VEHICLES CAN BE STRUCTURED TO TAKE ADVANTAGE OF E&P INVESTMENT OPPORTUNITIES IN '90 TAX ACT

Philip Mandelker
Rosenman & Colin
New York

The crisis in the Persian Gulf and the sharp rise, and subsequent volatility, in crude oil prices have once again brought energy markets to the forefront of world economic interest.

The bitter experience of many who invested in exploration and production plays in the 1970s and early 1980s, however, has kept the investment community wary of testing the water.

This wariness has been exacerbated by a perception that the Tax Reform Act of 1986 (the "1986 tax act") eliminated much of the tax-advantaged status of exploration and production activities.

Today, the oil exploration and producing industry, particularly the natural gas sector, provides interesting market opportunities, and there are substantial tax incentives to exploit those opportunities.

To a large extent, this is so because of important tax incentives provided in the 1990 Revenue Reconciliation Act (the "1990 tax act") for domestic exploration and production activities, including provisions that extend valuable tax credits, expand the benefits of percentage depletion allowances and reduce alternative minimum tax liability (Table 1), and the adoption in November 1990 of the Clean Air Amendments Act.

Investment vehicles to take advantage of these opportunities and incentives can be structured. Given certain restrictions placed on the nature of such vehicles by the 1986 tax act, their structure will have to be carefully monitored.

But with appropriate professional assistance, the pitfalls of that act can be avoided and appropriate vehicles can be developed.

Investment managers interested in taking advantage of the 1990 tax act's estimated $2.5 billion of incentives (Table 2) and in positioning themselves for significant upside market opportunities in the next several years should consider these possibilities.

What follows is a review of key tax incentives now available and certain newly developing market opportunities. Possible investment vehicle structures and potential investor groups are listed.

OIL, GAS TAX ADVANTAGES

1986 TAX REFORM ACT

In adopting the 1986 tax act, Congress recognized the undesirability of the continued increase in U.S. reliance on imported oil and gas and was careful not to vitiate the tax advantages traditionally available to domestic exploration and production activities.

Most importantly, Congress allowed an exception to the "passive activity" rules for exploration and production investments conducted through nonlimited liability vehicle.

As a general matter, the passive activity rules limit the ability to write off expenses or losses from nonportfolio investment activities. However, the 1986 tax act provides that expenses and income related to exploration and production investments are not treated as passive activity income and expenses, and continue to be available for general use by the investor. The nature and effect of the requirement that the investment be made through a nonlimited liability vehicle are discussed below.

Thus, as a general matter, the major tax benefits associated with the industry have remained available to the independent investor.

These benefits include:

• The expensing of intangible drilling costs normally accounting for some 67% of the cost of drilling and completing a successful well;

• An annual depletion allowance of 15% of gross revenues of a producing property, which allowance is available for the life of the property and is not limited by the investor's basis in the property (percentage depletion); and

• A tax credit, the adjusted 1990 value of which is about $5/bbl of oil equivalent of various fuels produced from nonconventional sources, including natural gas produced from certain high cost formations. The 1990 value of this Sec. 29 credit in a natural gas context is approximately $1/Mcf.

WORKING INTEREST LIMITATION

As noted above, for oil and gas investments to be recognized as nonpassive activities under the 1986 tax act, they cannot be made through a vehicle that limits the investor's liability.

Thus, investments made through a limited partnership or an S corporation do not avoid passive activity status. Rather, to avoid passive activity treatment, investments must be in the nature of a working or general partnership interest.

While preserving the tax benefits associated with oil and gas investments, this provision appears on its face to increase the investor's exposure to certain risks associated with oil and gas activities.

However, Treasury regulations promulgated with respect to the provision make it clear that various techniques to protect the oil and gas investor against loss in excess of the amount committed for investment will not cause the investment to be- come a passive activity.

Specifically, the regulations provide that indemnification agreements, stop loss arrangements, insurance, or similar arrangements that protect the investor against potential liability in excess of his investment will not taint the investment for purposes of the passive activity exemption.

To the extent that such indemnification, stop-loss, and similar arrangements are used to protect the investor only against losses over and above the amount of his subscription, such arrangements should not raise any problems under the "at risk" rules to the extent that the investor's aggregate IDC or other deductions, other than depletion allowances, from the activity do not exceed the investor's cash investment.

Furthermore, conversion of a working interest in a well to a limited partnership interest immediately following termination of drilling and completion activities will not affect the nonpassive status of the expenses, including IDCS, incurred prior to the conversion or the nonpassive status of the well's income subsequent to the conversion.

Thus, the net effect of the 1986 tax act is that the traditional limited partnership vehicle is no longer appropriate for an oil and gas investor interested in the tax benefits of such activities. However, the act and the regulations leave ample opportunity for structuring investment vehicles having most of the protections of the limited partnership but without loss of any of the tax incentives left in place by the act.

MORE LIMITATIONS

The 1986 tax act retained various previously existing limitations on exploration and production tax benefits.

