The Complete Guide

Working Interest vs. Royalty Interest

Table of Contents

If you know where you’re going, go ahead and click on a chapter.

Introduction: Welcome to Gas and Oil Investment! 3

Chapter 1: Investing in Gas and Oil – The Big Picture 6

Chapter 2: Working Interest Investment – The Scoop 11

Chapter 3: Royalty Interest Investment – An In-Depth Look 16

Chapter 4: Oil and Gas Laws – Trying to Prevent Problems 20

Chapter 5: Sale of Gas and Oil – Where the Money Comes From 25

Chapter 6: Determining Royalties – From Underground to Bank 29

Chapter 7: Tax Implications – More and Less 33

Chapter 8: Gas and Oil Well Fraud – Be Aware 35

Chapter 9: Royalty and Working Interests – Comparing the Two 39

Chapter 10: Investment Points to Consider 42

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Introduction:
Welcome to Gas and Oil Investment!

Welcome to Gas and Oil Investment!

In most countries, if you own land, you do not own what’s under it. Governments
have rights to any and all minerals beneath the surface. However, that’s not the case
in the United States. If you hold a property title, any buried minerals are yours, too.
Though local, state and federal governments sometimes have mineral rights, most
are held by individuals, companies or Native American tribes. Just like you can rent
your land, you can also lease your mineral rights.

Depending on where you live, those mineral rights might be in great demand. The
vast majority of land-based oil wells are drilled in Alaska, California, Colorado, New
Mexico, North Dakota, Oklahoma, Texas and Wyoming. The top states for natural gas
production are Louisiana, Oklahoma, Pennsylvania, Texas and Wyoming.

Landowners allow the establishment of gas or oil wells on their properties in return
for payments. This royalty interest investment for oil and gas drilling has the
potential for significant gains with little risk.

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The company running the show has a working interest investment for oil and gas
drilling. This is a big gamble, but successful wells generate huge profits.

Investing in gas and oil wells calls for endurance, because the exploration, drilling,
producing and shipping of minerals can take time — sometimes a lot of time.
Proceeds do not pour in immediately, even from flourishing wells. While waiting,
people with working interests can take advantage of significant tax benefits from
investing in oil and gas drilling. Multiple deductions are available, as are oil and gas
drilling tax credits.

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This is not a simple, frivolous or casual investment. Whether you are considering a
royalty or working interest in a gas or oil well, you need to investigate the transaction
thoroughly. The two types of investments are distinctly different. Each has advantages
and disadvantages that are not always obvious. A working interest brings many
responsibilities. Though holders of royalty interests are less burdened, they still need
to fully understand how, when and if they will get paid.

Even though government entities do not own most mineral rights in the U.S., they still
regulate the ownership, sales and leasing of oil and gas rights. The rules are complex
and change from time to time. People who seek royalty or working interests in wells
should protect themselves by consulting lawyers who are experienced in these
investment fields.

You want your agreement to be as favorable as possible, and you certainly do not
intend to be taken advantage of. When there is money to be made, scam artists pop
up, and it’s no different with gas and oil drilling. Unwary investors with their eyes on
the prize — and not the fine print — can be defrauded. Gas and oil speculation is risky
even when everything is on the up and up. Throw in a little deception, and investors
have no chance of success.

Now that you know what’s at stake, get ready to learn the ins and outs of royalty
interests and working interests in gas and oil drilling. Once you understand the nature
of each, you can make an informed decision. Because of the potential for tremendous
profits, you might well conclude that gas and oil wells are worth further exploration
— at least with an advisor. Save the actual drilling for the professionals!

If you have questions about investing in gas and oil, either before or after you read
this guide, contact us for a free consultation.

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Chapter 1:
Investing in Gas and Oil – The Big Picture

Risking money on gas or oil industries is not for everyone, but some people see
benefits over other types of investments. Gaining an understanding of the advantages
and disadvantages is the first step towards deciding if you should invest and what
form your investment should take.

The Structure of Gas and Oil Wells

The very nature of gas and oil wells provides advantages. If a substantial amount of
a resource is discovered, the payoff can be huge. It will likely last for years and years.
Investors recoup their money — plus a lot more — over time.

Because of this, gas and oil wells have the possibility of earning far, far more for
participants when compared to traditional investments. This is especially true in
the United States, where domestic oil production has been increasing dramatically.
Meanwhile, the use of foreign oil has dropped.

Diversify, Diversify, Diversify

Higher oil and gas prices typically lead to higher returns on gas and oil investments.
That’s a winning scenario for investors. But those same rising prices usually
accompany a declining economy. Inflation also goes hand-in-hand with more
expensive gas and oil. Diversifying investments helps protect against financial
downturns. Having money in gas and oil markets can counter losses from other
investments that are negatively affected by an economic slump.

