price ETF, which is important when violent price swings occur, but the size and liquidity of the fund will not protect investors from harsh price movements.  Just be aware of the underlying risks when markets turn ugly.  With that said, the pendulum swings both ways and can be an excellent way to invest in the price movement of oil if you believe in oil’s recovery.
DBO: Flying under the radar is DBO. The underlying objective of DBO does not differ much from that of USO – it is the underlying investments that are very different. DBO invests in longer-dated futures contracts which results in much lower volatility and smaller price swings. While both USO and DBO have fallen precipitously this year, DBO has held up relative to its peer, with a 51% loss versus USO’s 84% decline.
USO and DBO are similar in that they are both ETFs and they both hold WTI futures contracts, but that’s about where it ends. DBO uses an optimization process in selecting which futures contract to own. This process involves a cost-effectiveness calculation on DBO’s part. Before its futures contracts roll over, the fund determines which futures contract has the best economics for the investor. At the end of the day, DBO uses a more proactive and analytical process for determining which contracts they should invest.
USO/DBO:  One strategy to consider employing is a blend of both ETF’s which allows more flexibility in trading and taking profits on big “up” days using USO, while remaining in DBO for longer-term exposure to oil price recovery. A suggested split would be 80/20 in favor of DBO.
BOTTOM LINE:  In normal times, oil price ETF’s will move closely with changes in WTI – and if used properly will provide clients with a tool to track the directional price of WTI.   The question is how much volatility can your client handle? As seen in the following chart, DBO is much less volatile and sensitive to daily price movements than USO, but if you believe in the recovery in oil prices, USO will react much faster.  (See Chart).

SECTOR-SPECIFIC ETF’s

There are too many ETF’s to count and very few standouts to mention, however there are a select few standouts that do deserve attention which we have broken into 3 categories below:

  • Upstream (Exploration & Production)
  • Downstream (Refineries) Oil Field Services (OFS)

 
UPSTREAM ETF’s
Here, the question comes down to bullishness. Upstream exploration and production (E&P) companies are going to see the greatest risk/reward from any uptick in oil prices, whereas midstream transport companies or downstream refiners will provide a more hedged bet. On the E&P side of the spectrum, energy companies are price takers, depending wholly on the price of oil — and they’re leveraged as well — which means their shares enjoy outsized gains when prices are rising, and steep declines when the opposite happens.  
Recommendations & Explanations:  
PXE: The Invesco Dynamic Energy Exploration & Production ETF is the purest play on E&P companies.  Unlike many ETF’s that claim to be E&P focused, PXE is a invests in mostly upstream companies. It is a smaller ETF that gives investors exposure to 30 US E&P companies.  While many sector funds simply assign weights to each stock based on their relative size (e.g., the largest stocks account for the largest percentages of the fund’s assets), PXE does things a little differently. For one, its underlying index evaluates companies based on various criteria, including value, quality, earnings momentum, and price momentum. It also “tiers” market capitalization groups, ultimately giving mid- and small-cap stocks a chance to shine. Roughly half of PXE’s assets are allocated to small companies, and another 36% are in midsize firms, leaving just 14% to larger corporations. Perfect for investors who prefer a more tactical research driven approach.

 

DOWNSTREAM ETF’s

Refineries are ugly, dirty and typically boring.  However, they can be a great way to play an oil recovery because they are not as directly tied to oil prices. The oil glut we are reading about eventually needs to be refined and refineries will stay busy.  Refineries are buyers of oil from the producers, so when oil prices drop, they can sometimes get a boost from the lower prices since their cost of raw materials (oil) has dropped.   As with any business, there are other factors that will drive profitability, but the largest driver is the price (cost) of oil.
Recommendations & Explanations:  
CRAK: The VanEck Vectors Oil Refineries ETF tracks the performance of refiners, has a relatively low expense ratio of approx. .59% and is the purest play on refineries available to investors.  Refineries are overlooked because they are not “sexy”, but they can be a great addition to a portfolio and used as a hedge against the volatility in oil prices. Consider using CRAK as part of your overall allocation to oil by allocating 15% -25% of your total energy allocation to refineries to smooth returns. As a bonus, the portfolio kicks off a yield of approximately 2%.

