TAX-SAVVY INVESTING FOR PILOTS: A DEEP DIVE INTO OIL & GAS

[00:00:01]In the US tax code, and it’s actually been written in order to develop our own natural resources, keep us off of the dependency of really going and purchasing oil from our adversaries. We have our own oil and gas right here in the United States, and some would argue the most in the world, but the tax code was written so that if you’re gonna spend the money to go out and find oil so that our country can be self-reliant. Then by taking that risk, you get to write off, in most cases, 85 to 90% of that investment in the year that you make that investment. That comes right off of your ordinary income. And then when the wells go into production, because the oil in the ground will not last forever, there is a 15% depletion allowance on the revenue side. So 15% of every dollar that an oil well generates is tax free.
[00:01:00]You are listening to the Pilot’s portfolio, the show dedicated to guiding professional pilots towards a future of financial success and stability. Fly along with your host Timothy P. Pope, as he provides financial planning insights and answers to your burning questions and dives into real life stories from fellow pilots who share their success. And cautionary tales, the pilot’s portfolio takes off now.
[00:01:29]Well, welcome to this episode of Pilot’s Portfolio. This is the show where we discuss all things personal finance for professional pilots. My name is Timothy P. Pope. I’m a certified financial planner specializing in the planning needs of the professional pilot. In this episode, we have. An awesome conversation about alternative investments that can actually help you lower your W2 income. I mean, tomorrow is tax day. Some of you are crying as your tax payments get direct deposited to the IRS. Some of you bit the bullet. You stroked the check earlier. Either way, it’s never fun paying taxes and especially as a high W2 earner, in a lot of ways, we’re always looking for some opportunity to reduce our tax burden.
[00:02:20]So today we get into the nitty gritty of that. We’ve talked about real estate as an alternative investment in the past. In many cases, you’re not able to offset your W2 income for the year in which you make your investment. In a lot of cases, in some cases you are, but in a lot of cases you’re not able to. So super excited to get to today’s conversation, but before we do that, we need to talk about something else, and that’s the market. It has been quite the volatile time in the market lately, and by the time of this recording, the president has raised tariffs on. Many of America’s trading partners, which saw huge and dramatic declines in the market.
[00:03:04]And then most recently, he’s put a 90 day pause, which saw a historic bounce, and it’s been back and forth, back and forth, right? You are watching in real time what this magnitude of uncertainty does to the equity markets. It can be unsettling. You know, with the exception of 2022 and 2018, the market has been up year after year after year for the past decade and then even beyond. And so, you know, a lot of folks are asking themselves, okay, this is ugly. What should I do about it? My answer to you is, stick to your financial plan. Okay? If you’ve got a financial plan, it should have been carefully crafted. It should have been thoughtfully. Stress test for times just like this. When we give our clients a probability of success, we let ’em know where that line is.
[00:04:00]It says, hey, you can withstand some market shocks. You can withstand things in your personal life going wrong. You can extend below average market conditions and you should still be fine if your success rate is below that. Then they also know where, where, where they stand. But we also have a plan to to get it up there. Okay? So stick with your financial plan, and if you do not have a financial plan, times like this might spur you to create one because there’s likely a lot of unanswered questions about your financial life in your financial future. Now add to your own uncertainty. You know, our clients here talk about the intellectual and emotional components to risk tolerance all the time.
[00:04:39]Okay. And I think, I mean, this year has been demonstrating this, plus a lot of other topics I’ve been talking about on the show. But that intellectual side says, hey, I know my time horizon. I know that investing in US companies and global companies is an excellent way for me to grow wealth over time. The intellectual side of our risk tolerance is that, hey, when looking at the long-term averages of stocks, it includes some amazing runs and it also includes some pretty ugly stuff like we’re experiencing right now. The graph just typically smooth it out into a trend that goes up and to the right. Okay, so that’s the intellectual side kind of knows that. The emotional side, however, includes the fact that, you know what, the stock market just doesn’t just simply drop dramatically. By itself in a vacuum. If it did, that would be weird. Nobody would invest in it. Okay. But usually when you have substantial drops like this, it’s accompanied with a steady drumbeat of negative news.
[00:05:41]It’s accompanied by a steady drumbeat of alarming headlines. There’s usually. A lot of things that we can’t make sense of. Like right now it’s like, hey, why is the president doing this? And if it’s implemented, what is the short-term impact going to be? Or what is the long-term impact going to be? Five years ago it was. Huh. We’ve never artificially shut down the economy, just like on demand like this during COVID, what is this impact going to be? Before that, it
was, wow, have we really had, you know, this real estate crisis before and these subprime mortgages, these issues, and this whole global financial crisis. You know, before that it was the tech bubble.
[00:06:20]Right? Before that it was issues in the late eighties, and then of course you’ve had wars and everything’s figured in. So when these things happen, there’s always this big. Crisis or this big level of uncertainty. And I think it’s natural to ask, hey, what is the short-term impact? What is the long-term impact going to be on me or on you? And what you know, what your specific goals are. Like if you are on the bottom of the seniority list, you’re thinking, goodness, what is this going to mean? If we go into recession, airlines are gonna slow down. Am I going to get furloughed? Am I still gonna have a job in 12 months or 18 months? Right? If you are on the opposite end of the spectrum, and maybe you’re a couple of years out from retirement or five years out from retirement.
