THE UNKNOWN TAX WRITE-OFF

Last September, John Fahie, a Calgary financial advisor, participated in a farm-out to drill a shallow gas well in central east Alberta. To test the waters, he invested $20,000 for a 3.75% working interest in the project. The well is now a producing gas well, and due in part to the ever-increasing price being paid for natural gas, he will received his investment back in less than 15 months - an 80% rate of return. He also expects to receive over $100,000 in the next 7 years. John is extremely happy about his investment, but now questions "This is one of the best investments in Canada - why hadn't I heard about this type of write-off sooner?" THE BASICS The overall philosophy here is simple: The government tax collection department - Canada Customs and Revenue Agency, (CCRA) allows up to 100% deduction of drilling costs from your personal or corporate income. So why give your money directly to the taxman if you don't have to? IN A NUTSHELL Investors drilling for oil and gas are able to deduct the costs of drilling well(s) under Regulations 1206-1219 of the Income Tax Act. Any and all Canadian individuals or corporations, not just oil companies, can deduct the costs of drilling wells from ordinary income. Deductions come primarily in the form of Canadian Exploration Expense (CEE) - 100% and Canadian Development Expense CDE - 30%. There are also deductions for equipment (25%) and land acquisition (10%). A SAMPLE Peter Krebbs invested $50,000 in a wildcat well in North central Alberta. The total well costs were $750,000 including land costs. Peter ended up with 5% of a discovery well, which will pay him quite handsomely. He was told he should expect to receive around 8 times his initial investment over the next 10 years. The well qualified as an exploratory well so he deducted 75% of the $50,000 from his gross income. He also deducted 25% of the remaining $12,500 for his portion of the equipment costs. Had this well been a development well his deduction would only have been $15,000 (30% of $50,000). He would receive the same equipment deduction. THE OIL PATCH FARM-OUT (really a Joint Venture) While most of the capital utilized to drill Canadian oil and gas wells comes from cash flow of the oil companies themselves, there are several other sources (e.g. Flow-through Shares and Limited Partnerships). But the main outside source of capital is the Joint Venture (JV). The JV is called a farm-out in the oil patch, and is almost always a Joint Venture between an oil company and investors. WHY DON'T CANADIANS KNOW ABOUT THE JOINT VENTURE? The oil patch is a highly technical industry with very specific classifications of personnel in it. Where else is there a roughneck, a roustabout, a SAGD engineer, a log analyst, or a frac engineer? Indeed, many employees within the industry do so specific a task that they have no idea how the industry works from a bird's eye viewpoint. Add the fact that there are thousands of consultants, service and supply businesses, plus a drilling and geophysical contracting industry within the oil industry, and an insular problem develops. These products and services are the very backbone of the industry, and each one of them caters to a specific need of the oil companies. It is complex! To further compound the complexity, fund raising is done by a very few because cash flow from their own production provides oil companies with most of their financing. Outside capital for the oil patch is raised through brokerage houses utilizing many types of share issues and/or different types of debt securities. Liability for most individual oil companies is reduced through farm-outs and partnerships made primarily within the industry. In this manner, the brokerage and bank industries have become the major sources of funds of the oil patch. But there's a conundrum: Most bankers and brokers are not trained to evaluate farm-outs. In addition, most accountants and lawyers, especially outside of Calgary, have no training in this regard either. Engineers and geologists and landmen each look at farm-outs from a totally different viewpoint. Thus the circle becomes complete - and closed. After learning the complexity of the industry, oilmen find it difficult to describe it to others, and so end up being seen as insular. People outside the oil patch come to a conclusion that the oil patch doesn't want them. I.e. The oil patch unwittingly presents a closed door to most potential investors. Regardless of how irritating this is to outsiders as well as insiders, it has become the status quo. SOME CONSIDERATIONS When considering investing in an oil and gas Joint Venture, the investor should keep the following maxims in mind: The quality of the investment is by far the most important consideration. In general - the greater the risk, the greater the return. (duh!!) Remember that most step-out and infield wells have a relatively high chance of being a producer. (But there is a sign over my desk that reads "there is no such thing as a sure thing.") Be careful of whom you hire for legal, engineering, geological, accounting, tax and management advice. They need to understand the industry; and many that give advice - don't. The JV investment package should have a geological or engineering opinion and/or a cash flow attached. Should you be uneasy, have it checked out, but remember, a friend's free evaluation may cost you far more than you paid him or her. Don't only buy tax deferrals; buy the best and logical proposition. Buy management who have a strong knowledge of the oil and gas industry and who have a good track record. WHO HAS DONE THIS? The tax advantages of investing in O&G JV's can be large. However, the list of investors in oil and gas Joint Ventures from outside the oil patch is still relatively small. Over the past decade, several pension and trust funds, as well as some of the insurance companies have participated in this highest taxed nation in the free world. Additionally, more than a few oilwell service and supply businesses have ventured into the fray. Wealthy individuals and a small number of not so wealthy individual investors have also invested. And businesses not associated in any manner with the oil industry are starting to inquire. Recently there has been an increase in investing consultants introducing their clients into this type of oil and gas financing. Why wouldn't they? Let's face it: The mutual fund business has not been their friend over the past several years. The Rates Of Return from Joint Venture farm-outs within the oil industry appear much more interesting than the discounted mutual funds. THE OPPORTUNITY It's up to you to decide whether your tax money should go directly to Ottawa to get lost in their bottomless pit, or to have the possibility of receiving a good return on your investment. There are over 500 rigs at work, crude oil prices are high, and natural gas has become a premium commodity. Opportunities for those wishing to participate in the drilling boom in Alberta is at an all time high. The future for Western Canada and the oil patch looks exciting and rewarding. AND IN CONCLUSION Most Canadians, including Albertans, are not knowledgeable about the oil and gas business. Individuals and businesses outside the oil and gas industry traditionally have ignored investing in the industry by asserting, "Drilling for oil and gas is high risk business and you're better off staying away it." But John Fahie doesn't agree! He states: "The farm-out has been good to me! I believe Canadian investors need more education about this great write-off." He also said; "We also need more knowledgeable contacts in the industry. This will help us to understand the risk and take advantage of what is really the best tax write-off in Canada."   LARRY C.M. DARLING IS A PETROLEUM PRODUCER AND CONSULTANT SPECIALIZING IN OIL AND GAS JOINT VENTURES. FOR FURTHER INFORMATION CONTACT LARRY AT (403) 265-7170 OR FAX (403) 246-4741. e mail address is larry @larrydarling.com.