OFS ETF’s (Services)

OFS stocks are highly correlated to oil prices and these companies are at the mercy of the capital budgets of the producers – and for this reason and others, the services sector is tough. Cap-ex budgets were already under pressure in 2019 and now with oil prices where they are now, budgets are getting slashed for 2020 and likely in 2021. Producers cannot control the price of oil, but they certainly can try to control what they pay for services, and right now they don’t want to pay much. It is worthwhile keeping a pulse on OFS ETF’s as they are typically the first sector to turn around as oil prices rebound and producers begin to spend money again. Until then, pricing pressure will be an overhang for service providers and OFS ETF’s.
Recommendations & Explanations:  
OIH: There are approx. 4 services ETF’s – and they all perform almost identically. Their strategies are similar, and expenses are within basis points. With that said, we recommend OIH because it is the largest, most liquid, and slightly outperforms its peers.

MLP’s

Appropriate for investors seeking both yield and total return with less volatility than more direct oil exposure. MLP’ have historically been a safer way to play a recovery in oil prices because they are not a direct investment into oil.  However, since MLP’s are in the business of transporting oil and gas through vast networks of pipelines, they typically get “lumped in” with oil & gas companies and tend to rise in good oil environments and fall in bad.  MLP’s get paid a fee for transporting oil and gas through their pipelines, yet they can still carry direct and indirect risks listed below. With all this said, we do not expect oil prices to remain subdued long enough to create any notable issues for the larger better capitalized MLP’s.

  • Commodity Price Risk: Although the majority of MLP’s are mostly immune to commodity price volatility, they still tend to get “lumped in” to the oil category because they still carry some level of commodity risk. For example: Enterprise Products’ (EPD) revenue is approximately 86% fee based.
  • Tenant Risk: MLP’s are mostly protected from commodity price swings, but their clients are not. Therefore, MLP’s could possibly need to restructure existing contracts, resulting in lower income. Some could even go into bankruptcy.

Recommendations & Explanations:  
BMLP: The Dorsey Wright MLP Select ETF (symbol: BMLP) is different from most MLP ETF’s for several   reasons:

  1. BMLP uses the long-proven Dorsey Wright methodology to actively manage the portfolio and add value in terms of both risk and return. Other MLP ETF’s attempt to “hug” the index and not get involved with active management.
  2. BMLP includes only the top 15 MLP’s they deem to be the best vs. the mammoth Alerian MLP fund (symbol: AMLP) which has 23 or more holdings and passive management.

 

 

ROYALTIES

Yield:                                                                                                                              
Clients seeking yield and who desire income that rises (and falls) in sync with commodity prices, Royalties are a great play. Not only do they offer an exceptional yield, 15% of the income passes tax-free to the investor. Think of The Beverly Hillbillies and Jed Clampett.  Jed found oil on his property, but never spent a dime to drill and complete a single well.  Instead, for a perpetual stream of royalty payments he allowed others to spend their money to produce the oil – and he received a royalty check for every ounce of oil produced. There are three ways to invest in royalties:
Recommendations & Explanations:

  • Publicly Trade Royalty Trusts (PRT’s)

While most publicly traded royalty trusts are not worth mentioning because their history of    reserve replacements is poor or the reserves are short lived, there are several that should be considered. It should be noted that Sabine Royalty Trust (symbol: SBR) is the only pure play on    oil and gas royalties because it contains no working interests. Below are 2 recommendations:

  • SBR: Sabine Royalty Trust: Forward Yield 61% (as of 5/20/2020)
  • PBT: Permian Basin Royalty Trust: Forward Yield 30% (as of 5/20/2020)
  • Royalty MLP’s

Royalty MLP’s differ from PRT’s mentioned above because unlike PRT’s they actively manage and constantly aggregate minerals resulting in a constantly growing portfolio. It is for this reason Royalty MLP’s offer the greatest potential during low oil prices as it allows them to buy mineral rights cheaply from sellers. Below are 2 recommendations:

  • KRP: Kimbell Royalty Partners: Forward Yield 81% (as of 5/20/2020) *
  • BSM: Blackstone Minerals: Forward Yield82% (as of 5/20/2020) *
  • VNOM: Viper Energy Partners: Forward Yield 81% (as of 5/20/2020) *
  • Private Placement Royalties

For accredited investors, private royalty funds are a more favorable way to invest in royalties. Private placement funds can yield in the low to mid-teens, with 15% of the income passing tax free to investors. There are a few groups that specialize in royalties, but before investing be certain to do your homework to make sure the group you chose is aligned with the investor and structured with a fair and reasonable fee structure.   If you want suggestions for private royalty funds, please feel free to reach out to me to discuss or send me an email.