[00:07:02]Or less, you’re saying, goodness, you know, if this thing persists, am I gonna have to change what I have planned on for my own retirement? And so there’s all these uncertainties and these anxieties that could be swirling around your head. And I think that, you know, questions start to pop up. Like, is now a good time to be investing? Or you might say to yourself, well yeah, but I know historically we’ve had these issues, but this time it’s different. Right? And I would tell you that questions like that are normal. Okay? Questions like that are normal. I think the thing we gotta understand is during times like this, we want to let our intellectual risk tolerance overcome the emotional risk tolerance.
[00:07:42]Okay? Let’s remember why am I investing? Is it for retirement? Cool. How long away is that? Five years. Less than five years. More than 10 years, okay. The longer the time horizon, the more you give yourself permission to relax. You’ll be fine. If you say, well, I’m investing for a house down payment or a new car, or something like that, then you know, no, it is probably not a good idea to buy the dip here and put the principle at risk.You know, if you’ve got decades of time horizon left, then quite honestly this decrease in stock prices is amazing. You might consider tightening your belt and investing more, as much as you possibly can, your future self will. Thank you. If you do not have decades of time, horizon left, then maybe you’re gonna proceed with caution.
[00:08:53]But knee jerk reactions and selling out when the market is down is rarely ever advisable. And I’ll tell you, and you know, I was talking to clients after the oh seven to oh nine, and this is several years after that, and some clients were saying, man, you know, I’ve never got back. They sold out. I never got back in. That’s the issue. You sell out because you’re nervous and then
you’re gun shy, so you don’t enter. You don’t re-enter the markets and then you miss out on the upswing, and so doing that. It’s really ever advisable because it’s, it’s really hard, if not impossible to make that up. Like if you sell out when the market’s down. So if you have a shorter time horizon and your portfolio is down just like everybody else’s, I want you to ask yourself a series of questions. Okay? So when do I need cash? How much cash do you currently have? How are you allocated inside of your portfolio? Is there a bond portion that you could draw from, if needed, how stable is your cashflow?
[00:09:34]And then what other options of cashflow do you have? Are you married filing jointly? Does your spouse also work in the airline industry? Are they doing some, some other kind of work? And so maybe, maybe you got some diversification there. And I will say that if you were fairly equity heavy and you have a short time horizon, and this caught you by surprise. We still don’t wanna make a knee jerk reaction. You could direct future investments to safer assets or to cash if you’re gonna need it very shortly, you could start to build up the safer side of your portfolio if you don’t need it in, you know, immediately. Essentially you wanna be thoughtful. Yeah. As you proceed. And by the way, when I say shorter time horizon, yes, I am talking to you that are a few years out from retirement, but even still. Let’s acknowledge, let’s say you retire at age 65, you still have several decades that you need your funds to last before the end. That’s the hope anyways. And so, you know, even still, ’cause I, a lot of times I’ll hear folks say, well, I don’t, I don’t have a long time horizon.
[00:10:35]Well, couple decades, that’s, that’s still a long time horizon. It’s not like you were 25. Sure. But still, you still have the proper time horizon to, to invest appropriately here. I also wanna point out that, look, it is okay to have cash on the sidelines. You are not required to squeeze every ounce of yield outta your financial situation. Because there is a price to peace of mind. Sometimes that price is the cash that’s sitting in the bank that’s not working quite as hard as it otherwise could be. But it brings you peace of mind because you know, you don’t have to worry about the market volatility typically, I, I advise against of having a war chest. In the bank, but you know, having cash is quite fine and sometimes folks will carry cash four times like this, and then they want to enter the market when everybody else is exiting, uh, because they’re, you know, they’re thinking about a long-term place. So at the end of the day, we can’t control trade policy, but we can control how we respond to market events and things like rebalancing your portfolio dollar cost averaging into the market.
[00:11:42]Completing a Roth conversion on a pre-tax account because it’s worth less now than it was six months ago. All of those. Are acceptable courses of actions in times like these. So I wanted to address the current market conditions
before we get to today’s episode and the interview. Because right now things are extremely fluid. As the White House, I dare say, figures out exactly what it’s going to do with its free policy, then the market will find its footing thereafter. We hope that. We’re not led to recession, but we are seeing that the banks are, you know, raising their guidance and things like that, the probabilities for recession. So, you know, we will see. But I, you know, I believe, and I have trust, that all of you that are listening are savvy and you will know how to steer your own ships as a means to your portfolios. The decisions that you make and the decisions that you avoid making during turbulent times, because this is certainly the price that we pay for compounded returns over time. This is part of it. Now,I will continue to address market conditions as these things, uh, progress. And if there’s something that you guys want to hear about, like, Hey, when you say rebalance portfolio is exactly what am I looking at, or when does it make sense to do a Roth conversion when the markets are down?
