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The Hudson family invested $200,000 in an oil and gas well
The family received considerable tax benefits: a 88% depreciation deduction in the first year and 12% over the next 6 years
They earned high returns from the investment, allowing them to diversify their portfolio and maximize their earnings in a way that the traditional stock market couldn’t offer.
Over 20 years, they received ~$130,000 more in post-tax benefits
Introduction: The Diversification Dilemma
The Hudsons live in New York City, make $1.4 million per year, are contemplating an oil and gas well investment. Why? Let’s delve into their financial journey, year by year, comparing it to a typical stock portfolio. Below is a quick reminder of the risks and benefits of oil and gas well investments:
Risks of Oil and Gas Investments
Market Volatility: The market is highly volatile, and oil and gas prices can fluctuate significantly, affecting the income generated by the investment.
Well Variability: Drilling may not lead to commercially viable quantities of oil or gas.
Variable Costs: Operating costs may exceed expectations, or revenue from low oil prices may reduce income and revenue.
Benefits of Oil and Gas Investments
DepreciationTax Savings: You can potentially write off 35%-50% of your investment as tax savings against ordinary income in the first year (typically ~88% of the investment can be taken as depreciation in the first year).
Partially Tax-Free Returns: One perk of investing in oil and gas wells is that 15% of the income generated by an oil and gas investment is excluded from your taxable income.
Potential for High Returns: When oil prices are high and wells are productive, the financial gains can be substantial and considered passive income, which has its own advantages for tax planning.
Diversification: Investing in oil and gas can diversify your portfolio against public market returns.
The Investment Kickoff: Setting the Scene
The Hudsons, who expect to pay $700,000 in taxes on their $1.4 million income, are choosing between investing $200,000 in oil and gas or in the stock market. Let’s walk through the potential returns.
Depreciation: The Hudsons expect to receive 88% of their investment as depreciation in the first year. Since their marginal income tax rate is 50%, that depreciation will save them $88,000 in taxes this year (or 44% of their investment). This effectively lowers their-out-of-pocket investment in the oil and gas from $200,000 to $106,000 because $88,000 is money that would have otherwise been lost to taxes. Critically they will also receive depreciation for the additional 12% of their investment over the next 6 years, lowering their out of pocket investment to $100,000.
Oil & Gas Returns: The Hudsons examined the historical annualized returns for their producers’ oil and gas wells based on the years the wells were drilled. Here’s what they found:
Year
Return
2022
20.40%
2023
38.18%
2024
43.39%
2025
18.13%
2026
11.31%
2027
8.87%
2028
13.64%
2029
10.96%
2030
8.97%
2031
3.84%
2032
5.65%
2033
5.48%
2034
3.70%
2035
2.57%
Convinced, they take the plunge.
Year-by-Year Cash Flows from Oil & Gas
Based on their $200,000 investment, here’s what the Hudsons can expect in terms of returns:
Year
Return Calculation
Annual Income
2022
$200,000 * 20.4%
$40,800
2023
$200,000 * 38.18%
$76,360
2024
$200,000 * 43.39%
$86,780
2025
$200,000 * 18.13%
$36,260
2026
$200,000 * 11.31%
$22,620
2027
$200,000 * 8.87%
$17,740
2028
$200,000 * 13.64%
$27,280
2029
$200,000 * 10.96%
$21,920
2030
$200,000 * 8.97%
$17,940
2031
$200,000 * 3.84%
$7,680
2032
$200,000 * 5.65%
$11,300
2033
$200,000 * 5.48%
$10,960
2034
$200,000 * 3.70%
$7,400
2034
$200,000 * 2.57%
$5,140
The Magic of Depreciation
In the first year, the Hudsons can depreciate 88% of their oil and gas investment, or $176,000. Given their 50% marginal tax rate, this translates to a tax saving of $88,000 in the first year alone.
In addition, 15% of the income from the oil and gas wells are tax exempt! That’s a huge, overlooked benefit of investing in this space.
You might be wondering what these benefits look like over time . . .
Effective Cash Flows from Oil and Gas, Factoring in Depreciation
If the Hudsons are able to replicate these previous returns, then over 14 years they will get $127,000 in post-tax benefits from their $200,000 investment! If they invest in oil and gas wells and reinvest the cash flow in the stock market, they will end up with roughly 35% more in assets than if they had just invested in the stock market for 20 years. Another way to think about it is that the tax savings create leverage. That leverage allows investors like the Hudsons to invest more in oil and gas wells than they would have been able to invest in the stock market otherwise, because they can invest dollars that would have been lost to taxes. You can estimate what the returns could look like in your situation on our calculator here.
If the Hudson’s had use Solar to offset their oil & gas income they could have increased their return potentially 20% or more. You can estimate your potential returns in this calculator.
Conclusion: The Hudsons’ Winning Strategy
The Hudson family took a calculated risk by diving into oil and gas well investment. The considerable tax benefits of 100% depreciation of their investment (88% in the first year), the 15% income exclusion, and the strong returns from the underlying investment allowed them to generate after-tax returns that a typical, broad stock portfolio wouldn’t have been able to generate.
By taking this route, they turned their $200,000 into a tax-efficient and highly profitable investment, proving that sometimes the road less traveled is worth taking.
We’ve built a platform to give everyone access to the tax and wealth-building tools typically reserved for wealthy individuals with a team of accountants and lawyers. We make it simple and seamless for our customers to take advantage of these hard-to-access tax-advantaged structures. With Valur, you can build your wealth more efficiently at less than half the cost of competitors.
From picking the best strategy to taking care of all the setup and ongoing overhead, we make things simple. The results are real: We have helped create more than $3 billion in additional wealth for our customers. If you would like to learn more, please feel free to explore our Learning Center. You can also see your potential tax savings with our online calculators or schedule a time to chat with us!
Mani is the founder and CEO of Valur. He brings deep financial and strategic expertise from his prior roles at McKinsey & Company and Goldman Sachs. Mani earned his degree from the University of Michigan and launched Valur in 2020 to transform how individuals and advisors approach tax planning.