DIRECT LP INVESTMENT

Tax write-offs, tax-advantaged cash flow and better upside potential.
Thanks to the Tax Cuts and Jobs Act signed in 2017, the already very favorable tax incentives for direct oil and gas investing are even more beneficial as an investor can write-off the tangible costs of wells through accelerated depreciation.  This new tax incentive allows in many circumstances for 100% of an investment to offset AGI in the year the investment has been made. As an example, this means a properly structured direct investment of $200,000 could save your client between $65,000 – $80,000 in taxes on day one. This is an excellent way to add direct value to your clients.  Direct investment funds can also yield in the low to mid-teens with 15% of the income passing tax-free to investor.
Direct investments are the most favorable way to invest directly in oil and gas wells. Key to direct investing is conducting basic due diligence on the sponsor to answer the following questions:

  • Does the sponsor have technical staff with strong operational backgrounds on their team?
  • Are the sponsor incentives aligned with investor?
  • Is the fund structured with fair and reasonable fee’s?
  • Does the sponsor have “Skin in the Game”?

The qualifications of the sponsor’s staff are critical when conducting due diligence.  Are they petroleum engineers, geologists, or land men with prior upstream operating experience?  Or are most of their backgrounds in sales, marketing, and business development?   Without question, you want to align yourself with sponsors who have strong technical teams and decades of oilfield experience as part of their company rather than a team comprised of sales and marketing.
Misalignment of incentives occurs when the sponsor is making a substantial portion of their promote up front before the well is drilled.  It is critical that you can answer the question:  How is the sponsor making money?  Is it from the production of the well like the investor? Or is it upfront from fees before the well is drilled?  Additionally, many funds have high fees due mainly to the fact that they are paying commissions to sales teams.  You should ask the sponsor if there are upfront commissions being paid.
Lastly, does the sponsor invest their personal money directly alongside the investors?  If the answer is “yes”, you can feel certain their interest in the success of the investment being perfectly aligned with that of the investor.  If the answer is “no”, investors should be very cautious.

Bottom line: The tax benefits associated with direct investing offer a unique incentive for advisors’ clients and are an option that should be given consideration in the overall wealth management of advisor’s clients.

If you would like additional information on any of the methods listed above, please do not hesitate to email, call directly, or schedule a call via my Calendly link provided in my email.  You can also access a Tax Guide on Direct Investing by visiting www.invitoep.com and clicking on the Advisor Access tab and registering for access – or you can email me back directly and request the Tax Guide
*Source: Yahoo! finance

 

 

David Swearingen

invitoep.com

Every day, as an organization, we speak with individuals about the building and preservation of capital.  But along this journey with investors, invariabla few intangible factors always seem to influence an investors decision-making mindset…even more so than the numbers or return profile. Their HEALTH! 

“When health is absent…wealth becomes useless.”Herophilus 

The Deep link between health and wealth is clear and few things destroy wealth, or impact the upward mobility of wealth, like poor health.  However, most folks think of health in the context of the body only.  The basics for a healthier body is a trillion dollar industry including, the right foods, diets, supplements, limiting sugar, exercising regularly, not smoking or taking illegal drugs, limiting alcohol consumption, stress reduction, and getting plenty of sleep. 

However, focus on distilling the human experience down to only the physical outermost man, dilutes the mind/soul and spiritual health of an individual.  All three ingredients act like a threelegged stool supporting one another towards total health.  If one is weak, the stability of overall health will be impacted, or may not function at all. 

The connection between health and wealth should be deeply understood by everyone, and it is therefore important to create and roll out strategies to manage both for truly life-enhancing benefits and opportunities. 

But why is this such a challenge?  And where does it typically go wrong? 

 

 

Definitions 

Health: “A persons mental or physical state of being free from illness or injury” 

Wealth: “What is left over in abundance that has and stores value” 

Does more monetary wealth mean an abundance of health?   

The Body 

According to the studies from Universities and CDCincome is directly linked to physical health outcomes (figure 1).

Figure 1  CDC, Self-reported poor health by income, 2011

This would make sense on its face, as wealthy individuals have more access to healthier food, housing, transportation, school systems, investment opportunities, and medical resources.   

 However, what about investors who have currently built their wealth…those who have spent their life making wise financial decisions or sacrificing for their business?  Many times, this cost of abundance has come at the cost of physical health.  Americans spend more than $3.5 trillion annually on health-related expenses. There are very few destroyers of wealth quite like poor physical health. Per the HHS, more than 80% of adults do not meet the guidelines for both aerobic and muscle-strengthening activities. Recent reports project that by 2030, half of all adults (115 million adults) in the United States will be obese.  But the state of physical health is not as simple as just taking care of the body.   