[00:13:01]I am happy to talk about that. Just, uh, drop a note, the infos in the show notes there. So with that guys. Wow, a 13 minute. This could be a standalone episode, a 13 minute intro. Let’s get to today’s conversation, and I hope you’re excited to listen to today’s interview as I was to record it. Well, John Engle, chief Operating Officer of Gulf Coast Western, welcome to the Pilot’s Portfolio.
[00:13:27]John:Thank you, Tim. I’m glad to be here.
[00:13:31]Tim:We’re excited to have you for a number of reasons, which we’re going to get into. But as you know on the show, we talk about all things personal finance. For the professional pilot. You happen to have some aviation experience as well. So tell the listeners a little bit about that.
[00:13:45]John:I’ve been flying since I was four years old, but I am the perpetual student pilot. My grandfather was a hump pilot during World War II, and then he flew the Berlin Airlift. He was also one of the aerodynamic engineers for the P 51 Mustang. Mm. So he helped design the lines for it. So yeah, I grew up flying with him. He only flew instruments, so I only learned to fly the six pack in a uh, turbo commander. And then just, I’ve had so many family members. One of my uncles was an American Airlines pilot. So I had so many ways of having access to airplanes, and then I’ve been on probably more types of aircraft than I can name as far as flying them and having the benefit of just being invited to fly on them. So I just never got my license. However, I just had my solo. I’m flying a sir SR 20, so finally getting it outta the way after 52 years, but it’s getting done. That’s the goal.
[00:14:47]Tim:That’s right, man. I hear so many good things about that airplane, so I’m sure that you’re having lots of fun with that. Boom. The reason that we’ve got you on the show is, like I said, our practice. Specializes in financial planning for the professional pilot, and one of the things that our clients are always talking to us about and asking about is, I have a high W2 income. How can we reduce taxes? It was actually a mutual, somebody that we both know when another pilot in the industry introduced us.
[00:15:20]He said, Hey Tim, this is what I’m doing in his personal life. And then so that got the conversation started. So you are COO of Gulf Coast Western. Who is Gulf Coast Western and what are you guys doing?
[00:15:32]John:So Gulf Coast Western is a Dallas based venture capital firm focused on the energy sector. We were founded in 1970 by my CEO’s grandfather. They drilled all of their own oil wells up until about 2007 when Matt took over the reins of the company. From that point on, we started building joint venture general partnerships to drill the oil wells that we participate in. You know, what that allows our partners to do is number one, for the company.It diversifies us. We’d much rather drill. A hundred wells and own 10% of them rather than 10 wells and own a hundred percent of them. So it diversifies us, it diversifies our partners, and we pass along the numerous tax advantages that are available. In US tax code for people who help develop our natural resources.
[00:16:32]Here in the United States, obviously the goal is to generate revenues from those oil wells all the while providing our high net worth. We only work with accredited investors, but it offsets some of their tax burden by taking some of that hard earned income that the government’s going to take anyway without asking and give you a zero return. And put some of that money at work for you to offset. Some of those revenues that we’re going to the government.
[00:16:55]Tim:So you guys are venture capital firm specializing in the oil and gas space. Before we get to some of the unique tax characteristics that come with your partners, and by the way, just for everybody listening to home, when we say partners, we’re talking folks who invest in the deals.
[00:17:13]John:Correct.
[00:17:15]Tim:So before we get to some of the tax characteristics, why don’t you tell us the type of deals that you’re working on right now?
[00:17:20]John:Yeah, that’s a great question because the tax benefits that are written in the US tax code are there because of the inherent risks in drilling and
exploring for oil and gas. If you’re going out and Wildcatting looking for oil, exploring for oil, there is a very high degree of risk. The risk of drilling a dry hole. Is a real thing because you can have the best engineers in the world and geologists in the world, but mother nature in more cases than not, can throw a monkey wrench in the plan. So what we focus on is infield developmental drilling, where we know the oil is proven to be. And we only work with some of the best operators in the country. A lot of our wells are operated by Chevron, Occidental. Conoco Phillips broad spectrum of the big oil and gas companies. We essentially ride their coattails.
[00:18:10]We participate in the wells with those operators. They are in charge of the drilling, their geologists, their teams of engineers. They’re the ones who pick the locations, and we only drill horizontal wells, so we are not exploring for oil. We’ve de-risked the dry hole scenario. And we do multiple well programs, so we’re not just relegated to one. Well, I won’t put one. Well, in a program, it’s multiple wells with multiple miles of pipe in the oil drilled by some of the best operators in the world. And we’re able to rely on those geologists and engineers and their multi-billion dollar budgets. So we have de-risked. The finding of the oil and gas as much as humanly possible, but those same tax advantages that apply whether you’re out looking for oil high risk, those same tax advantages apply when you’re drilling for proven reserves.
[00:19:07]So yeah, we pass on those tax advantages as if we were searching for oil, but all we’re doing is drilling in the best areas of the country, the big basins with the best operators in the country, and. Generating revenues from those wells because in 98% of the cases they work commercially. But we still pass on those tax advantages to them.
[00:19:30]Tim:So you said a couple things that I wanna focus on, right? So oil and gas, wildcatting, you called it. So the exploration of it is just inherently risky. And you said in the past there’s
[00:19:40]John:absolutely.
[00:19:41]Tim:Could you quantify like the probability of drilling a dry hole?
