Oil 101

Understanding the Market

The oil market is a global system that involves the production, distribution, and trading of crude oil and its refined products. Key factors influencing the market include global supply and demand, geopolitical events, production decisions by major oil-producing countries (such as OPEC), economic conditions, and environmental factors like weather.

Oil prices are primarily benchmarked by WTI (West Texas Intermediate) and Brent crude. Futures contracts allow traders to speculate on price movements. WTI futures are primarily traded on the New York Mercantile Exchange (NYMEX) and Brent futures are primarily traded on the Intercontinental Exchange (ICE). The market plays a crucial role in the global economy; impacting energy, transportation, and manufacturing costs. 

Oil Futures

Much like an individual stock, WTI and Brent crude prices fluctuate on the futures market. The pricing of WTI and Brent oil futures is based on the spot prices of their respective crude oils, which reflect the current market value for immediate delivery. Futures prices are shaped by market expectations regarding future supply, demand, storage costs, interest rates, and other factors as mentioned above. The relationship between futures and spot prices is influenced by market sentiment and the cost of carrying oil inventories.

WTI vs. Brent

The two main differences between WTI and Brent are their location and oil quality, which contribute to a price difference known as the "spread".

• Location: WTI is produced in the U.S., mainly from Texas, Louisiana, and North Dakota. Brent crude comes from the North Sea region off the coast of Europe, primarily from the U.K.

• Quality: WTI is considered a light and sweet crude, with a lower content of sulfur, which makes it easier to refine. Brent crude is a blend of both "light sweet" and "heavy sour" grades, making it a mixture of qualities. 

The spread between their prices fluctuates based on supply, demand, and geopolitical factors. Brent crude serves as the global benchmark, influencing oil prices in Europe, Africa, and the Middle East, while WTI primarily affects prices in North America. Despite their regional focus, both benchmarks have a significant impact on the global oil market.

As we are oil investors in the U.S., the price we sell our oil for is the spot price of WTI at the time the refinery picks up a load.

More on WTI

WTI has been used as a U.S. benchmark since the early 20th century. WTI's significance grew in the 1980s when the New York Mercantile Exchange (NYMEX) introduced WTI crude oil futures, allowing traders to speculate on its price. Over time, WTI became a major reference point for oil pricing in North America. However, its influence has fluctuated due to factors like U.S. infrastructure constraints and the rise of Brent crude as the global benchmark. Despite this, WTI remains a key indicator of U.S. oil market conditions and continues to play a significant role in global oil pricing.

Source: https://oilprice.com/futures/wti

WTI vs. Brent in the Market

Over the last 20 years, Brent crude futures have traded on average $4.38 higher than WTI, with Brent averaging $75.55 per barrel and WTI averaging $71.17 per barrel over that time. Over the last 3 years, Brent has traded on average $4.00 higher than WTI, with Brent averaging $87.11 per barrel and WTI averaging $83.11 per barrel over that time.

Source: U.S. Energy Information Administration, Crude Oil Prices: West Texas Intermediate (WTI) - Cushing, Oklahoma [DCOILWTICO], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DCOILWTICO, September 10, 2024.

Tax Benefits of Investing in Oil

Investing in oil is not just about profiting from one of the world’s most valuable commodities, it also offers a range of tax benefits that can significantly enhance your returns. Understanding these benefits is crucial for maximizing your investment potential. Let’s explore four key tax concepts: intangible drilling costs (IDCs), tangible drilling costs (TDCs), depletion, and the distinctions between working interest and royalties.

Intangible Drilling Costs (IDCs): An Immediate Deduction Opportunity

Intangible drilling costs encompass the non-salvageable expenses involved in drilling a well, such as labor, chemicals, and site preparation. These costs don’t have physical value but are essential for getting oil out of the ground.

Tax Benefit: The IRS allows you to deduct up to 100% of your IDCs in the first year of the investment. This means you can offset a substantial portion of your taxable income early on, which is a major advantage for investors looking for immediate tax relief. For instance, if you invest $100,000 in a well, and $70,000 of that is considered IDCs, you could deduct the full $70,000 from your taxable income that year.

Tangible Drilling Costs (TDCs): Depreciation Over Time

Tangible drilling costs refer to expenses related to equipment and materials, such as rigs, pumps, and storage tanks. Unlike IDCs, these costs are associated with items that have salvageable value.

Tax Benefit: TDCs cannot be fully deducted in the first year but are depreciated over several years. This gradual depreciation allows you to reduce taxable income steadily, offering long-term tax savings.

Depletion: A Tax Deduction for Resource Extraction

Depletion is a tax concept that accounts for the reduction of a well’s reserves as the oil is extracted. There are two methods for calculating depletion: cost depletion (based on your investment) and percentage depletion (typically 15% of gross income from the well).

Tax Benefit: For many small producers and investors, percentage depletion provides a generous deduction, even if it exceeds your initial investment. This deduction rewards you for the diminishing value of the asset, reducing your taxable income year after year.

Working Interest vs. Royalties: Understanding Your Tax Obligations

When investing in oil, it’s essential to know whether you hold a “working interest” or a “royalty interest”, as each comes with unique tax implications: 

Working Interest: This gives you direct ownership in the well, and with it comes unlimited liability and active participation in operations. While working interest exposes you to more risk, it also qualifies you for tax benefits like deductions for IDCs, TDCs, and depletion. Most investors who are looking to offset active income invest initially as General Partners to be able to take advantage of these tax benefits from their working interest. Then once the tax benefits are realized, they are converted to Limited Partners by the operator, which limits further liability.

Royalty Interest: This provides you with a percentage of the income from oil production without liability or operational responsibilities. Royalty income is treated as passive income, and while you can benefit from depletion deductions, you won’t qualify for IDCs or TDCs deductions.

Why Tax Benefits Matter for Oil Investors

The U.S. government provides these tax incentives to encourage domestic energy production. As an investor, these benefits can significantly improve your after-tax returns. Whether you’re looking to shelter current income, build long-term wealth, or diversify your portfolio, oil investments offer a unique blend of financial and tax advantages.

By understanding and leveraging IDCs, TDCs, depletion, and the nature of your ownership (working interest vs. royalties), you can craft a tax-efficient investment strategy that works for your financial goals. 

Oil investments are not without risks, but the tax benefits can offset some of these challenges, making it an attractive opportunity for certain investors. Consult with a tax advisor or financial professional to maximize these advantages and ensure compliance with IRS regulations.

On behalf of all of us at GDI Capital Partners, we appreciate you taking the time to further your education and we hope we provided value. Do you have questions about passive investments, investing in oil, or anything else real estate related? We’d love to hear from you!