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Investors often diversify within gas and oil industries themselves. Focusing on a single
investment can be risky, because significant losses are possible. Fortunately, working
interest investments for oil drilling offer many ways to approach risks, including
investing:

»» Across several counties or states

»» In gas, oil or both
»» Across several different drilling sites
»» In fields with different maturation levels
»» Across multiple site operators
»» Among a variety of distributors

Working interest investments for gas drilling are also handled through diversification.
Participants may work multiple properties. These are often at different production
levels, including startups, existing fields and wells being reworked.

Better Than Buildings?

Though risky at times, gas and oil investments do not have the same inherent
problems as real estate investments. For instance, when a well stops producing,
investment income ends, but the property cannot suffer foreclosure like a building
can. Transferring an interest in a gas or oil well is quite simple when compared to a
similar real estate transaction.

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Tax Implications

Depending on the type of investment, participants in top income brackets can get
tax benefits from investing in oil and natural gas drilling. Investors get significant
initial tax write-offs for intangible drilling costs, including labor and insurance. These
expenses eat up more money than any other aspect of drilling in the early days of
a well.

A well’s output decreases over time as the gas or oil starts to get used up. Working
interest investors receive tax deductions for these depleted resources. Royalty
interest holders, though, do not benefit from this tax perk.

Changing Regulations

Tax laws benefit gas and oil investors, but deductions and credits are not guaranteed.
Consider what happened in Alaska during 2016. Its government depends on oil
revenues to make ends meet, but very low prices for a couple of years led to a huge
budget deficit. Members of the state government proposed significant changes to the
state tax credit system to bring more money in, but production companies worried
that they could not handle both tax benefit losses and reduced profits.

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A Roller Coaster Market

Gas and oil markets are volatile, which makes them both chancy and potentially
high-yielding investments. Prices fluctuate from year to year. For instance, in Summer
2008, the price for a barrel of crude oil was over $130. In the beginning of the next
year, a barrel cost less than $50. More recently, the price during the spring of 2015
reached over $60. By January 2016, the cost had been cut in half.

The Long Haul

Gas and oil wells are not investments with quick turnaround times. They are long-
term ventures, so participants cannot cash out quickly. All money is tied up in
production, meaning there are no liquid assets. There is also no guarantee of success.

Well output varies over time, gradually declining until it is not profitable to continue
extraction. During production time, individuals with working interests must keep the
system up and running. Equipment must be maintained and repaired, and employees
must be paid.

Weather Worries

Investors are at the mercy of extreme weather conditions and natural disasters.
These can slow production considerably. For instance, over 40,000 wells have been
drilled in the Outer Continental Shelf of the Gulf of Mexico since the mid-20th century.
This area experiences regular tropical storms spring through fall. If a hurricane
develops, production shuts down. Pipelines, refineries and processing plants stop
working. Supply ships, transport vessels and workers must leave the area.

Harsh winter weather slows oil production in the central United States. This cutback,
however, is more predictable. Producers are used to scaling back operations during
the coldest weather months. This slowdown reduces supplies, which sometimes leads
to higher prices.

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The Importance of Investors

If there is so much money to be made, why do gas and oil producers want to split it
with investors? Simple: Someone has to pay for all the work. Drilling is expensive:

»» Tangible drilling costs involve paying off equipment as well as keeping it in

working order.
»» Intangible costs account for about 85 percent of costs, including salaries,
insurance and chemicals.

When investors come on board, everyone involved shares the risks. If the well is a
big success, all participants win. However, a well that does not produce hits hard.
Investors have no recourse. Their money has long since been used.

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Chapter 2:
Working Interest Investment – The Scoop

An individual with a working interest in an oil or gas well has the possibility
of receiving big payouts. However, the accompanying financial gambles are
proportionally high.

Working Interest Overview

Though all investors face risks, individuals with working interest investments for oil
and gas drilling also have responsibilities. A drill site can have one or more investors
with working interests. They may personally manage the well, or they may have a
contractor who oversees day-to-day operations. An investor’s greatest responsibility
is to provide money for exploring, drilling, running and maintaining wells on leased
property.

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A working interest lasts as long as a lease is in place.

Investors with working interests are responsible for paying landowners according to
the terms of their leases. Working interest investors get their cuts — the “net income”
— only after all other accounts have been settled.

Because of this, though, they bear 100 percent of the financial burden. Working
interest investors receive less than 100 percent of the proceeds.

Some of these investors begin with completely undeveloped land and must drill
wells. However, working interests can be available at other stages of development.
Investors can add cash when an established, working well has run out of funding. In
other cases, existing wells need improvements in order to provide maximum yields.

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Types of Working Interests

Investors attracted to the responsibilities and rewards of working interests can

choose from different models. All carry significant risks but have the potential for high
returns.

»» Standard working interest: With this format, participants have full responsibility
for running drilling operations, or they can designate another party as the
general contractor.

»» Specified properties: This type of investment often takes the form of a limited
liability company (LLC) or limited partnership. The company or partnership
functions as the project manager.

»» Direct participation: Investors who take this route obtain an interest in a well
that can be sold, used for collateral or bequeathed.

