Imagine you’ve just sunk a significant chunk of your savings into an oil well, drawn by the promise of high returns and a piece of the energy boom. Months later, the news hits: the well is dry, and your investment has evaporated. You’re left with regret and a serious dent in your finances. This scenario isn’t far-fetched—it’s a reality for many who dive into oil and gas investments without fully grasping the risks or evaluating their financial capacity to handle potential losses.
Oil and gas investments can seem alluring, with tales of big profits and the excitement of the energy sector. But they’re not for everyone. If you don’t understand the complexities involved and can’t afford to tie up more than 25% of your liquid net worth, don’t do it.
However, that is only one of the many types of investments. Here is a guide on the types and insights you need to know to invest in oil and gas.
Jumping in without a clear understanding of the industry is like navigating a minefield blindfolded. Here’s why comprehension is non-negotiable.
Types of Oil and Gas Investments
To start, let’s look at the main ways you can invest in oil and gas:
- Direct Investments (exploration)
Also called “wildcatting”, this is the exploration of new oil and gas wells where there seems to be oil from research. The funds invested are used to confirm and extract. Most of these projects give you tax benefits but if the well is a dud (a “dry hole”), you could lose every penny you put in from a return on investment. These investments are the riskiest due to geological uncertainties but can yield 40%+ in annualized returns.
- Royalty Interests
With royalty interests, you get a cut of the revenue from oil or gas production without being involved in the equipment operations. The returns are lower with this, about 10% – 20% annualized returns. If the well underperforms or prices tank, your payouts shrink.
3. Working Interests
This means buying a stake in an oil or gas well or a drilling project. Typically, this is expanding on the existing wells with better drilling and equipment to improve or adding additional wells alongside what has already been drilled. Returns are normally 15% – 30% annualized returns. Also, how the income and expenses are reported as a 1099 instead of a K1 gives added benefits for the expenses shown on the schedule to help offset taxes. Consult a CPA professional who has experience in tax strategy.
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4. Stocks and Mutual Funds
Prefer something more familiar? You can invest in oil and gas companies through stocks or mutual funds. These are more liquid—you can buy and sell shares on the stock market—but they’re still tied to the energy sector’s ups and downs. Company performance, market trends, and global events can all sway your returns. Also need to be aware of short term and long term capital gains since you can buy and sell more fluidly than in a company or investment opportunity. Consult a tax advisor on some of these implications.
The Risks You Need to Grasp
Each investment type comes with a unique cocktail of risks:
- Geological Risks: Even with cutting-edge tech, there’s no surefire way to predict if a well will produce. Geological surveys support the confirmation to drill. Horizontal wells are riskier, while vertical wells are more predictable. Be sure to review the surveys and ask for them. Some investors don’t think to ask—but you aren’t like most investors.
- Market Risks: Oil and gas prices change. Think of 2020, when oil prices briefly went negative due to a demand collapse during the pandemic. That’s not a rare fluke—prices are at the mercy of global supply, demand, and geopolitics. Over the next five years, prices are expected to hover between $70 and $75, which will still make for profitable investments. Be sure to look at the deal’s underwriting based on the assumptions the offering is making on the price of oil.
- Operational Risks: Drilling is messy business. Accidents, spills, or equipment breakdowns can halt production and eat into profits. A good operator is essential for your investment. How do you know if they are a good operator? Look at their experience and learn how they have handled situations.
- Regulatory Risks: Governments can change the rules—new environmental laws or tax policies might increase costs or restrict drilling, hitting your bottom line. Now this is less likely to change, considering the long process of regulations and that most operations aren’t near city limits – typically the bottle neck of passed regulations.
Without understanding these risks, you’re essentially gambling. A slick sales pitch or a friend’s hot tip isn’t enough. You need to know the odds and how they stack against you. It is your responsibility to do your own due dilligence.
More information on the risks and types of investments you can make in oil and gas: YoutubeThe Tax-Smart Investor’s Guide to Oil & Gas with Michael TannerThe Tax-Smart Investor’s Guide to Oil & Gas with Michael Tanner
Financial Considerations: Can You Afford the Risk?
Even if you’re an oil and gas guru, investing is a no-go if it jeopardizes your financial stability. Here’s why affordability—specifically keeping your investment under 25% of your liquid net worth—is crucial. Expect to keep you investment in the opportunity for the life of the wells.
What Is Liquid Net Worth?
