Non-traded energy opportunities

Historically, tax-advantaged drilling programs have dominated the non-traded energy investment arena. While drilling in certain US basins today may work on a pure field-level basis (with the Permian Basin presenting better economic opportunities), break-even capex points for retail syndicated drilling partnership programs ("drilling programs") trend about 25% higher than the field-level capex based on offering costs and program manager compensation.

Certain proactive drilling program sponsors are addressing pricing challenges by applying improved completion technologies to old fields where oil and natural gas resources were established years ago. Even with better completion strategies and income tax deductions that generate tax savings of 40% to 45% of an investment, many drilling programs will be hard pressed to make their programs model at adequate returns under current pricing conditions.

In spite of energy prices, trends developing within the non-traded retail-syndicated energy product space are focused upon capturing acquisition-driven upside that might not have existed at higher commodity prices. We'll begin with a review of what's happening with historically popular drilling program investments and then follow with a discussion of some emerging retail product structures positioned to take advantage of today's commodity prices.

DRILLING PARTNERSHIPS

Despite a growing number of programs with acquisition-based strategies, there continues to be an appetite among high net worth investors for programs that are designed to provide high income tax deductions through drilling. These programs are structured as limited partnerships and are marketed to retail investors through private placements.

Drilling programs are designed to provide investments whereby 65% to 85% of the investor's capital will be deductible in the first couple years of the investment through special allocations of IDCs to investors. For high tax bracket investors in states with high income tax rates, the IDC deduction can potentially translate into a tax deduction equal to 35% to 40% of the investment.

In addition to getting the allocation of IDCs, investors can determine the active or passive character of their IDCs by electing to participate in the program as a limited partner or as a general partner. For investors who participate as general partners, they can deduct IDCs and other drilling costs against active income such as wages and income from managed businesses. Investors participating as limited partners must deduct IDCs and other related deductions against passive income such as income from most real estate investments and income from businesses not actively managed.

Drilling partnerships also seek to provide investors with long-term cash flow from oil and gas production revenues. Historically, the geographic coverage of these programs spanned across plays that included the Appalachian Basin, Rockies, Anadarko Basin, East and West Texas, and the Louisiana/Texas Gulf Coast. However, in view of lower oil and gas prices and the offering costs that must be paid by investors to fund a drilling program, a substantial majority of the drilling capital raised from investors in 2015 was put to work in the Eagle Ford Play in South Texas, the Permian Basin, and portions of the Anadarko Basin.

While the geographic footprint of today's drilling programs has shrunken for now, the operational resolve of some operators to offer economic programs has been observed among a small group of companies seeking to apply better completion technologies to established oil fields to increase production per wells. Examples of this practice include: (i) increasing the number of frac stages for horizontal wells, (iii) increasing the amount of water and sand used in the completions, and (iv) applying frac staged completions to vertical wells.

Thus, while a well using a certain drilling and completion method in 2013 might cost 50% less to drill today, the approach among some sponsors has been to spend close to what has been historically spent, but to dramatically improve the impact of the completions to produce more oil and gas at a substantially similar cost level. Time will soon tell whether such methods will improve the economics of these programs.

MLP DESIGNED PRODUCTS

Master Limited Partnerships are publicly traded companies structured as limited partnerships for income tax purposes that engage in upstream, midstream, or downstream operations. There is also a non-traded MLP look-alike product ("MLP designed" products) that does not offer market liquidity but that has almost the same income tax consequences as MLPs and that is structured similar to them. The MLP designed products are offered through private placements conducted under Rule 506 of Regulation D of the SEC Act of 1933 or by prospectus in an S-1 offering.

By analogy to non-traded Real Estate Investment Trusts (REITs) in the market today, non-traded MLP designed products aspire to become traded securities upon the development of their portfolio assets. While the culture of the MLP designed products is still in its infancy, the reach of the product may be very significant if one analogizes to the historic marketing success of REITs.

MLPs and their non-traded companions are set up to operate energy assets on a day-to-day basis. Many public MLPs today are midstream and downstream, but MLP upstream products that engage in drilling and lease development are growing in number. In contrast, the non-traded MLP products we have seen marketed over the past year have focused their business on upstream operations.

Investors who buy the public MLPs want regular income that comes to them on a tax-preferred basis, which makes midstream assets such as pipelines a natural fit for the public products. Buyer motivations differ in the non-traded MLP designed products, which seek to build a base of reserves that can be rewarded through a future IPO. Distributions will be moderate within the non-traded products due to the reinvestments of earnings used to develop the assets to position the product for a future MLP listing event in five to seven years.

MLPs and their non-traded companion products are both managed by a General Partner that receives a small minority equity interest. The General Partners also receive incentive distribution rights (IDRs). In the public arena, the IDRs incentivize the General Partner to distribute as much of the MLP's cash flow to investors as possible. On the public side, the General Partner's share of cash flow above a preferred investor distribution (e.g., 8% to 10%) varies depending upon the investor distribution.

On the private side, the General Partner of the MLP designed product receives IDRs that entitle it to a share of the fund's upside return if it is successful in listing its units at a certain valuation. The distributions may be moderate (e.g., 6% annual target as opposed to an 8% to 10% target) due to the fact that the fund is reinvesting its cash flow to develop assets and build value that can be potentially recognized at a listing event.

