DRILL FOR YEAR END WRITE OFFS IN OIL AND GAS DRILLING PROGRAMS

Exploring for a year-end tax deduction? Sinking some dollars into an oil and natural gas drilling deal can be risky. But such investments can offer robust returns as well as write-offs.

One benefit provided by the tax code is an upfront tax deduction. "Often, a large portion of your investments may be deducted in the first year," said Ronald Rutherford, a certified financial planner in New York. In other types of business, more of the costs must be written off over long time periods.

The amount you can deduct would vary according to details of the transaction. But suppose you invest $25,000 in a drilling deal this year. Say you get to deduct $18,000 from your 2007 income. In a top 39.6% federal tax bracket, that deduction would save you more than $7,000 in tax payments. State tax deduction might increase your total savings.

Depletion Allowance

If your drilling investments find oil or gas, you may get revenue starting in late 2007 or 2008. Then your taxable income will be reduced by depletion allowance. That's a second tax break to encourage energy exploration. It assumes the well in which you've invested loses value as the energy resource is pumped out. You can treat part of your revenue as a nontaxable refund of your original investments rather than as taxable income. Imagine you're paid $4,000 in 2007 for your 2007 investments. Because of the depletion allowance, you might have to report only, say, $3,000 as taxable income. The exact amount will vary each year, depending on factors such as the amount of oil and gas produced and income reinvested. This shelter can go on as long as the oil and gas keeps flowing.

A third reason to consider making this type of investment is for the sake of diversifying your portfolio. When stocks or bonds are weak, oil and natural gas prices may rise. Despite these benefits, there are risks. Mainly, the driller might not discover enough oil and gas.

KEY DRIVERS OF OIL EXPLORATION

Price of oil - The backdrop to all conversations about oil exploration is both the price, and the current worldwide proven reserves, of oil. Taken together, these determine whether a specific exploration project will be economically attractive. In particular, the higher the price of oil, the more expensive it can be to draw oil out of the ground and still make a profit. This makes smaller fields, more remote fields, and oil that require more processing all the more viable.

Technology - As one might imagine, the availability of computers and advances in seismic technology have drastically improved the process of oil exploration, which was once little more than drilling a well and crossing your fingers. Advances have pushed the envelope of what is feasible, both in terms of finding where oil is and figuring out how to extract it once a company has identified where it is. General Electric Company (GE), for example, offers "Intelligent Drilling" technology, while a variety of engineering and seismic services firms offer the latest in technology to find oil.

Availability of oil field services - The availability of equipment and qualified professionals to service it represents a genuine bottleneck in oil exploration. The price of "oilfield services," which includes all the ancillary requirements for drilling and operating a well, rose 20% in 2006. Lack of availability of drill rigs (for drilling oil), skilled petroleum services professionals, seismic trucks, etc., can be a constraint in oil exploration. Note especially the increase in drill rig rental rates experienced around the world.

In its Q4/2007 Earnings Call, Andrew Gould of Schlumberger pointed out that, worldwide, 93% of jackups, 97% of semi-submersibles, and 100% of drillships are currently being utilized, with very few new offshore rigs coming online in 2008. This makes significant offshore growth in 2008 relatively unlikely, as capital is already being used almost to capacity. This lack of capital to meet demand will probably drive up oilfield services rates significantly.

Weather - Difficult weather, especially hurricanes and tropical storms, can create a challenging environment offer a double whammy for oil & gas companies. Not only do they disrupt current supply chains (making tanker deliveries difficult, for example, or disrupting refining processes), but also they may disrupt or disable offshore drill rigs. This disruption ultimately feeds through to the oil field services pricing, as discussed above. And, of course, leads to further difficult conversations about the impact of climate change on extreme weather patterns....