[00:19:44]John:I would say 75 to 80% when you’re exploring for oil and the wells that you might hit oil, but your oil might not be commercially productive enough to offset the cost of finding that oil.
[00:19:55]Tim:Okay.
[00:19:56]John:So there’s a lot of factors to watch out for, and that’s something that we did a lot of right up until about 2018. We did a lot of exploring for oil because they’re cheap to get into because there’s no oil proven around them. So if you find it, you might hit the mother load. You get a tax deduction if you miss, but again, our clientele, we’re not interested in going out and doing that. I’d much rather drill wells with reputable companies in areas where the oil’s proven to be and have a much higher success rate. To give you an example, you might have a 25% chance of hitting oil while you’re exploring for oil. Since 2018, I’ve drilled coming up on 400 wells with zero dry holes.
[00:20:38]Tim:Let’s talk about that. So oil and gas, inherently there’s a risk there. You quantified the exploration as 75 to 80%. But what you and the team have done is you diversified away a lot of that risk by number one drilling in holes that have known oil reserves. And the way you’re doing that is working with large operators is you get in the game once there’s known oil, and then two, you diversify your deals to where instead of owning, like you said. 10 wells, a hundred percent of it, you might own 10% of a hundred wells, and you diversify that way as well.
[00:21:16]John:Yeah. So what we do, and just to clarify, we buy what’s called non-operated working interest. If one company owns 51%, that’s the company that’s gonna call the shots on the drilling of the well. The company that has 49% typically does not want to answer to the company that has 51%. They might have just a slight differing opinion on how to produce the wells the best. So in that case, they will put in a lot of cases that 49% of working interest out on the marketplace. And I have teams of landmen that look for these deals. They bring ’em to us, and if I like them, will participate. So we’re essentially letting that operator who has 51% of the working interest in that pad of wells.
[00:22:00]We let them run the show. I have nothing to say to, for example, Chevron’s team of engineers. I trust that they know what they’re doing and so in that case, we just pay our proportionate share of the drilling and we get our proportionate share of the revenues when the wells go online.
[00:22:18]Tim:So in that case, you’ve taken something where there was a 25% from the exploration you’ve done since 2018, over 400 something wells with zero. You coming up dry, now let’s talk about the tax benefits that you’re passing along to the partners.
[00:22:31]John:Yeah,so in the US tax code, and it’s actually been written into the tax code for almost a hundred years. In order to develop our own natural resources, keep us off of the dependency of really going and purchasing oil from
our adversaries, which, you know, Iran, Iraq, Saudi Arabia, Venezuela, and Russia. We have our own. Oil and gas right here in the United States, and some would argue the most in the world depending on if we can get it out economically. But the tax code was written so that if you’re gonna spend the money to go out and find oil so that our country can be self-reliant, then by taking that risk, you get to write off, in most cases, 85 to 90% of that investment in the year that you make that investment.
[00:23:20]And so that comes right off of your ordinary income. So if it’s 2024, you get to write off that investment. If you invest $200,000 in an oil well. That may knock you down a tax bracket or two if your reported income is 600,000 or 400,000. If you invest 200,000, you get to write the majority of that off. So now your reportable income is down in the 200 to $400,000 range. And then when the wells go into production, because the oil in the ground will not last forever, there is a 15% depletion allowance on the revenue side. So 15% of every dollar that an oil well generates. Is tax free subject to that depletion allowance, so you get to write off almost the entire investment on the front end.
[00:24:08]In the year that you make the investment and these wells can run for 15 to 25 years, you get 15% tax-free income. So if a well generates a million dollars over its life, you get $150,000 of tax-free income on that side of it.
[00:24:24]Tim: Because there’s two tax advantages that you just mentioned. I wanna make sure that we understand them. The first tax advantage is when I put dollars into the deal, and you said that’s off of. So I’m a captain at some major airline. My W2 says whatever, five or $600,000 for that year, and if I take a hundred or 200,000 from the bank account, from a brokerage account or whatever you’re saying, up to 85 to 90%, I would be able to write off of that investment,
[00:24:59]John:correct.
[00:25:02]Tim:On the front end. And that goes against my ordinary income. So this is unlike, say, a passive real estate deal where I might put money in and I pull forward some depreciation, but it’s only gonna offset other passive income at that time. That’s a big distinction. And then you mentioned the revenues that I start receiving from the deal. There’s 15% of those revenues would be tax free, so 85% would be taxable. When you guys are looking at a venture, you’re putting something. Together. What kind of projections are you using in terms of ROI? So let’s say I invest $200,000, and you speak in broad ranges, of course, because you know.
[00:25:46]John:Oh yeah, because they’re developmental. Like if I was looking at an exploratory wildcatting project, the ROIs might be 20 to one because. We don’t know what we’re gonna hit, and they’re very cheap to get into. When you’re drilling in an area known to have production and proven reserves. Those just to get into the lease are extremely expensive. So we’re looking for, from an annualized return basis, I try to build in based on the wells that are producing in the area around where I’m drilling my wells, I’m projecting high double digit annualized return. Okay, so in the 50 to 70% annualized return, not including the tax advantages on the front end.