»» Blind Pool: With a blind pool, a limited liability company or limited partnership
raises money for drilling undesignated resources. This is the riskiest working
interest structure because investors are “in the dark” about the use of their funds.
However, when blind pools are successful, they bring the highest returns.

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Risky Business

Working interests have inherent dangers, there are specific steps participants can
take to reduce uncertainty.

»» Gas and oil price variations: Within the gas and oil market, prices can change
dramatically within months. Fluctuations have a number of causes, including
war, extreme weather, technological advancements and cartel agreements. To
deal with this volatility, investors should be willing to wait for success. In the
meantime, diversifying mineral interests offers additional protection. This is
important both in the type of resource and the geographical location of wells.

»» Depletion of reserves: Eventually, even successful wells run dry. New wells can
sometimes be drilled near wells that are dying out.

»» Unprofitable well or unsuccessful exploration: Sometimes, exploration does

not pan out. A well performs poorly — or not at all. To lessen the impact of an
unsuccessful drill, investors should balance new drilling with continued work in
established fields.

»» Land damage, environmental problems or personal injuries: Investors

with working interests are subject to state and federal laws that make them
responsible for many complications.

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Some of these issues are avoided by drilling in established fields with a good record
of return. It’s also important to invest in organizations that are experienced and
successful.

In general, establishing a limited liability company helps protect individual investors

from personal responsibility. It also provides tax benefits from investing in oil drilling.
Since there is a process in place for succession and transfer of ownership, an LLC can
also extend beyond the lifespan of the participants.

Oil and gas investments are precarious, participants do not have to sit by helplessly
while fate controls their money. Establishing the right structure and diversifying the
investment puts investors in the driver’s seat.

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Chapter 3:
Royalty Interest Investment – An In-Depth Look

Royalty interest investments take several forms. Liability is limited in each.

A royalty interest investment for natural gas and oil drilling ensures that individuals
have no responsibility for wells. Their only concern is when — and if — money comes
in. Participants have no voice in where, when or how the work is done. There are a
few variations of royalty interest structures, and they depend upon the status of the
participants as either landowner or producer.

Types of Royalty Interest

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Royalty interests have three basic variations:

»» Ownership: This is the most common type of royalty interest in the United
States. Individuals who own property generally also control the use of minerals
— including gas and oil — under the surface of their land. Therefore, to drill on
private land, producers must obtain permission from owners. In exchange for
allowing well development, a landowner is typically given two types of payment:
a signing bonus and royalty interest. Once property is leased, development can
begin.

A typical ownership royalty interest rate is 12.5 percent of gas or oil value at the
wellhead. However, highly desirable property might bring in 25 percent or more.
Unless a cut-off date is specified in the lease, royalty interest continues indefinitely.
Landowners also have the option to sell part of their interest.

»» Non-participating royalty interest: Individuals obtain this when a landowner

transfers part of an ownership royalty interest. It’s used most often when
property is sold, but the original landowner wants to continue receiving proceeds.
They receive payments, holders of non-participating royalty interests do not own
the mineral rights to the land, and they cannot lease it. They are also ineligible for
bonus payments.

»» Overriding royalty interest: This is the “having your cake and eating it, too” type
of royalty interest. Sometimes, a working interest producer transfers that interest
to another producer. By establishing an overriding royalty interest, the original
producer still earns royalties. An overriding royalty interest can also be granted in
order to raise capital for an ongoing project.

In contrast to a royalty interest, an individual with an overriding royalty interest has

no mineral rights, and the interest ends when the lease is up.

The Low-Down on Leases

Royalty interest revolves around leases that mineral owners — typically landowners
— grant to oil and gas well producers. The lease allows the producer to develop the
land in exchange for part of the proceeds. Leases usually designate the number of
years they will be in effect. Two terms are often included:

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»» The primary term is the initial production period.

»» A secondary term might be needed if the first phase is successful. “Success” is

defined as the producer’s ability to pay royalties.

A lease may also include a delay rental clause. This allows producers to postpone
development of the land. However, during this period, the landowner must receive
regular payments.

Are Royalty Investments Easy Money?

Though investment in gas and oil industries is uncertain, royalty interests are
traditionally low-risk.

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Holders have no responsibility for production, so they also have no liability if anything
goes wrong, such as injuries, negligence, environmental contamination or land
damage.

On the other hand, having no responsibility also means these individuals have no
input or control over production. Royalties stop when a well is no longer being used.
Sometimes, this happens suddenly. Tax benefits from investing in oil drilling typically
go to those with working — not royalty — interests. Royalty interest payments are
also subjected to taxation.

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Chapter 4:
Oil and Gas Laws – Trying to Prevent Problems

Both state and federal laws regulate gas and oil investments. Legal complications
include mineral rights disagreements, inaccurate royalty payments and delivery
disputes.

As with many types of investments, gas and oil investors are speculating on success.
State and federal laws help clarify the investment process.

Investments Are Securities

According to the Securities and Exchange Act of 1934, gas and oil investments are a
type of security.