Let’s define the term. Your liquid net worth is the value of assets you can quickly turn into cash, minus your debts. Think:
- Liquid Assets: Cash in bank accounts
- Semi Liquid Assets: stocks, bonds, mutual funds (though retirement accounts might have withdrawal penalties), whole life insurance cash value. These values are considered 70% of what they are because of taxes and the change in value.
- Minus Liabilities: Subtract car loans, student or personal loans, credit card debt—anything you owe.
Why Liquidity Is Your Lifeline
Liquidity isn’t just nice to have—it’s essential. Here’s why:
- Emergencies: Life throws curveballs—medical bills, car repairs, or a sudden job loss. You need cash on hand to cover 3-6 months of living expenses, as financial advisors recommend in addition to having savings of annual expenses (think vehicle and house expenses that will come up at some point).
- Annual Living: tires, upgraded phone, new computer, and household appliances are all annualized for each month based on when they will need to be replaced (ex. fridge every 5 years is the cost of the fridge divided by 5 to get the annual savings you should have in a separate account for when it comes time to replace.)
- Opportunities: Liquid cash lets you jump on new investments or deals without scrambling to free up funds.
Oil and gas investments, especially direct ones, are notoriously illiquid. Your money stays in the investment for sometimes a decade—with no easy way to cash out. If you sink too much into them, you’re left strapped when you need funds most.
The 25% Rule: A Safety Net
Here’s where the 25% guideline comes in: don’t invest more than a quarter of your liquid net worth in illiquid assets like oil and gas. Why 25%?
- Balance: It leaves 75% of your liquid net worth free for emergencies, expenses, and flexibility.
- Risk Management: If the investment flops, you’re not wiped out—you’ve got a cushion.
Here is a scenario:
$200,000 in savings
$30,000 in stocks
$10,000 in whole life insurance policy cash value
$20,000 in consumer debt (Variable debt like credit cards)
$60,000 in monthly living expenses, typically save 3-6 months (Fixed debt like car, mortgage, student loans, general living expenses and entertainment and travel)
$5,000 in annual living expenses (Anticipated expenses such as new tires, new technology every two years, new house appliances every five years, etc.)
Savings cash can be fully used, while stocks and bonds are semi-liquid and are used as 70% of value since they fluctuate, and you pay short-term or long-term capital gains when sold—unless you get a stock-collateralized loan – but still don’t count the full amount. 70% is the percentage that loan servicers look at the debt, like when you buy a house.
Liquid Net Worth = cash + investments – variable consumer debt – fixed debt and living expenses – annual expenses
$200,000 + $30,000 0.7 + $10,000 0.7 – $20,000 – $60,000 / 12 * 6 – $5,000 = $173,000 in liquidity
Using the 25% rule we see that $43,500 doesn’t meet the minimum $50,000 threshold of most private placements. So should you invest? Well – using the best practices in family offices and ultra high net worth individuals – you wouldn’t.
NOTE: Home Equity Lines of Credit and Loans + Home Equity Investments should only be counted if you have them accessed and treated as such:
- Home Equity Line of Credit – variable consumer debt as used
- Home Equity Loan – fixed debt
- Home Equity Investment – cash (there is no monthly payment)
It’s the money you can access without selling your house or waiting years for an investment to pay off.
Newer investors tend to view all cash and investments as an opportunity to invest and might put $100,000 in where if they lost their job and the deal went south, they would have to drastically change their living expenses or draw from their long-term retirement accounts. Equally as bad, they might go to the syndication to ask for some of their investment back, and traditionally, if a sponsor is willing to give an investor money back, it would only be about half of what they invested.
The Perils of Overcommitting
Invest to avoid overexposure and prepare for financial challenges and future investment opportunities. Being aware of how your cash is used allows you to be a savvy investor not a loss investor.
Conclusion: Invest Wisely, or Not at All
Oil and gas can tempt with visions of wealth, but it’s a minefield for the unprepared or overextended. If you don’t understand the risks—from geology to geopolitics—or if investing more than 25% of your liquid net worth leaves you cash-strapped, walk away. Knowledge and financial flexibility are your gatekeepers.
Before you commit, educate yourself: read, research, and consult experts. Calculate your liquid net worth and stick to the 25% rule—or less if you’re risk-averse. Diversify, keep an emergency fund, and prioritize liquidity.
Investing should build your future, not gamble it away.
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