In the case of an energy-based program, most of a participant’s interest lies underground; hence the term “subsurface interests”. Subsurface interests are often referred to as mineral rights and include interests in oil and natural gas.
There are two types of mineral rights for an investor to consider. The first type is called a royalty interest, in which owners do not have the right to enter the land to extract oil or gas on their own accord, but they are entitled to a percentage of any extracted minerals. A party separate from the owner of the royalty interest is contracted to enter the land for exploration and drilling.
The second kind of interest in mineral rights is called a working interest, under which the owner of the working interest is given exclusive authorization to enter the land to extract oil and gas. So, in addition to sharing in production revenue, working interest owners share in development and operating expenses as well.
These two different investment structures offer participants varying levels of involvement and ownership. Both working and royalty interest investment programs feature advantages similar to many DST/TIC investments, such as monthly cash flow, tax deferral and a 15% depletion allowance.
There are other advantages to consider when deciding on diversification outside the traditional real estate sector. In many of these oil and gas programs, there are no mass closings or closing costs. Such an investment is not dependent on real estate values or rent collections, and participants benefit from a virtually unlimited product demand. Also, the ability to diversify out of 100% real estate makes these programs appealing today for many high net worth individuals.
However, direct investment in oil and gas requires a great deal of due diligence. Even though product demand is practically unlimited, the market price can vary significantly based upon ever-changing variations in supply and demand as well as unpredictable geopolitical events. These investments can offer higher rates of return than other real estate offerings, but they should be considered more risky. Before proceeding, it is important for investors consult their financial advisor to consider their overall portfolio diversification and goals, and whether or not an investment in oil and gas interests is suitable for them.
Finally, many oil and gas programs are designed to meet the qualifications of “like-kind” replacement property, and are thus eligible for 1031 exchange purposes.