[00:26:24]Then on an overall basis, because those wells are gonna produce for years and years. I’m projecting anywhere from a three to one to on the high end of a six to one overall return. The way I try to structure them is so that an investor who comes in, in year one, let’s say 2025, based on the wells in the area, ’cause the best, just like, just like real estate, you have your analog wells or your comp properties, your wells that are in the same areas, general vicinity. That are the same lateral link into the reservoir and the type of reservoir they’re producing from should produce in a similar quantity based on, it’s the same rock, same operator and technology used to complete those wells. So from those production standards of the wells in the area, that’s what I expect.
[00:27:16]I try to build in a. Payback time period, you know, making somebody whole outside of the tax advantages on the front end, 12 to 24 month payback. So if we use the $200,000, that’s 200,000 is not our minimum. 50,000 is our minimum because everybody has a budget and tax needs. But if I use that $200,000 threshold. Somebody who invests $200,000, they’re gonna save approximately if they’re in the highest tax brackets and depending on the state they’re in. You know, they could be in the 50% tax bracket. If it’s a high income earner living in California, they’re gonna save a hundred thousand dollars from going to the government in year one.
[00:27:58]Then they’re going to, based on the wells in the area, if they perform as I would expect them to get a payout in two years. So they’re made whole. So if you compare it to real estate, you’re buying a home for $200,000, the government’s paying half of it for you. So you’re really only out of pocket $100,000, but you make $200,000 back in two years, and then you have renters in that property for the next 15 to 25 years paying you income. On top of that, so, and then 15% of that income is tax free. So I like to equate it to real estate in a lot of ways because it’s very similar in a lot of ways outside of the tax advantages are substantially greater.
[00:28:43]Tim:Thanks for painting that picture.
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[00:29:46]Tim:So we’ve talked about taxes. Let’s talk about liquidity. Like everybody’s familiar with the public markets. So hey, I can buy some publicly listed company today. I can sell it in a year. I can lock in some long-term capital gains, or a year and a day I can lock in some long-term capital gains and go my way. What should partners be thinking about for these types of deals?
[00:30:15]Okay. Major difference there. True. You can go out and if you wanted to invest in the energy sector, you could buy Chevron, you could buy Occidental. You’re buying ownership in that company. That company is taking that capital and going out and drilling oil wells with it. They’re not going to pay you on a monthly basis based on the production of those oil wells. You are hoping that that stock price goes up and you’re hoping that while you’re holding that stock, you get paid some dividends along the way.
[00:30:38]Until you sell the stock though, that’s your, your main payout. So you’re taking a risk in owning a piece of that company during that timeframe. If that company loses money from the place you bought it and you sold it, you get to write off that loss. But at $3,000 a year in perpetuity, in this case, you’re investing in, really yourself. You’re joining a partnership that owns interest in a dedicated number of wells. How those wells produce. You are going to receive the benefits by way of monthly revenues directly deposited into your account, and you’re getting to write that amount off of your, your ordinary income in the year you invested in it, and then you get monthly revenue for the next 20 to 25 years from a standpoint of capital gain.
[00:31:26]You’re gonna be taxed as ordinary income on the revenues that are generated by the oil wells, but you get that 15%. Tax free because of the depletion out. You’re doing the same thing that the big companies are doing.
They’re diversifying themselves by selling ownership in their company, taking that money and drilling oil wells, we’re doing the same exact thing just in a different model that in a lot of ways can benefit the participant. Much better than investing in stock in a company
[00:31:54]Tim:And with the partnership, once you have it is your ability to sell your interest in the partnership or you, you have that interest, you cannot sell it, but you would receive those monthly distributions.
[00:32:08]John:Right? The other key takeaway is this money is being spent to drill a bunch of wells and place those wells into production.There is a market if you wanted to sell it, it’s an illiquid asset. If you’re gonna sell it, you’re gonna go to your other partners that are in that same partnership and say, I would like to sell my one unit of ownership and I would like X based on the revenues that the wells are generating as of right now and what they should be doing in the next, you know, 15 years. And at that point, your partners would either make you an offer or not. But in most cases, if you have oil wells that are generating revenues. On a regular basis, you’re probably not gonna wanna sell it, and if you don’t have wells that are generating revenues, nobody’s gonna wanna buy it.
[00:33:02]So it’s something to think about. Again, it’s only for accredited investors because it is higher risk and the money is spent. But if you keep in mind that the government is going to be taking 30 to 50% of that income from you anyway. Most of our partners, we do have a lot of airline partners as clients. There’s a reason we’re open on December 31st because people meet with their accountants at the end of the year and they’re like, oh my gosh. I’d much rather put it to work for me than have it just go to the government willy-nilly and then have them ship it off to a foreign country. But yes, the money spent, it’s not like something I just want to, you know, set a stop-loss and I wanna sell my Chevron stock at, you know, a hundred bucks.