Specifically, these provided that:

1. IDCs in excess of a certain portion otherwise entitled to be deducted, for simplicity's sake 20%/year, and percentage depletion allowances in excess of the taxpayer's basis in the property were tax preference items for alternative minimum tax purposes;

2. Percentage depletion was not available to transferees of a producing property and could not in any year exceed 50% of a property's net revenues; and

3. Sec. 29 credits were available only for production through Dec. 31, 2000, from wells drilled before Jan. 1, 1991.

EXPANDED 1990 INCENTIVES

Given the continuing deterioration of domestic oil and gas operations and the steady increase in the percentage of imported oil, Congress enacted several significant tax incentive provisions in the 1990 tax act to encourage increased domestic exploration and production.

The effect of these provisions is to mitigate or eliminate most of the three limitations referred to above.

The 1990 tax act also includes increased incentives for stripper well, heavy oil production, and tertiary recovery operations and sales of ethanol based fuels.

The value of the incentives during the next 5 years has been estimated to be about $2.5 billion. Of primary importance to the general investor are the extension of Sec. 29 credit, mitigation of the percentage depletion limitations, and AMT relief.

1. The availability of the Sec. 29 credit has been extended by 2 years, so that production through Dec. 31, 2002, from otherwise qualifying wells drilled prior to Jan. 1, 1993 will be entitled to the Sec. 29 credit.

   Given the growing interest of exploration companies in production entitled to a Sec. 29 credit and the effective unavailability of Sec. 107 Natural Gas Policy Act incentive pricing, the extension of the credit's availability is particularly interesting in light of the new market opportunities discussed later.

   Various uncertainties regarding the availability of Sec. 29 credits in the case of exploiting untapped qualifying formations through otherwise unqualifying existing wells have recently been addressed in several IRS letter rulings.

   These rulings indicate a liberal IRS policy relating to credit availability and open up interesting opportunities for drilling programs that reduce costs by going back into previously drilled wells to tap previously untapped producing horizons.

2. The percentage depletion rules have been modified in several ways so as to substantially increase their value. Of particular interest, the allowance will now be available to transferees of a producing property and is no longer capped at 50% but may reach 100% of net income of a well.

   The effect of these amendments to the potential investor is obvious.

   First, he can acquire an existing income stream with a built-in tax writeoff that is not limited by his basis in the property.

   Second, the after tax value of the income stream is increased; it will not fall off to the same extent as previously in the later years of a well's life when operating costs and taxes may result in the depletion allowance's 15% of a well's gross revenues being greater than 50% of its net revenues.

   The repeal of the nontransferability rules is also of prime importance to independent exploration companies with existing reserves.

   These companies traditionally financed new exploration activities through production loans. Since the mid-1980s, production loans have been extremely difficult, if not impossible, to obtain.

   As a result, most new exploration activities have had to be financed by sales of reserves. Such sales now become much more attractive to the general investor.

3. As noted above, under previous law both IDCs in excess of otherwise deductible amounts, for simplicity's sake 20%/year, and percentage depletion deductions in excess of the taxpayer's basis in the property were tax preference items for AMT purposes.

   The 1990 tax act provides a special energy deduction for the purpose of computing AMT taxable income. This deduction equals the sum of: 75% of excess IDCs attributable to exploratory well costs, plus 15% of excess IDCs attributable to other well costs, plus 50% of the excess percentage depletion allowances attributable to production from stripper well and heavy oil properties.

   For the purposes of the special energy deduction, exploratory wells are defined as including among others wells at least 1.25 miles from, or completed at least 800 ft below completion depth of, a completed oil or gas well capable of production in commercial quantities.

   The 1990 tax act also provided that under certain pricing scenarios, the percentage depletion allowance for stripper well and heavy oil properties may increase to a maximum rate of 25% of gross income.

   The special energy deduction is not allowed to the extent it exceeds 40% of AMT taxable income determined without regard to the deduction.

   There are additional limitations to the special energy deduction insofar as it interacts with other deductions from AMT taxable income calculations. Further, the amount of the deduction is subject to reduction in any year in which the average annual wellhead price for a barrel of domestic crude oil exceeds a certain inflation adjusted base price, which base price in 1990 is $28/bbl.

   Given the increase of the AMT rate to 24%, the special energy deduction should be of interest to investors subject to AMT.

RECENT DEVELOPMENTS

DISSIPATION OF GAS BUBBLE

The current spot price of natural gas is about 40% of the price of oil on a BTU basis.

Traditionally, and currently outside North America, the ratio varies around 100% (between 60%-120%) of the price of oil depending on the local market.

The reason for this pricing anomaly has been the gas bubble that has existed in the U.S. as a result of the drilling boom of the late 1970s and early 1980s.

Given the lack of any significant drilling activity during the last 5 years, this gas bubble is slowly dissipating.

Current indications are that natural gas consumption is now greater than new production, and it has been estimated that the bubble will disappear by 1993-94.

As this trend has continued, gas prices in the last several months have started moving from $1.60/Mcf, where they hovered for about 3 years, to $1.70/Mcf. Prices are expected to continue increasing in tandem with the bubble's dissipation.

Assuming that oil prices settle in a $19-$23/range following the end of the Persian Gulf crisis, there is still substantial upward potential for gas prices before reaching traditional levels.