Securities include stocks, bonds, gas and oil leases, and many, many other kinds of
profit-sharing arrangements. In general, a “security” is defined as an investment that:

»» Has value
»» Expects to make a profit

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»» Has proof of ownership
»» Can be bought or sold

Since they are legally considered securities, gas and oil investment opportunities must
usually follow regulations that help protect the public. These include the Securities
Exchange Act and, where applicable, the Ohio Securities Act. Securities lawyers are
often consulted to make sure sales are handled properly. The most important aspects
of these laws are:

»» Sellers must disclose all relevant details to any purchasers.

»» Individuals who handle sales must be licensed as broker-dealers or affiliated
salespeople.
»» If the sale does not conform to regulations, purchasers must get their money
back.
»» If the sale does not conform to regulations, participants may suffer civil or
criminal penalties.

It’s possible for certain sales to qualify for exemptions to regulations. However,
exemptions do not mean these transactions are free from all rules. The interactions
must still provide investors with all pertinent information concerning the deals.

How Do State and Federal Laws Agree on Oil and Gas

Investments?

In the world of gas and oil investment, state laws usually regulate agreements.
Federal laws are generally reserved for wells that are drilled on federal land or
offshore. There are a few primary types of agreements:

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»» A lease is a contract between the mineral owner — usually the landowner — and
the well’s producer. The lease spells out the rights and responsibilities of both
parties. This begins with exploration of the land in question to determine if it
is, in fact, worthwhile to drill. The lease also extends to possible drilling and
production.

Since a lease is a legal agreement, both sides must accept all its provisions. This
provides room for negotiation. A landowner’s leverage during these talks depends
upon the acreage, the location and the number of oil or gas companies interested in
the property. Conditions that may be on the table for discussion include:

°° Termination date for the lease

°° The schedule for royalty payments
°° The acreage covered by the lease
°° Responsibility for damage done to property
°° Access to water and water disposal
°° Location of drill sites
°° Use of roadways on property
°° Protection of farming or grazing lands
°° Removal of structures and equipment when the lease ends

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As with any legal document, all aspects of the agreement, including negotiated
changes, should be formally recorded. Oral agreements are not often enforceable.
Landowners should research oil and gas companies to learn about their experience,
competence, reputation and scope.

»» Pooling agreements combine at least two leases on separately owned parcels of

land in order to drill a single well. There are two types of pooling:

°° Voluntary: Conditions for combining land tracts are articulated in

the lease.

°° Compulsory: Landowners are required to allow companies to extract

gas or oil beneath the surface. Companies must pay for this. However,
producers do not get access to the land — just to the minerals located
within it.

»» Joint operating agreements are between producers. These arrangements

allow sharing of expenses and risks. One participant produces, while the others
contribute financially. The actual operator is usually the party with the greatest
stake in the venture. Non-operators do not take part in day-to-day operations.
They oversee the general process and provide funding, when necessary.

What Do You Actually Own Within a Gas or Oil Agreement?

Most commonly, land ownership entitles an individual or entity to mineral rights.

These rights extend straight down from surface of the property. However, since gas
and oil are fluids, they sometimes move from one property to another, even when
wells are properly placed. In these cases, gas or oil may be extracted from land not
covered by a lease. However, producers are not allowed to purposely place or angle
wells in order to collect gas or oil from neighboring properties.

Why Lawsuits Develop Over Gas and Oil Wells

Gas and oil wells have the potential to make tremendous amounts of money. Because
of the high stakes, people with royalty interests in natural gas or oil drilling sometimes
wind up as plaintiffs in lawsuits. These cases often stem from:

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»» Underpayment of royalties: An unscrupulous company does not follow the
compensation procedures set out in a lease.

»» Misused resources: Gas or oil reserves are lost, wasted or ruined because of the
production company’s mistakes.

»» Damage or pollution: Irresponsible behavior by the company results in harm to

the surface land.

Individuals or groups with working interest investments for natural gas or oil drilling
also file lawsuits on occasion. These often involve a disagreement among company
over rights to:

»» Drilling in a specific location

»» Geological data
»» Purchase of specific areas of land or certain stocks

The delivery — or non-delivery — of gas or oil to processing plants also leads to

lawsuits involving producers.

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Chapter 5:
Sale of Gas and Oil – Where the Money Comes From

Natural gas fills more than 25 percent of energy needs in the United States.

The market naturally fluctuates, it is poised to increase, as the U.S. decreases imports
and increases exports.

The Natural Gas Price Yo-Yo

Investors with working interests or royalty interests in natural gas drilling should be
aware of national and international factors that affect prices.

The price of natural gas showed some variation in the final quarter of the 20th
century, the price has been very volatile in the 21st century. Volatility is based on
fluctuations in price over time, not how high or low prices go. For instance, the
wellhead price at the end of 1976 was 64 cents per thousand cubic feet. “Wellhead
price” indicates the cost as gas comes out of the well, before processing or
transportation.