[00:33:41]If it hits there, you’re in the wells. And from that same standpoint, we do have a lot of retirees and they look at it as an heirloom investment. My CEO still gets revenue distributions from wells his dad drilled back in the seventies. The mail comes to me as the COO and I’m like, I don’t even know these wells, you know? And he’s like, oh, that must be something my dad drilled. But it’s, it’s neat to see those come in. That’s how a lot of our partners look at it too. They know they may not be around when these things pay out, but we basically follow the directions of the estate. So whoever the heirs are or the executor tells us to ship the revenues to, that’s who we send the revenues to. It can become an heirloom investment in a lot of cases.
[00:34:25]Tim:Somebody that’s considering this type of investment, they want to understand the risk in the industry, what you’ve done to diversify in a large way. The risk and to produce. I mean, over the past eight years since you guys have been doing the horizontal, you’ve not had one dry hole. So they wanna understand that, understand the tax benefits that are available, understand just the nature of the investment. Hey, this is the illiquid portion. It’s illiquid, but you are expected to have long-term revenues and that just behaves differently than say your capital market, stocks, bonds, ETFs, or even your real estate, right?
[00:35:02]So it, it behaves differently and, and it deserves a different part of the portfolio. So John, you were saying that before 2018 Gulf Coast Western was doing vertical wells. Since then you’ve transitioned to horizontal wells. Talk to us about the difference.
[00:35:17]John:The main difference is exactly how it sounds. Your vertical well is drilled straight down from the surface of the earth into the formation, and depending on how thick that formation that your, your target formation is, you could have 10 feet of oil, you could have 50, you could have 400 feet of oil. And you’re gonna perforate or pop holes in that pipe to allow that oil to flow through. But you can only produce from that zone and however thick that zone is. So in a vertical, well, you are limited to the amount of surface area that you have touching that oil. Think of it like if you’re a pilot, how much wing do I have? You know, on the air. The same thing is true in horizontal drilling.
[00:36:02]Horizontal drilling works exactly the same way, except you’re drilling down to a depth that your target formation is: you’re bending that pipe, that steel pipe, and then you’re drilling laterally through the thickest part of that formation. And if it’s only 200 feet thick, you don’t care because you’re putting two miles of surface area. In that oil where you might have only had 200 feet. So what it’s done for the industry is, it’s allowed from one surface location. To cover multiple square miles of oil with one drill pad, and you can put 14 wells where it may have taken hundreds of wells to produce the same amount of oil. So it’s much more efficient, but it’s really all about surface area.
[00:36:46]But that same reason that you’ve got so much pipe in the oil is the reason that these wells work so well. It is specific to these areas where you have large. Blanket reservoirs that cover a large, large section. One of our best fields is in Colorado, just north of the Denver airport. Actually, the Denver airport sits right on top of it. But airplanes and oil rigs don’t work too well together, but there’s oil to the north and south of the Denver airport. If you’re flying into Denver and you look down, you’re flying over to the fourth largest proven
reserves in the country. Right now, it’s 2000 square miles of reservoir, so it’s perfect for that horizontal drilling.
[00:37:25]If you’re going out and exploring for oil, looking for pockets of oil, you’re gonna drill vertical wells first just to prove that oil’s there, and that’s where the risk comes in because a lot of those. Pockets of oil that seismic tells these geologists there. It’s really just bouncing back a return that says there’s fluid there.
[00:37:45]In a lot of cases, that fluid is water because almost all of these reservoirs back millions of years ago where the bottom of the ocean, there were ancient shallow sea. The Wattenberg oil field where we’re producing in Colorado was at one time the bottom of the great inland seaway. It’s now 7,000 feet below the surface, but that’s where all of these major reserves were deposited were these shallow seas, the Permian Basin, the Delaware Basin, the Wattenberg Field, the DJ Basin were at one point the bottom of the ocean. That’s where all of the organic life and organic matter piled up on itself because it had a lot of sunlight. Your reefs and your shoals, all of that life was deposited in these areas, and that’s what makes for perfect areas for drilling horizontal oil wells. Because it was deposited in such mass and not just little pockets, that’s taken away a lot of the risk as far as hitting the oil.
[00:38:44]And then even with that. I will not put together just a one well project, because I can have 14 wells on a five acre pad covering eight square miles of reservoir, and I’m always going to have one. Well that outperforms the others, and I’m gonna have one. Well, that underperforms against the others. That’s why I look at averages, and that’s why I put together multi well projects. Our current project right now is an eight well program. So there’s gonna be that top producer and that underperformer, but the average of those eight wells. Should be somewhere in line with the wells that produced in the air.
[00:39:21]Tim:Just another way of diversifying the risk and increasingly increasing the odds of hitting the averages there
[00:39:26]John:built in redundancy.
[00:39:28]Tim:Oh, that’s right. That’s right. That’s exactly right.
[00:29:33]John:One other avenue, Tim, that I wanted to bring up is, you know, a lot of our credit investors have IRAs or 4 0 1 Ks that they’ve been building over time, and at some point. In those tax deferred accounts, the IRS is going to make you subject to RMD, pull some of that money so that they can tax it ’cause
it’s been tax deferred this whole time. We have a way of doing this through an IRA, self-directed IRA and the IRA purchases the asset for you and then we send the revenues to. IRA. So in some cases it can satisfy your r and b if you’re subject to it, but in other ways if your IRA is, you know, generating one to 5% for you over the last few years, it’s a way of taking some of that money that the government was going to grab from you at some point and putting it into a vehicle that can build it exponentially over time, five to one. Overall return over time. It’s just another way of doing it. And then if you have a Roth IRA, you can take some of that and then build it tax free through a Roth IRA conversion. So there are lots of different ways you can do it. The best way is if you are liquid and you have the cash sitting there that the government was gonna take.