Certain new environmental regulations discussed below may even result in natural gas eventually being priced at a premium over crude oil.

GULF CRISIS, SOVIET SITUATION

While not having any direct impact on domestic natural gas prices, the recent events in the Middle East and the substantial increases in crude prices make the availability and ownership of domestic natural gas supplies of greater attractiveness to U.S. industries and utilities.

Consumers have begun to voice their concern, and there is an increase in home owners converting from oil to gas heating.

An additional source of potential oil shock lies in the rapidly deteriorating situation in the world's biggest producing country, the U.S.S.R.

While the U.S.S.R.'s reserves remain great, production has declined by almost 10% in the last 2 years due to rapidly deteriorating production and transportation equipment and infrastructure. It has been projected that during the next several years exports of crude will be off by as much as 50% from 1990 levels.

No significant equipment or infrastructure investment has been made since the 1950s, and the political and economic situation of the country is such that major new investments are unlikely at this time.

Indeed, no one is even sure who has the authority over exploration and production activities: the central government, the republics, the local authorities, or some combination. Without such investment, production is likely to continue to decline with serious potential implications to the world energy markets.

Assuming U.S.S.R. production does not collapse completely, its problems may, to a large extent, be offset by Saudi Arabia's announced intention to increase its production capacity within the next several years to 10 million b/d, about 30% more than its pre-gulf crisis capacity.

ENVIRONMENTAL CONSTRAINTS

Added upward pressure on natural gas prices results from newly enacted environmental constraints on the use of high sulfur oil in many areas and the requirement that some new cogeneration plants use gas as their fuel.

In addition, the recent spate of oil spills and attendant environmental legislation expanding the liability of ship owners for such spills are making the import of oil more costly and difficult.

Many carriers are considering following Shell Oil Co.'s recent announcement that none of its tankers will be permitted to enter any U.S. ports, except the Louisiana Offshore Oil Port.

Perhaps most significant is the enactment in November 1990 of the Clean Air Amendments Act which establishes, among other things, programs to encourage the use of "clean fuels" such as methanol, ethanol, and natural gas and strengthens standards to control tailpipe emissions from cars and trucks to be phased in starting in 1992.

Compliance with these standards will entail use of natural gas additives. Included in the programs is one looking towards the conversion of truck fleets to natural gas burning engines in place of the gasoline and diesel engines currently in use.

A version of the truck fleet program has recently gone into effect in Los Angeles, and at least one such fleet has already been converted.

These and similar actions can be expected substantially to increase the demand for natural gas as a substitute for oil and raise gas prices.

ESTABLISHMENT OF FUTURES MARKET

The recent commencement of trading in natural gas futures on the New York Mercantile Exchange established for the first time a centralized source of market and price information for natural gas.

This development should enable the development of a national market for natural gas with resultant stabilization and efficiencies in what has traditionally been a highly regionalized and fractionalized marketplace.

CONCLUSION

The 1990 tax act includes provisions that are very favorable to investments in oil and gas exploration and production.

Market conditions make the natural gas industry particularly attractive today. In combination, these developments indicate that attractive investment vehicles for exploration, income, and perhaps most interestingly, combined programs can be developed.

The key questions become identifying the appropriate investor groups and exploration companies and structuring the investment vehicles so as to avoid passive activity characterization while limiting investor exposure. Answers to each appear to exist:

INVESTOR GROUPS

Opportunities exist to structure various types of programs that should be of interest to several different investor groups.

• Drilling programs with semi-proven and exploratory activities, though of higher risk, should be of interest to investors subject to AMT.

• Development drilling programs can be of interest to high income individuals, not subject to AMT, looking for significant current deductions with good potential for long-term tax sheltered income streams.

  To the extent such programs are involved in exploration for gas qualifying for Sec. 29 credits, income in excess of that generated by the programs may also be sheltered.

• Investors interested in investments with tax sheltered income streams and upside market potential, which do not have most of the risks attendant upon oil and gas investments, should find interest in production purchase programs.

  Again, to the extent such programs purchase production qualifying for Sec. 29 credits, income in excess of that generated by the programs may be sheltered.

• Programs combining elements of exploratory drilling, developmental drilling, and production purchase can be created that would result in a limitation of risks while generating both up-front and long term tax benefits and providing upside market potential. These programs should be of interest to a wide range of potential investors.

EXPLORATION COMPANIES

The last 7 years have seen the disappearance of most marginally solvent oil and gas operators and promoters, leaving in the field those companies that are, for the most part, experienced, proven, and financially sound.

Much of the bad taste of the last go-round was due to the questionable nature of many of the operators and sponsors.

INVESTMENT STRUCTURE

For drilling programs, a general partnership converting to a limited partnership following completion of drilling activities; during the general partnership period, managing general partners provide appropriate stop-loss and indemnification arrangements and back-up insurance coverage for liabilities beyond the investment amount.

For production programs, limited partnerships with the option of investing as a general partner in Sec. 29 credit qualifying programs where the tax on the income expected to be generated by the program will be less than the value of the credit.

Copyright 1991 Oil & Gas Journal. All Rights Reserved.