Since then, this average wellhead price has varied, sometimes dramatically:

»» End of 1985: $2.28

»» End of 2000: $5.77

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»» End of 2005: $9.08
»» End of 2009: $4.66

By December 2015, the average wellhead price in Marcellus Shale had dropped to
$1.75 per thousand cubic feet. The rise and fall of gas prices does not have one cause.
Rather, it reflects what is happening in the industry specifically and in the economy
generally. For instance:

»» When natural gas prices rose in 2000, an increased demand for all energy
supplies resulted in higher prices across the board.

»» The 2009 global economic collapse led to a drop in gas prices.

»» During the mid-2010 decade, Marcellus Shale in the eastern United States was
overproducing. Though regional demand was satisfied, no pipeline infrastructure
existed to carry all the excess gas away.

A Long-Range Look for Traditional Wells

The production of traditional gas wells has been in decline since 2008. This trend will
continue, since fewer companies are drilling long-established wells. This leaves some
big supply holes to fill, because gas imports from Canada are dropping. Meanwhile,
the U.S. is stepping up exports to Europe, South America and Asia.

As the use of coal-powered plants decreases, natural gas will be used more to make
electricity. If production cannot keep up and there is a shortage, stored gas may come
into play. This would mean higher prices for consumers.

The decline in the number of conventional wells likely means that shale fields will
have to fill in the gap — and they are starting to. In 2006, natural gas from shale
deposits accounted for only five percent of production in America’s contiguous states.
Within eight years, that rose to 40 percent.

The Oil Upswing

Oil has a somewhat rosier outlook. Production is up in North America. Between 2008
and 2013, production increased 45 percent.

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That made the U.S. less dependent on imported oil. This bump was primarily due
to accessing oil in shale, especially in Texas, Montana and North Dakota. However,
current pipelines cannot completely handle increased oil flow.

International Oil Prices

Oil is a global commodity. Prices are partially determined by worldwide supply and
demand. Production cuts or increasing need affects availability and often inflates
prices. A recession impacts the price of many resources, including oil. Also, political
instability and conflict interferes with production, especially in Africa and the
Middle East.

Some examples of international effects on oil prices include:

»» Between 2003 and 2007, oil prices more than doubled because of China’s and
India’s increasing needs.

»» In 2008, prices spiked again. This was followed by a plunge the following year due
to the worldwide economic slowdown.

»» 2010 to 2013 was a global financial recovery period that saw prices rise almost to
where they were in 2008.

The Future of Oil?

Traditionally, producers have adjusted output to control prices. They based their
supply on the demand. Long-term demand for oil has increased steadily worldwide

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between one and two percent annually. However, American shale oil production has
developed comparatively quickly, increasing output dramatically. In January 2016,
the United States started exporting its oil for the first time in 40 years. China and
Argentina are also on track to develop their shale oil supplies.

If these newer suppliers do not follow the pricing and distribution guidelines of the
Organization of the Petroleum Exporting Countries (OPEC), the entire world’s oil
market could be affected. Countries with government-run oil companies, such as
Venezuela, Nigeria, Iraq, Iran and Russia, may experience national budget shortfalls.

Conventional oil-producing countries, including Saudi Arabia, the United Arab

Emirates, Kuwait and Qatar, may need to tap into monetary reserves they have
accumulated to deal with lower oil prices. About five percent of oil fields must be
replaced each year because they are played out. The global oil industry has several
options for dealing with these changes, including:

»» More countries might move toward developing shale fields.

»» Companies may try to reduce production costs through additional automation

and better data collection to find reserves.

»» The development of improved technology will help ensure continued access.

Much of America’s oil is located in difficult-to-reach areas — deep underground
and offshore — that require new drilling methods.

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Chapter 6:
Determining Royalties – From Underground to Bank

Provisions for paying royalty interests vary from well to well. These plans are based
on the location where the price is set, the current value of the gas or oil, prior bonus
payments and other lease conditions.

Gas and oil producers undertake a multi-step process in order to pay royalty interest
for oil and natural gas drilling. Its three components are upstream, midstream and
downstream.

Stage One: Upstream

Upstream has many phases, beginning with the exploratory process. This is the start
of working interest and royalty interest investments for oil or natural gas drilling.
Geologists search on dry land or in oceans for signs of gas or oil deposits using:

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»» Satellite images that provide details about the terrain

»» Gravity or magnetic measures that show small changes caused by the presence
of minerals

»» Seismic surveys, which indicate how elastic substances are and may suggest the
presence of minerals

When a geologist locates a potentially useful field, a producer leases it. Then, the
company drills an exploratory well — or perhaps several — to determine whether
the geologist’s report is on target and if gas or oil is present. If so, drilling will help
determine if there are enough mineral deposits to make production worthwhile.

Drilling is both expensive and financially insecure. A promising geologist’s report

may simply not be accurate. Excavating multiple wells increases both the cost and
chances for success. The drilling process can take years, and technological advances
improve the process and increase the likelihood of success. A profitable gas or oil well
is usually under production for 10 to 20 years. However, if exploratory drilling fails,
producers plug and abandon the wells.

