Key Takeaways
- The Hudson family invested $200,000 in an oil and gas well
- The family received considerable tax benefits: An 80% depreciation deduction in the first year.
- They earned consistent high returns from the investment, which allowed them to diversify their portfolio and maximize their earnings in a way that the traditional stock market couldn’t offer.
- Over 14 years, they received ~$350,000 more in post-tax benefits, or 150% more than just investing in the stock market
Introduction: The Diversification Dilemma
The Hudson family in New York City, makes $1.4 million per year, are contemplating an oil and gas well investment. Why? Let’s delve into their financial journey, year by year, comparing it to the traditional stock market investment. As a quick remainder on the risks and benefits of oil&gas well investments, we’re including them below:
Risks and Benefits
Risks
Oil and gas well investments are not without risk:
- Market Volatility: The market is highly volatile, and the price of oil and gas can fluctuate significantly, affecting your income share from the investment.
- Well Variability: Drilling may not lead to commercially viable quantities of oil or gas which adds more risk.
- Variable Costs: Operating costs might exceed expectations or revenue from low oil prices might reduce income and revenue.
Benefits
Despite the risks, there are some compelling benefits:
- Depreciation Tax Savings: You can potentially write off 35%-45% of your investment as tax savings in the first or second year of the investment (typically 70-90% of the investment is depreciation that can be taken in the first or second year)
- Potential for High Returns: When oil prices are high and wells are productive, the financial gains can be substantial and considered passive income which has its own tax planning advantages.
- Diversification: Investing in oil and gas can diversify your portfolio against public market returns.
The Investment Kickoff: Setting the Scene
The Hudsons expect to pay $700,000 in taxes on their $1.4m in income and are choosing between investing $200,000 in oil and gas or in the stock market. Let’s walk through the potential returns.
Depreciation: The Hudson’s expect to receive 80% of their investment as depreciation in the first year, which will save them ~$80,000 in taxes this year at a 50% tax rate. This effectively lowers their out of pocket investment from $200,000 to $120,000.
Oil & Gas Returns: The Hudsons examine the historical annualized returns for their producers oil and gas wells based on the years the wells were drilled. Here’s what they found:
The Investment Kickoff: Setting the Scene
The Hudsons expect to pay $700,000 in taxes on their $1.4m in income and are choosing between investing $200,000 in oil and gas or in the stock market. Let’s walk through the potential returns.
Depreciation: The Hudson’s expect to receive 80% of their investment as depreciation in the first year, which will save them ~$80,000 in taxes this year at a 50% tax rate. This effectively lowers their out of pocket investment from $200,000 to $120,000.
Oil & Gas Returns: The Hudsons examine the historical annualized returns for their producers oil and gas wells based on the years the wells were drilled. Here’s what they found:
Year-by-Year Cash Flows from Oil & Gas
Based on their $200,000 investment, here’s what the Hudsons can expect in terms of returns:
The Tax Advantage: The Magic of 80% Depreciation
In the first year, the Hudsons can depreciate 80% of their oil & gas investment. This means depreciation of $160,000. In their high tax bracket, this could translate to a tax saving of ~$80,000 upfront on their $200,000 investment. In addition, 15% of their income from the oil & gas wells are tax exempt!
Your probably wondering what do these benefits look like over time, lets get to it.
Effective Cash Flows from Oil & Gas, Factoring in Depreciation
Over 14 years, if they replicate the previous returns which isn’t expected, they would get $732,000 in post tax benefits which is great for a $200,000, or $120,000 after tax investment! If they invest in Oil & Gas wells and reinvest the cash flow money in the market they would end up with roughly 150% more assets than if they had just reinvested $120,000 into the stock market for 14 years in this situation. Another way to think about this, is the tax savings create leverage and allow the Hudson’s to invest more in oil & gas wells than they would in the stock market by investing dollars that would otherwise have been lost to taxes.
Conclusion: The Hudsons’ Winning Strategy
The Hudson family took a calculated risk by diving into oil & gas well investment. With the considerable tax benefits of 80% depreciation in the first year, along with the returns and diversification allowed them to create returns the traditional stock market couldn’t offer.
By taking this route, they managed to turn their $200,000 into a smart, tax-efficient, and highly profitable investment, proving that sometimes the road less traveled is indeed the one worth taking.