Both public MLPs and the MLP designed products are pass-through entities whereby income and deductions are reported at the individual investor level. Ordinarily, a partnership whose units trade on a secondary market will be taxed as a corporation. However, special tax legislation adopted in 1987 carves out an exception for certain publicly traded partnerships engaged in natural resource development, production, and transportation (i.e., IRC §7704). Public MLPs and their non-traded companions are both passive income generators due to the nature of the income (i.e., which is normally operations-driven income) and the nature of the interests being acquired by investors (i.e., which are limited partner interests). Note that passive deductions in a public MLP product only offset passive income of that product. So, if an MLP investor has excess passive deductions from the investment that exceed income, those deductions must be suspended and can be used to offset income from the underlying MLP for several years. The treatment of passive deductions for non-traded partnerships is different. Those losses can offset passive income from other investments if needed.

Unrelated business taxable income (UBTI) is a special income tax incurred by qualified plan and IRA sourced investments in partnerships that engage in energy and real estate. UBTI will generally be incurred in both public and private products if that income exceeds $1,000 per year.

OPPORTUNITY FUND PROGRAMS

Unlike drilling partnerships that focus upon the delivery of competitive investment year income tax benefits, energy opportunity partnerships are structured to provide a non-traded investment that will focus upon a diverse universe of assets that may include: (i) royalties in properties that produce hydrocarbons, (ii) working interests in leases with undrilled locations or where hydrocarbon production may be enhanced through remedial operations, and (iii) infrastructure assets.

The strategy of the opportunity partnership is to provide economic value to investors in the form of income and asset growth by focusing upon (i) acquisitions of oil properties and direct investments at a time when market developments present opportunities for favorable valuations, and (ii) properties that provide income and opportunities for value-added growth. While the opportunity partnership compares to the non-traded MLP designed product in the sense that both are seeking to deliver value to retail investors through strategic acquisitions of energy assets, the opportunity partnerships assume a diversified investment mandate whereas the MLP will concentrate its assets in one sector of the energy industry.

Similar to MLPs, the opportunity partnerships are structured to mitigate the liability exposure associated with energy operations by offering limited partnership interests to investors. As the opportunity programs are structured as partnerships for tax purposes, this product will provide income tax-related benefits to investors through pass through of depletion, intangible drilling cost and tangible equipment deductions.

As the investors in the opportunity partnerships will not have material participation in the partnership, they will be subject to passive activity limitations in relation to the income and deductions associated with the program investment activities, such as drilling and midstream or downstream operations. In some cases, however, royalty revenues, interest payments on debt investments, and dividends from portfolio companies may be treated as portfolio income as opposed to passive income.

As is the case with non-traded MLP products, the tax consequences of UBTI will apply to operations-driven revenues for investors acquiring their interests with IRAs or other forms of qualified money. Accumulated unused passive deductions from energy opportunity partnerships can be used to offset passive income from other passive investments.

1031 PROGRAMS

A third acquisition-focused product in the non-traded channel offers opportunities for investors to acquire interests in energy properties through like-kind exchanges that enable investors to sell real estate and acquire interests in the program assets on a tax-deferred basis. In fact, many royalty programs offered within the non-traded retail sector have been §1031 eligible programs. These programs are marketed to accredited investors through private placements conducted under Rule 506 of Regulation D.

While working interests in oil and gas leases and associated production can technically qualify for like-kind exchange treatment under IRC §1031, a majority of the assets acquired in these programs tend to be royalty interests (as income producing assets are generally favored by retail investors participating in the offerings). As the underlying research and buying analytics involved in buying royalties tend to materially differ from those of an up-stream drilling company, this segment of the retail energy channel has been underserved in our opinion.

In terms of program structure, the sponsor usually sets up an issuer entity structured as a limited liability company (Issuer LLC) that will acquire the minerals, royalties, and/or overriding royalties from a seller and that will take title to the assets. The Issuer LLC eventually will transfer title to the retail investors of the 1031 program as money is raised. In many cases, the Issuer LLC will also reserve a right in the offering documents to conduct multiple closings during the offering period so the investors that want 1031 treatment can close on the investments at needed times to meet various IRS deadlines.

An affiliate of the program sponsor will fulfill the role of asset manager and will enter into an asset management agreement with each investor. While the nature of the investment is passive, investors are afforded the tax advantages associated with real estate as the program assets are titled directly to the investors. As the underlying investments are direct interests in real estate, investors will receive Form 1099s from the manager and will account for their pro rata share of the income and expenses on a Schedule C of the Form 1040.

The subscription documents signed by investors contain special provisions that prohibit an investor from treating his/her investment as a partnership interest. Additionally, each investor must be given a right in the management agreement to terminate the sponsor's status as the manager and to assume the asset management duties if he or she so chooses.

From a due diligence perspective, the investor group's acquisition price should be based in substantial part upon what a reasonable buyer would pay for the properties (i.e., fair market value). At the end of day, investors should have a reasonable chance to earn high single-digit to mid-teens return on a load adjusted basis under average economic conditions.

CONCLUSION

Prior to 2015, non-traded energy investments accounted for $800 million-plus in retail investor sales, with the largest segment of the capital being raised from companies that sponsor non-traded drilling programs. While lower commodities prices will present challenges to drillers, business may continue as usual for sponsors that can make their projects work at lower price thresholds. Against the backdrop of lower oil and gas prices, however, one may expect the opportunistic programs to assume a greater share of the non-traded retail energy product market in 2016 and future years.

ABOUT THE AUTHOR

Brad Updike is an attorney with Mick Law PC and also serves as a board member of the Alternative & Direct Investment Securities Association. His areas of practice include securities law, oil and gas, private equity, conservation real estate syndications, DPP due diligence, and taxation analysis relating to private securitized financings. Updike received a JD with honors from the University of South Dakota School of Law, and a Master of Laws from the University of Florida School of Law.