Stage Two: Midstream

When a well is producing, oil or gas enters the midstream juncture. The resource
must be transported from its upstream site to its downstream location. The
middle part of the process requires cooperation among producers, storage
facilities, transportation companies, processors, technological companies and
terminal operators.

There are several options for getting the resource from Point A to Point B:

»» A pipeline is the most common method. It can cover long distances. However,
pressure, maintenance and terrain can cause problems. Also, if the pipeline
crosses borders, international relations become a concern.

»» Water vessels, such as ships or barges, are comparatively slow carriers of gas
or oil. They are the best method, though, if the resource needs to be sent across
water.

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»» A railroad is a fast and relatively inexpensive way to move large quantities of gas
or oil.

»» Trucks travel over highway systems, so they are only limited by a country’s
infrastructure. They are often able to go where ships and rails cannot.

Once refineries have received the gas or oil, it’s processed and sold to consumers
during the final stage.

Stage Three: Downstream

The downstream stage handles processing, selling, marketing and distributing gas or
oil. Final products depend upon the initial resource, but include:

»» LP, natural or vehicular gases

»» Diesel or jet fuel
»» Heating oil
»» Rubber, plastics and lubricants
»» Pharmaceuticals
»» Fertilizers, antifreeze and pesticides

Downstream clearly plays a role in the transportation and utility industries, it also
makes products for agriculture, manufacturing and medical fields.

Where Royalties Fit In

The royalty interest for oil or natural gas drilling is typically set during the upstream
phase because sales most often occur at wells. Sometimes, royalties are determined
downstream after processing. The resource is more valuable, so earnings are greater.

Royalties are usually based on the producer’s proceeds at sale. Lease terms influence
the exact price. Production expenses may not be deducted. However, if the price is
set downstream, certain expenditures, such as transportation costs, may be shared
between producers and holders of royalty interests. Timeliness is also an issue.
Royalties are often based on the “market value” of a mineral when it is removed
from well.

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Lease conditions affect royalty payments. For instance:

»» Although it is not common, some agreements allow mineral owners to receive

shares of the gas or oil taken from their wells. They are then allowed to sell those
shares.

»» Royalties may be impacted by the amount of the initial bonus. A bonus is typically
based on the acreage used. Other bonus variables include length of lease and
whether other production is occurring in the area. If a well seems promising, the
landowner may ask for a lower bonus and higher royalties.

»» Additional royalty conditions in a lease include the frequency of payments,

consequences for missed payments and the minimum amount for payments.

For landowners, royalties are not always straightforward. There is usually more to the
deal than “you give me money while you are using my land.” For the protection of all
parties, the lease needs to express arrangements in detail.

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Chapter 7:
Tax Implications – More and Less Account

Establishing gas and oil wells is time-consuming and expensive. To encourage

production, the IRS offers several types of tax breaks to individuals with working
interests. Royalty interest holders are eligible for a few tax breaks.

Working Interest Tax Benefits

The bad news: Oil and gas as an investment can be risky. The good news: Investors
with working interests are entitled to significant tax deductions.

They can make a big difference when a producer has a lot of money on the line.

»» Many of the costs associated with drilling, such as machinery and equipment, are
capital expenditures. These oil and gas tax deductions are due to depreciation or
depletion. Costs are deductible over a seven-year period.

»» Intangible drilling costs are associated with necessities that have no resale value,
such as wages, fuel, repairs and supplies. These costs are deducted as business
expenses, and this deduction has significant tax implications. Intangible drilling
costs take up 65 to 80 percent of a well’s funding, and they are fully deductible. A
well does not even have to be successful for a producer to earn deductions.

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»» In many cases, financial losses incurred from a working interest can be used to
offset income such as stock trades, business proceeds and salaries.

»» Purchase of a lease is deductible for the year the acquisition occurs.

»» Producers with marginal wells that function steadily, but not heavily, receive tax
credits. These wells account for about 25 percent of the U.S. oil supply and about
10 percent of its gas. The tax credit allows them to stay in operation. Without this
break, wells might be capped and abandoned.

»» Producers with small companies receive an additional gas drilling tax exemption.
Fifteen percent of their gross income is tax-free. This relief was set up in 1990 to
encourage further gas and oil well production.

Royalty Interest Tax Implications

Individuals with royalty interests are eligible for fewer oil and gas investment tax
benefits. These taxpayers indicate income and bonuses on Schedule E for Form 1040.
Important parts of this reporting process include:

»» Royalty interest holders are not subject to self-employment tax. However, many
people pay estimated taxes, since no taxes are withheld from this income.

»» Reserves drain over time, so taxpayers receive depletion deductions. These

reduce taxable income.

»» The IRS allows deductions for costs of negotiating leases, such as legal fees.

»» Although it’s not common, royalty interest owners who contribute to

transportation, processing or marketing costs can deduct those expenses.

Since participants with working interests risk a great deal in these ventures, they are
rewarded with greater oil and gas investment tax deductions.