[00:40:36]You get the most tax advantages by going the cash route, but you do have the alternative of using some of your IRA to invest in this for the future as well.
[00:40:46]Tim:Thanks for bringing that up. And I wanna follow up on that be you said the best way is cash because you can actually use the tax deduction, the IRA being a tax deferred account itself. Are you giving up then that initial write off and the 15% in income tax-free income, if you use it through the IRA vehicle
[00:41:02]John:You are because it is tax deferred. But if you look at it from a standpoint, if you’re approaching retirement and you’re approaching that RMD date. Where the government’s gonna say you have to, you have to liquidate X amount. In some cases. If you liquidate it out of your IRA, you’re satisfying your RMD ’cause you’re gonna get a tax write off for that same amount. So if you’re subject to RMD, pull it out of your IRA, they’re gonna tax you the $200,000, but you get a tax write off for almost the equivalent amount. Your net tax amount is equal, but then you still get the tax-free income from the revenue side.
[00:41:39]Tim:I see.
[00:41:40]John:The other way. Some of our partners participate is they invest through. A traditional IRA tax deferred. No real tax advantages there. The money that comes back into the tax deferred account is tax deferred as well. But in year two, remember when I said that the money is spent on drilling the oil wells, so in year one, the IRS wants to know what is the value of that asset. If you paid $200,000 for it in year one, that is the value of the asset. In year two, they’re going to ask you for a fair market valuation of that asset because you paid 200,000 for it. In year two, the money has been spent already on the oil
wells. So now you’ve got a significantly less amount to report as far as the asset value.
[00:42:31]And the only value remaining on that asset is the production equipment sitting at the wellhead to produce the oil. The real value is in the ground and it hasn’t come out yet. So in that case, what a lot of our partners do, this is not something we recommend. We’re not tax advisors. I’m just telling you that in the past, our partners with traditional IRAs, in year two, when that fair market value comes out, they convert it to a Roth. They pay tax on that conversion, but it’s a fraction of what it was going to be. And then their revenues from those oil wells once converted to a Roth Grow. Tax free.
[00:43:02]Tim:Tax free. Yeah. So you take the 15% tax free, turn it into a hundred percent tax free on the Roth side, there are a couple things that. You mentioned that a planning opportunity. I wanna circle back around to that RMD because I think the second time you said it, if you’re subject to RMD and the IRA is not invested in a partnership, you could take the RMD out and then use those proceeds to invest, thereby, almost potentially canceling. Tax liability generated from the RMD and then those future cash flows from that would be tax advantage, at least to the two of 15%. And that’s different than, say, just reinvesting it in a brokerage account.
[00:43:46]John:That’s right.
[00:43:49]Tim:Where possibly your long-term capital gains are either 15 or 20%, possibly zero. Typically not with our clients. Right? So that was the one. And then the other tax planning opportunity was the conversion of the IRA on year two because the paper value has gone down so much.
[00:44:06]I used to handle, because my background is I grew up in the oil industry. Then I got into finance and then I got back into the oil industry. So because of that, when I first joined Gulf Coast Western, part of my job was to help facilitate the IRA transactions. And so every year in March after the K ones go out, I was getting inundated by our partners that had IRAs. Roth conversion, Roth conversion, Roth conversion. And one of our partners was an ex IRS attorney. And I was like, why am I getting slammed with all of these Roth conversion requests now when they’ve had these accounts all you know, for the last several years. And he is like, here’s why. And he explained it.
[00:44:46]They don’t get any tax benefits from the traditional, but by converting to Roth, they pay, yes, they pay tax on the conversion, but it’s a nominal. Their revenues from the wells are now tax free. And I was like, oh, that’s brilliant. But
again, it’s not, it’s not something that we promote or we recommend to anyone. It’s, it’s it, the client has to request it. But that is what our partners have done for, for several years now as a way. To get some kind of an tax advantage by using an IRA that wouldn’t ordinarily be there.
[00:45:17]Right. So you’re saying it without saying, hey, this is not tax advice. Consult your CPA to run the numbers and your individual situation. But,
[00:45:30]John:And it’s fun when a partner brings it to their accountant and their accountant’s like. Oh, you know, that’s, it’s fun to see the light bulbs go off because just like mine did, I’m like, I’ve never heard of this. What’s going on? Oh, it does make a lot of sense For the right individual.
[00:45:39]Tim:Where can folks learn more about the process of, you know, oil and natural gas with Gulf Coast Western?
[00:45:48]John:Really the best place to start is our website, www.gulfcoastwestern.com, and uh, we have a lot of good information, video presentation that explains a lot of it. You can request more information and I’ll have one of my associates reach out to you.
