…The entire reason for investing in the first place, right?
The first step to understanding how to measure economic return is to decide what kind of oil investing fits your criteria. Are you looking for high risk/high reward drilling projects or production buys with smaller but more defined returns?
Understanding your risk tolerance and what kind of returns you are looking for will help you select projects that fit your goals. Our strategy for how to invest in oil takes into account the life cycle of a well, risks and potential ROI.
The most obvious benefits of oil investing stem from the large tax benefits Uncle Sam gives us when we invest in oil and gas.
You can deduct up to 80% of your investment within the first year. This gives you a nice instant return on investment, and the tax benefits don’t stop after the first year. You can take a depletion allowance of 15% each year to account for decreasing oil and gas production.
Rate of Return
Take a look at the low, mid and high-case production estimates (estimates of oil production potential in various scenarios). Determine what your rate of return is going to be in all situations, including dry holes. (Remember, even with a dry hole, the tax benefits give you a return.)
Another thing to consider is the source of the production estimates.
Even great geologists tend to lean on the high side. Make sure you get another set of eyes on the project. Third-party engineering economic reviews can help you make a decision and confirm the results of the source data or push you out of the project all together.
Look at how long the lease will yield production revenues. They differ by basin and whether you are producing oil and/or gas.
Also look at whether there other developmental opportunities if the first well is successful. If so, how many more wells can operators drill? How much more capital are you prepared to put into the lease if the operator decides to drill more wells?
What This Means for Investors
Before deciding to invest in oil wells, determine how much risk you are comfortable with and what types of investments meet your goals.
When evaluating the investment’s return potential, be sure to add in tax benefits, rate of return and investment life to get the full picture of how oil and gas investments can help diversify your portfolio.
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