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Chapter 8:
Gas and Oil Well Fraud – Be Aware

Though many legitimate gas and oil investment opportunities exist, there are also
scams that trick people out of thousands and thousands of dollars. Take steps to
avoid crooked deals, and look for warning signs that an investment is fraudulent.

Whenever there is a lot of money around, there will also be people trying to steal it.
The gas and oil industry is no exception. Investment in oil and gas is a big business. In
fact, in the United States, fraud in these fields is among the top 10 greatest dangers
for all investors. Here is a peek into one common scam.

Limited Partnership Con

A deal promoter focuses on collecting money for a limited partnership — working

interest — in an oil well. However, the sponsor is not concentrating on one important
thing: finding land to develop. Invested money should be used to lease land, explore
potential fields and drill wells. The work many never get that far. If it does, wells are
soon abandoned. Most of the money goes into the promoter’s pockets.

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Anyone considering investing in oil and gas will, of course, want to avoid frauds.
Certain practices provide clues that investment deals are not everything they seem to
be. Again: Avoid any offers to participate in these opportunities.

Warning Signs

Gas and oil prices have been in the news, often because of their volatility. Be
suspicious of the following:

»» The volatility issue is the basis for the investment. People are encouraged to
sign on and take advantage of price fluctuations. However, the proposal is
not thoroughly developed. There is a lot of excitement and hype — but little
substance.

»» The investment is described as “no-risk.” This red flag is waving fast and furiously.
There’s no getting around it: Gas and oil investments are inherently risky.
Producers with good history and records might be a safer bet, but nothing is
certain. No legitimate investment guarantees returns.

Also, if the rate of return for your investment seems too good to be true, it probably
is. Revenue from gas and oil investments is usually similar to strong stock indexes. If
you are promised far more, be skeptical of the deal.

»» If you are offered a gas or oil investment opportunity unexpectedly, it’s probably
a scam. Authentic producers of gas or oil wells do not send out mass letters,
faxes or emails. This bogus contact may arrive through certified or overnight mail,
which increases its sense of importance. The next step is a phone follow-up.

The salesperson on the line usually has little or no experience in the gas or oil
industry. However, that does not stop the caller from bombarding the target with a
scripted, high-pressure call. Credible deal sponsors do not use telephone banks to
make unsolicited contact.

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»» Because so much can go wrong, gas or oil deals take time to set up. Sponsors
want to do everything possible to support success. A true investment opportunity
will allow you ample time to explore and investigate. If you are being forced to act
quickly, the emphasis is on getting your money — not on developing a successful
drilling project.

»» Genuine deals are not secrets. You should feel free to discuss them with family,
friends and legal counsel and mineral experts. If you are pressured to keep an
investment under your hat, do not open your wallet.

»» Be wary of an out-of-state investment. If the drill site is far from you, the
producers may assume you will not stop in to check out the work. If you do not
have easy access to the well, it will be harder to tell if you are being defrauded.

Avoiding Oil and Gas Scams

Now you know potential investment danger signs. If you want to try investing in gas
or oil investments, delve into a potential deal thoroughly.

»» Collect information. Ask the sponsor questions, and be wary if answers are not
forthcoming. Get details. Examine the geologist’s report. Look at the leasing
details and royalty structure. Are any oil or gas investment tax deductions or
benefits specified? Do not simply take a producer’s word when claims are made.
If the deal is a sham, you will not get honest answers. Look for ways to confirm
assertions. Recommendations handed over by the sponsor are not enough.

States have regulatory agencies that handle gas and oil drilling. Check to see if they
are aware of the company and the proposed project. Does the company have a good
record?

»» Projects should also be filed with the state’s securities commission. Contact the
appropriate office to check out claims. If sponsors claim their project is exempt,
do not take their word for it. Check with the commission to see if the supposed
dispensation exists.

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»» Familiarize yourself with the sales agent. This person should be licensed to work
in your state and have experience with these types of deals. Find out how the
agent is being compensated. Is it based on commission? If so, signing up lots of
investors increases earnings. That may be an incentive to exaggerate or lie.

»» Investigate the flow of money. How much needs to be raised, and where will it be
placed? Development funds should be kept in a dedicated escrow account. Will
additional money be expected in the future? Also, find the specifics of how the
investment will be used. Advertising? Salaries? Sales commissions?

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Chapter 9:
Royalty and Working Interests – Comparing the Two

With knowledge about gas and oil development, production and sales, investors can
decide which kinds of projects suit them best.

Royalty Interest vs. Selling Mineral Rights

In some cases, producers may want to buy mineral rights outright in order to drill
for gas or oil. However, over the long run, it’s advantageous to see oil and gas as an
investment. A landowner will make more money by leasing rather than selling the
rights. Leases provide protection, too. The drilling company is required to follow
the stipulations spelled out within the document. A company that owns rather
than leases mineral rights can enter and work at any time, without the landowner’s
permission.

