Latest / The High Net Worth Podcast with Fexingo: Wealth Management, Tax Strategy, and Affluent Finance / How Wealthy Families Use Oil and Gas Partnerships
Transcript
- Lucas: So Luna, I was looking at a family office's allocation sheet last week, and buried in the alternatives bucket was something I don't think we've ever covered on this show: oil and gas partnerships. Luna: That's a throwback. I thought that was mostly a 1980s thing, you know, the 'wildcatter' era. Lucas: It's actually making a quiet comeback, and for a very specific reason. The 2017 Tax Cuts and Jobs Act capped state and local tax deductions, but it didn't touch the intangible drilling cost deduction. That's the gem. Luna: And for anyone listening who's not fluent in oil-patch tax law, what exactly is an intangible drilling cost? Lucas: Right. So when you drill a well, you've got two kinds of costs. Tangible costs are the actual hardware—the pipe, the pump jacks, the tanks. Intangible costs are everything else: labor, chemicals, site prep, the engineering. And for tax purposes, you can deduct a big chunk of those intangible costs in the first year, even before the well produces a drop of oil. Luna: So it's an upfront write-off against ordinary income. That's a big deal for someone in the top bracket. Lucas: Exactly. And that's why a working interest in a drilling program can be so attractive. You're not buying a passive LP interest; you're actually participating in the drilling. And the tax code treats that as active income, which means you can use those losses to offset your W-2 or your business income. That's a huge contrast to, say, a real estate partnership where losses are usually passive. Luna: So the wealthy can take a chunk of their ordinary income and shield it, essentially. Lucas: Right, but it's not without risk. And that's where the conversation gets interesting. Let's talk about a concrete example. Luna: Let's do it. Lucas: Say a family invests two million dollars in a Permian Basin drilling program. The operator drills four horizontal wells. Depending on the ratio of intangible to tangible costs, the first-year write-off could be around ninety percent of that capital. So roughly one point eight million dollars in deductions against ordinary income. Luna: At the top rate of thirty-seven percent, that's a tax saving of about six hundred and sixty-six thousand dollars. That's not chump change. Lucas: No, it's a lot. But the catch is, you've got to have at risk capital, and the well might not produce. So you're essentially buying a tax deduction with a lottery ticket attached. Luna: And that's why it's not for everyone. It's really for someone who has a very high income and can afford to lose the entire investment. Lucas: And that's exactly the profile we're talking about. But there's also the royalty interest angle, which is a completely different beast. In a royalty interest, you own a percentage of the production without any of the operating costs. It's passive income, and it's actually taxed at long-term capital gains rates once the well is producing, not ordinary income. Luna: So you don't get the big deduction, but you get more favorable ongoing tax treatment and no drilling risk. Lucas: Right. And that's a typical family office play: some working interest for the tax shield on the front end, and some royalty interest for long-term income. But the due diligence is critical. You're betting on the operator's geological interpretation and their execution. Luna: And that's where I imagine the horror stories come in. A dry hole is one thing, but what about the environmental liability? Lucas: That's the nightmare scenario. If you hold a working interest, you're jointly and severally liable for the well's plugging and abandonment costs. You could inherit a six-figure cleanup bill on top of losing your investment. The operators know this, and that's why they require substantial financial wherewithal or a credit check. Luna: So it's not a passive investment, even if you're not running the rig. Lucas: Not at all. You're essentially a co-owner of a small oil company. And that's why family offices usually partner with operators who have a track record and, crucially, who invest their own money in the deal. You want skin in the game on the operator's side. Luna: And that's something we've talked about in other contexts, like private equity, but maybe even more important here given the tax tail. Lucas: Exactly. And I've seen some family offices structure these as a series of small investments across multiple operators, rather than one big bet. That diversifies the geological risk, though it does add complexity. Luna: And it also spreads out the tax benefits, which could be a plus if you're trying to manage your income in a particular year. Lucas: Right. And the thing is, this is a niche strategy, but it's one that's been around for a century. The tax code has favored it for decades because it encourages domestic energy production. But for a high-net-worth family, it's really a tool for income tax planning, not a core portfolio holding. Luna: Before we get too deep into the structure, Lucas, I want to step back. We've been talking about this for a while, and if our listeners have found this helpful, you know, we do this show ad-free, and that's only because of listener support. If today was worth a coffee to you, that's the link — buy me a coffee dot com slash fexingo. It's a small way to keep us going. Lucas: Yeah, that's a nice way to put it. And honestly, we're not asking for much. Just a coffee's worth, if it's made a difference. Luna: And we get back to the oil patch in a second, but I think it's worth saying: we're not trying to sell you anything. Just an honest conversation about what works and what doesn't. Lucas: So, back to the structure. We talked about working interest and royalty interest, but there's a third layer: the partnership structure itself. Most family offices invest through a limited partnership or an LLC, which allows them to pass through the tax attributes without being personally on the hook for the liabilities in the same way. Luna: So the liability is contained at the entity level, but you still get the deduction? That's a nice setup. Lucas: It is, as long as you structure it correctly. And that's where you need a good tax attorney, because the IRS has rules about passive activity losses and at-risk limitations that can trip up even sophisticated investors. Luna: Can you give us a real-world example of how that might play out? I mean, besides the numbers we've already talked about. Lucas: Sure. I remember a case where a family invested in a natural gas well in Appalachia. The operator had a good track record, and the deal looked solid. But the family had a lot of passive income from other investments, and they assumed the drilling losses would offset that. But because the working interest was structured as a limited partnership, the losses were classified as passive, so they couldn't use them against their active business income. They ended up with a huge deduction that was deferred, and they had to carry it forward. Luna: Ouch. So the structure matters just as much as the geology. Lucas: That's the lesson. And it's why the best family offices don't just look at the tax benefits in isolation. They look at the entire income picture and how the partnership is set up to ensure the losses are usable. Luna: And that's probably why you see a lot of these deals done through a family LLC that elects to be treated as a partnership, not an S-corp or something else. Lucas: Exactly. That's a common mistake. If you hold your working interest in an S-corp, you could lose the ability to deduct the intangible drilling costs against your personal income, because S-corps have different rules for allocating losses. So you really need to be thoughtful. Luna: So, to sum up, oil and gas partnerships are a niche but powerful tool for high-net-worth families, but they require careful planning and a high risk tolerance. Lucas: That's the bottom line. And if you're a family office listening, the takeaway is: don't just chase the tax deduction. Make sure the underlying asset makes sense, the operator has skin in the game, and the structure is set up to deliver the benefits you expect. Get that right, and it can be a valuable piece of your overall tax strategy. Luna: Well said. And for everyone else, it's a fascinating window into how the wealthy use the tax code to their advantage. Thanks for listening, and we'll see you next time.