[00:46:02]Tim:Well, this has been a fantastic conversation, folks. John Engle, chief Operating Officer from Gulf Coast Western, coming on to talk about. Opportunities that are different from your publicly traded companies, different from your 401k, your stocks and bonds, liquid assets, different from real estate that have a tax benefit to your W2 income, which is what you guys email me and call me and talk to me about all the time as what can I do to offset my W2 income?
[00:46:30]Well, we’ve just talked about a potential opportunity and now of course you’ve gotta figure out if it’s right for you. So what I’d love to do, of course, this is an interview episode. You guys stick around for the debrief portion. But John, thank you so much for coming on the Pilot’s portfolio.
[00:46:45]John:Thank you, Tim. I enjoyed it. And if anybody has any questions, feel free to reach out.
[00:46:52]That brings us to the debrief. That was a fascinating conversation with John Engle from Gulf Coast Western. So today we’ve discussed how oil and gas can be an alternative investment and the associated tax benefits that are available. Now, because this is the debrief, there are three things that I want you to think about, and the first one is. That John mentioned his firm only works
with accredited investors. Okay, so this is common among alternative investments. Uh, most of our clients are accredited investors, and if you’re listening to the show, you probably are or are on your way to becoming an accredited investors soon.
[00:47:29]The definition of investors is simple, right? So, uh, if you’re an individual, you’re gonna wanna have a net worth of at least a million dollars, not including your primary residence. So, hey, we have a million bucks, um, in assets, or you’ve earned over $200,000 in the last two years if you’re single or if you are married, uh, you’ve earned $300,000 in the past two years, and you expect to do the same for the current year. So that’s the definition of an accredited investor, and I think it’s interesting. To see that these opportunities are open to accredited investors because they tend to be a bit more complex than some of the other, you know, capital market opportunities or real estate. There’s some real estate. I say some.
[00:48:17]Some of the syndications and things are only open to accredited investors also. So if you’re an accredit investor, it may be interesting to see how this might work in your financial. Situation. And if you’re not an accredit investor, that’s okay. Keep climbing. You’ll be there soon. So that’s the first thing I wanna point out and have you think about. The second thing that I’ll have you think about is tax benefits. Okay, let’s tax tax benefits. We heard John say that on the initial investment, typically 85 to 90% can be written off of your ordinary income. That is your W2 guys. That’s your W2 income. That is exciting. That should catch your attention, for sure.
[00:48:59]Um, so what exactly does this mean? Let’s say that you’re in a 35% marginal bracket and you make a hundred thousand dollars investment. By the way, I think John said his minimum was 50, but let’s just use a hundred to keep our numbers nice and easy and clean. So, uh, you make a hundred thousand dollars investment and let’s say that 90% of that is deductible. So what does that mean for you? That’s going to decrease your taxable income by $90,000 that year. And then to figure out how much you’re gonna save in taxes, we’re gonna take your marginal rate, your 35%. And we’re gonna multiply that by $90,000 and we’re gonna see that there’s $31,500 and taxes not paid.
[00:49:41]That’s money saved in your pocket. I think the ability to offset W2 income on the original investment is extremely interesting, but then it’s followed. It’s not done there. It’s followed by a 15% tax deduction on future income that the wells produce. So. As we discussed in the show, contributing with cash may give you the most tax deduction upfront. Okay? However, there seems to be opportunities to work the tax code in your favor. If you invest, say,
in an IRA. Then, you know, in years one or two that the value of it is gonna be substantially lower and then you’re doing those Roth conversions. It sounds very similar to what I mentioned in the intro about, you know, how you can take advantage of a down market by utilizing Roth conversions.
[00:50:39]So, you know, I think those tax benefits are certainly interesting and it, and it makes you take a closer look. The third thing that I want you to think about is just the overall investment characteristics. I cannot say that this is different. Then a lot of the other things that we’ve talked about on this show, this is truly a buy and hold investment, right? So you’d want to consider it as an income investment rather than a growth investment, right? The difference being the growth investment. Hey, I’m gonna buy something at $10, it’s gonna appreciate and become 20 or $25 over time, and then I’m gonna sell it and I’m gonna pocket the difference, right? You wanna think about this as an income investment because you know, John mentioned it’s rather illiquid.
[00:51:13]He said that there may be possibility of selling your interest to other partners, but I think that for planning purposes and an investment analysis, it’s probably best to consider this an illiquid investment, and that once you buy it, you’re going to expect income from it as long as the well is producing. If it outlives you, you’re gonna pass that, that interest on to your heirs. Right. So I don’t think I can state enough that just, you know, this is, the characteristics of this investment is quite different from capital markets, the stock bonds, mutual funds that you’re used to buying in your 4 0 1 Ks, or the real estate that you might’ve had experience with single family homes or quadplexes or duplexes or what have you.
[00:51:59]You can go and sell those, uh, if you want. And so, and I think there is a reason that these investment. Opportunities are open to accredited investors, uh, because they just, by nature tend to be more complex than buying just shares of, of your favorite company right off your phone or on the computer or what have you. So I think that it’s good for us to acknowledge. Those differences and then evaluate, is this an investment opportunity for me? And if so, how do I complete the due diligence on this? And then how do I move forward? So guys, that’s gonna do it for this episode. Thanks for joining and I’ll see you on the next one.
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