The Mind/Soul 

The link between the body and the outer man’s mind/soul is like determining which came first…the chicken or the egg.  Either way they are both dependent on each other for an abundance of health.  The soul encompasses one’s identity, personality, character, emotions, intellect, will, and conscience.  But outside of external forces, nothing has quite the power over the body, as the mind does.  The mind is the computer of the body, which performs over ten quadrillion (10,000,000,000,000,000operations per second!  But one in five Americans has a mental health disorder. Whether diagnosed or undiagnosed, an estimated 43.8 million Americans experience a serious mental illness such as depression.  Americans Spend Over $200 Billion annually treating mental health conditions between prescription medication, therapy sessionsand hospital visits. 

The 4 brain chemicals 

  • Endorphin — the pain-masking chemical 
  • Dopamine — the goal-achieving chemical 
  • Serotonin — the leadership chemical 
  • Oxytocin — the chemical of love/connection 

The mind controls the body with power chemicals that can aid in overall health.  However, an overabundance of survival chemicals like cortisol, adrenaline, and norepinephrine can lead to long term mental and physical health complications.  People with less income are four times more likely to report being nervous and five times more likely to report sadness “all or most of the time” (figure 2). 

Figure 2 – CDC, Feelings by income, 2011 

The Spirit 

The whole person is made of the tangible outer man, but also embodies the inner man.  Ones spirit is defined as “the spiritual or immaterial essence of a person, embodied.”  person’s spirit, or inner man, is where discernment, wisdom, peace, revelation, and communication with God take place.  A survey recently showed 9 out of 10 people believe in something higher than themselves, transcendent, and external.  This deep sense of worth, purposeand meaning has extremely powerful health benefits.  Spiritual wealth and abundance are not found in the tangible things, but perceived in the innermost intangible parts that transcend the physical man.   

“The mind governed by the spirit is life and peace.” Romans 8:6 

This innermost purpose and passion influence the mind/soul, change life decisions and paths, and can sometimes be considered as irrational or based on faith or things that are unseen.   

“The purpose of life is not to be happy. It is to be useful, to be honorable, to be compassionate, to have it make some difference that you have lived and lived well.” —Ralph Waldo Emerson 

However few people, 9 minutes on average, spend time connecting spiritually whether through prayer, meditation, reading, or nature.   

The Wealth Link 

Wealth is found in both monetary and non-monetary things.  Having an abundance of money, however, is useless unless built upon an abundance of healthbody, mind, and spirit.  While wealthier folks do experience better health outcomes because of their wealth, poor health can not only destroy current wealth but affect the occurrence of wealth to begin with.   

Mental pain, physical pain, fear, and worry are difficult conditions and mindsets that we see all the time…and they unfortunately impact the decisionmaking of many investors.  While the basics for creating a healthier lifestyle are widely accepted and known to many people…they still do not implement them!  The steps for devising, implementing, and managing financial planning strategies are, arguably, not quite as simple due to the personal mindsets and circumstances of each individual.  In all cases, having advisors, trainers, spiritual leaders, or friends that can speak into or implement your path to health and wealth…is the key to unlocking these challenges…and the life-changing benefits and opportunities that they may afford

 

Another decade is in the books…and boy has 2020 been a knee slapper. The ability to predict the future could deliver infinite profits…so how is that going for you?

“History repeats itself, but in such cunning disguise that we never detect the resemblance until the damage is done.” –Sydney J Harris

“Those who cannot remember the past are condemned to repeat it.” –George Santayana

The 2010s took most of us by surprise. U.S. stocks rallied all decade long, emergency-era monetary policy persisted throughout the decade, and yet neither inflation nor a convincing economic recovery ever occurred. But boy, was there money to be made just by sitting in U.S. equities.

Interest rates peaked in August 1981, the result of Fed Chairman Paul Volker’s efforts to conquer inflation which reached as high as 14.5%. Since that time, interest rates have steadily fallen to where they are today. The rate of inflation has fallen but the value of money has also depreciated. The dollars you hold in your pockets today buy less goods and services every year. If we begin with $1,000,000, below is the annual income per year in each decade if invested in 10-year US Treasury bonds.