Royalty Interest: Be Protected

With a royalty interest, the landowner has no responsibility for exploring, drilling or
maintaining the leased land and no financial burdens. Landowners’ specific rights are
broken down in the leasing contract. Lease conditions often depend on the amount of
land leased, nearness to proven wells and competition among producers.

From a landowner’s point of view, the more detailed a lease is, the better. Contracts
that spell out producers’ responsibilities protect lessors and their properties. For
example, water handling is an important issue. A lease should clarify the:

»» Method for disposing of wastewater created by the drilling company

»» Arrangement for drilling water wells to meet production needs
»» Price for selling water to the company

In addition, a lease typically gives a drilling company rights to use surface land for
production. However, it must clean up the property or pay damages at the end of
the term.

39
Royalty Interest: Be Wary

As beneficial as mineral rights can be, they are not a clear path to wealth for
all landowners. First and foremost, they must have these rights in areas where
producers want to develop. If this is the case, an advantageous, comprehensive
lease will bring a landowner the greatest benefits. Otherwise, payments are not
guaranteed. In addition, some conditions might be open to interpretation, such as
access to surface land, location of drill sites and usage of the lessor’s roads.

Even with a solid lease, the landowner has no control over the exploration and
drilling process. And, though the contract guarantees royalties, a percentage of
postproduction costs is often deducted.

Working Interest vs. Royalty Interest

Individuals with mineral rights — usually landowners — benefit from royalty

interest opportunities. That does not mean that working interest investments are

40
for everyone else. Though a working interest has a greater chance for financial gain,
there is also a higher risk for loss. A working interest requires a significant investment:
thousands or even hundreds of thousands of dollars.

Investing in wells currently in production is safer than exploratory drilling. Although

oil and gas investments offer tax deductions and benefits, working interest holders
should have tax profiles that let them take advantage of drilling tax credits.

Working Interest: The Upside

Working interests in gas or oil production can be superior investments for investors.
The risk is lowered by thoroughly investigating producers and their plans. If wells are
successful, investors usually see profits for at least 10 years.

Overall, the demand for gas and oil is increasing. Oil, in particular, is more than a
simple fuel. It’s also used in many everyday consumer products. The list is long and
varied, and includes contact lenses, shaving cream, nail polish, shower curtains, lip
balm, hearing aids, deodorant and dentures.

Working Interest: Thinking It Through

Because working interests are financially riskier than royalty interests are, investors
should be sure they can take the hit if they lose all the funds they supply. That may
be one reason why production companies want “accredited” investors, which means
their net worth is at least one million dollars. Because of this, legitimate working
interest investment opportunities might be hard to find.

Oil or gas well development is a complicated process that should be considered only
by experienced and sophisticated investors. Though working interest holders are
not always involved in day-to-day operations, they may still be liable if complications
arise, such as environmental problems or on-the-job injuries.

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Chapter 10:
Investment Points to Consider

Having an interest in an oil or gas well is definitely not for everyone. Landowners with
royalty interests are fortunate enough to have property that producers want
to develop.

Most individuals with working interests in gas or oil are wealthy, seasoned investors
who add these ventures to diversified portfolios. “Diversification” is two-fold. It
signifies multiple gas or oil investments, with wells in different locations, of varying
ages and with different producers. Additionally, these investors often put money
toward other commodities.

Gas and oil production is a high-risk endeavor. It is not simply about exploring the
best places, using the latest technology and hiring the most capable staff. Sometimes,
outside influences — such as weather, government regulations and political unrest —
are outside producers’ control but still impact the process.

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Streaming Gas and Oil

Gas and oil well production begins upstream by finding possible sites based on
specialists’ recommendations. Drilling exploratory wells discloses whether this
information is accurate. Resources from successful wells move to the midstream,
where they are transported for processing. Once downstream, gas and oil are
processed, marketed and distributed.

More and more often, these activities are taking place on the world market, rather
than just within the United States. Traditional gas and oil-producing countries are
being joined by nations that are developing resources such as shale fields. Since this
affects the amount of gas and oil available, prices are impacted.

The Flow of Money

To encourage oil and gas production, the U.S. government becomes involved
through tax credits and deductions. Most of these are aimed at investors with
working interests, since they are taking the greatest risks. Depreciation for capital
expenditures, as well as deductions for intangible drilling costs, can make huge
differences at tax time.

Though government regulations try to keep dishonest operators from taking

advantage of investors or landowners, anyone interested in becoming active in the
gas or oil industry needs to take precautions. All ventures are speculative, so none
should be advertised as “guaranteed.” True investment opportunities come from
credible sponsors, not mass mailings. These are long-term projects, so “get rich quick
schemes” are not on the up and up.

Gas or oil investment can bring big headaches, big payoffs and, sometimes, both.
Participants should become well-versed in both the industry and the individuals
involved before signing on, either as investors or lessors. Check out companies,
promises, claims, testimonials and anything else that might convince you to become
involved.

If you’d like to learn more about gas and oil investment opportunities, get in touch
with us for a free consultation.

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