1980s: $140,000

1990s: $80,000

2000s: $50,000

2010s: $40,000

2020s: $7,000

That’s a 20x decrease in income. While inflation has fallen, the purchasing value of money and its return has also fallen dramatically. The federal reserve would not allow asset prices to fall and had the power to make sure it didn’t happen by implementing QE and other methods.

Why are they doing this? One word…debt.

As the economy heads into a retraction, credit spreads between treasury debt and corporate debt start to widen as the risk of default rises on lower-quality debt. So…the Fed intervenes with bond buying to keep the bond market from imploding, which is why they are expanding their balance sheet. Currently the Fed’s balance sheet will go from $4 trillion at the start of 2020 to $10 trillion by year end.

This is good news if you are a debtor…not so much as an investor. Cash yields next to nothing, money markets are at 0.0% and even short-term treasury yields are below inflation rates. Translation…you are losing money after taxes and inflation on cash investments.

This brings us to the devaluation of the US dollar. It will be sudden and come out of nowhere, but the only relief valve out of our mounting debt will be a devaluation. Overnight, tens of trillions of government debt will be wiped out and become worthless to those who hold this debt, be it foreign governments, pensions, companies, or individuals.

What trend should an investor do with inflation on the horizon? THINGS!

Investors have been following the deflationary trend of the last decade. This was a period when paper assets such as stocks and bonds did well. This led to the index bubble and the proliferation of passive investment strategies. It didn’t matter if you owned stocks or bonds, both made money over the last decade. Indexing led to extreme market valuations as the index favored large-cap stocks which drove the indexes higher. The result was most of the index returns were concentrated in a handful of stocks, giving the illusion of the overall index performance.

This new trend will take the place of depreciating paper money and into things: natural resources, hard assets, and businesses involved in both. This trend will be fueled by resource shortages and a tidal wave of money printing. But there are two things the markets aren’t ready for right now which are the return of high oil prices and inflation.

The markets have bought into the idea that we have reached peak oil demand as a result of COVID-19 and that we are entering a new green economy where electric cars will replace the gasoline combustion engine. This is utter nonsense and wishful thinking. Electric cars make up only 0.3% of the global car fleet. This is an opportunity that few investors will see coming, and it is why we started our Tax Advantaged Energy Fund (TAEF) which invests into direct energy investments. Its benefits are long-term hard assets that are immune to inflation, cash flow and substantial up front and ongoing tax benefits.

The last thing that the economy needs post-Covid-19 world is that world getting more expensive. But that is exactly what would happen under democratic presidential nominee Joe Biden’s proposed tax policies. But fear not, we have some simple solutions on what to do, and how to do it.

The Tax Foundation estimates that over the next decade, Biden’s plan would raise tax revenue by $3.05 Trillion, reduce GDP by 1.47 percent over the long term, and reduce jobs by over 600,000. This estimate has been lowered due to the effects of coronavirus, the economic downturn, and new tax credit proposal introduced by the Biden Campaign.

Summary of Joe Biden’s Tax Plan

Biden’s tax plan includes the following payroll tax and individual income tax changes:

  1. Imposes a 12.4 percent Old-Age, Survivors, and Disability Insurance (Social Security) payroll tax on income earned above $400,000, evenly split between employers and employees. This would create a “donut hole” in the current Social Security payroll tax, where wages between $137,700, the current wage cap, and $400,000 are not taxed.
  2. Reverts the top individual income tax rate for taxable incomes above $400,000 from 37 percent under current law to the pre-Tax Cuts and Jobs Act level of 39.6 percent.
  3. Taxes long-term capital gains and qualified dividends at the ordinary income tax rate of 39.6 percent on income above $1 million and eliminates step-up in basis for capital gains taxation.
  4. Caps the tax benefit of itemized deductions to 28 percent of value for those earning more than $400,000, which means that taxpayers earning above that income threshold with tax rates higher than 28 percent would face limited itemized deductions.
  5. Restores the Pease limitation on itemized deductions for taxable incomes above $400,000.
  6. Phases out the qualified business income deduction (Section 199A) for filers with taxable income above $400,000.
  7. Expands the Earned Income Tax Credit (EITC) for childless workers aged 65+; provides renewable-energy-related tax credits to individuals.
  8. Expands the Child and Dependent Care Tax Credit (CDCTC) from a maximum of $3,000 in qualified expenses to $8,000 ($16,000 for multiple dependents), and increases the maximum reimbursement rate from 35 percent to 50 percent.
  9. For 2021 and as long as economic conditions require, increases the Child Tax Credit (CTC) from a maximum value of $2,000 to $3,000 for children 17 or younger, while providing a $600 bonus credit for children under 6. The CTC would also be made fully refundable, removing the $2,500 reimbursement threshold and 15 percent phase-in rate.
  10. Reestablishes the First-Time Homebuyers’ Tax Credit, which was originally created during the Great Recession to help the housing market. Biden’s homebuyers’ credit would provide up to $15,000 for first-time homebuyers.

In a nutshell, if you make over $400,000 dollars, congratulations, your job is now figuring out a strategy on what to do to reduce your taxes. Luckily, we have you covered.

If you have loses, carry them over to 2021 under Biden’s higher tax rates.

In Estate planning, Biden wants to bring back double taxation of estates. The current exception amount is $11.58M, Biden’s proposal is $3.5M…if you are waiting to estate plan…don’t!

On the income tax side, push as much in 2020 under the trump rates as possible; take bonuses, convert your Roth IRA’s, differed comp. plans, and sell businesses. Do not wait, start today with your tax or financial advisor.

If you do not have one…we can point you in the right direction….and if you qualify we can save you up to $0.35 on every dollar you would have to pay to Uncle Sam.

The modern tax code, with few exceptions, is filled with complexity and confusion, much to the chagrin of the average tax-paying citizen. But before taxation became a political punching bag, contributing to one’s government or one’s fellow man invoked a sense of duty rather than disdain. So why the negative feelings today? Have we lost our sense of duty to the greater good?

When taxes were instituted in the old world, they were done so in very different ways with very different goals. In ancient Athens, taxes were voluntary. Liturgy was how the rich shared their wealth with the rest of the population. And not only did the rich pay for essential public works, they carried out these works themselves. On the opposite side of the spectrum, in authoritarian societies such as North Korea and the U.S.S.R. the government determines the greater good, and individuals have no ownership of their labor or their profit. In Europe, at the end of the 20th century, the tax rate was running around 10% of GDP, slightly lower in the US. This ran closely to the historical tithe rate, which goes all the way back to Mesopotamia. But the halcyon day of low taxes were not to last; ended by two world wars.

The idea behind social democracies’ intermittent high levels of taxation, was a method for traditionally raising funds for the war efforts. But the high rate of today’s modern tax policies, absent of war, seem to strategically abandon its historical legacy, and shift to solve more seemingly modern problems. But do they? There are two reasons for the un-level playing field in this inequitable tax system; complexity and what is taxed.

First, with the notable exception of Hong Kong and a few others, most modern tax systems are filled with complexity. The worst offender, the United Kingdom, has the longest tax code in the world: 10 million words on 21,000 pages, or nearly 12 times the length of the Bible! Complexity begets loopholes, and loopholes are exploited by individuals with the resources to identify them. This can produce some unintended consequences from the sheer volume in the tax code on a country and the individual.

Creator: Ethan Miller | Credit: Getty Images Copyright: 2015 Getty Images

Secondly, what is taxed, or what is NOT taxed, is the engine of these consequences. Much of the wealth of the rich does not derive from their labor, but rather the appreciation in value of their assets. Appreciated value is not taxed until the asset is sold or realized, which does not happen with regularity. So, in practice one group, the less prosperous, is taxed heavily, while the other is not. And not only is the lower/middle class citizen taxed disproportionately, he/she is paid in currency that loses its purchasing power over time thanks to policies of the treasury department, that debase that currency. All the while, as his/her purchasing power decreases, the cost of goods and services are subject to regular inflationary increases.

In 1945 Hong Kong’s population was 600,000 and it’s per capital GDP was on a level with most African counties. By the late 1980’s, its per capita GDP was higher than that of the U.K., and in the late 1990s it overtook the U.S. Today, Hong Kong is one of the wealthiest regions in the world. Its historical tax rate is roughly 14%, with no income tax, except for the very wealthy. They taxed the wealth, not the labor. Based on the historical tithing rate, and the above example, it is hard to argue that the “natural” tax rate shouldn’t be significantly lower than modern levels.

The danger of high taxation as the government’s method and manner to the prosperity of its citizens, has indirect and complication implications. However, the complexity of the tax code can lead to disproportionate application to the taxpayer and country, and therefore, negative sentiment. What began as a system to contribute to the greater good, has now become a conversation of exacerbating the inequality it was thought to combat. Indeed, the current tax code is confusing and heavy handed. But the average taxpayer should educate one’s self on solutions to navigating and the implications when that rate becomes higher than the historical “natural” rate.