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Energy investments can be very profitable in a vacuum, but their value may be even higher in the context of a VHNW/UHNW investor portfolio, given the substantial tax benefits.
Matt Iak, executive vice president at U.S. Energy Development Corporation, joins the show to discuss several tax-advantaged energy investment strategies that family offices and VHNW/UHNW investors should consider.
Watch On YouTube
- Background on USEDC (the U.S. Energy Development Corporation), and who the company serves.
- How the fundamentals of energy investment in 2022 make it a very attractive space to invest.
- The reason why many institutional investors are leaving the space (and why that creates an opportunity for family offices and private investors).
- The four major types of private energy investments (and which three have the most massive tax advantages).
- Details on how USEDC works with RIAs and other advisors to help them select offerings that are optimal for any particular tax situation.
Featured On This Episode
- For Financial Professionals (USEDC.com)
Today’s Guest: Matthew Iak, U.S. Energy Development Corporation
About The Alternative Investment Podcast
The Alternative Investment Podcast is a leading voice in the alternatives industry, covering private equity, venture capital, and real estate. Host Andy Hagans interviews asset managers, family offices, and industry thought leaders, as they discuss the most effective strategies to grow generational wealth.
Andy: Welcome to the Alternative Investment podcast. I’m your host Andy Hagans. And today, we’re talking about a very exciting topic, tax-advantaged energy investing, very top of mind right now, this year, especially. And with me, I have Matt Iak who is Executive Vice- President at U.S.
Energy Development Corporation. Matt, welcome to the show.
Matt: Thank you so much for having me, Andy.
Andy: So before we dig in here, could you tell us a little bit more about U.S. Energy? What the company does? Who it serves?
Matt: Yeah. It’s a phenomenal question. U.S. Energy has a long storied history. We’ve been in the energy space for over 40 years. And we’re one of the few, I call it U.S. success stories, where you start with generation one, and you successfully transition to generation two and beyond. And I think we’re most proud of, kind of, that family tradition of being here thick and thin through an awful lot of ups and downs in the energy space, right?
It’s probably the most cyclical and violent alterations in your business model from year to year. So we’ve really built this lasting enterprise that we are very thankful for the generations before us, that put in all the hard work to allow us the opportunity to do what we do now. So, in the most macro sense, our company, although you know, many, in the oil and gas space, see us as a great joint venture partner, where we’re participating in what you call upstream E&P, exploration and production business.
We’re also probably one of the largest and most successful sponsors of investments in the U.S. in private placements in oil and gas. And what we love to do is, kind of, be a thought leader on designing tax arbitrages that meet the energy space. And so our whole thesis as a company is to be the most well-known and well-respected direct energy company in the U.S., that’s really what we try to do and really shine a light that there are so many good tools in this space, so many good partners to choose from, and kind of change that whole paradigm of what people think energy investing is.
There’s just an awful lot of opportunity sets. And our goal is to bring as many of our partners and friends and industry peers into the light to allow investors to really take advantage of those unique domestic investments that often have disproportionate advantages to the wealthy because of the tax side of it. So, that’s really what we do as a company.
Andy: Absolutely. So on that note, so, a couple of things you mentioned that I thought were interesting. I mean, I think a lot of people don’t really understand the U.S. energy, you know, industry. They’re thinking, “Oh, it’s these mega-corporations,” when in reality, a lot more smaller, independent firms, family-type businesses. It’s a really interesting world.
But, you know, one thing you mentioned is the tax advantages and how USEDC is a thought leader in how to, I guess, wrap some of these investments in attractive wrappers. So, yeah, I know a lot of family offices, a lot of ultra-high net worth, and RAA’s who we work with, ultra-high net worth investors, you know, they would be a fit, certainly for these types of investments.
But sometimes they’re more used to, you know, multifamily, industrial, real estate, those types of private placement offerings. So, I guess, how would you compare an energy investment or the appeal, I should say, of these types of investments to, you know, that more kind of typical real estate investment?
Matt: Yeah, there’s always a discomfort for someone who’s not used to it yet, right? Because you don’t have that structure that you can just juxtapose one investment to the next because they’re all so different, right? Because of the nature of so many small businesses in oil and gas, and especially those that are allowing investors to participate outside of the public markets, there’s just so much separation in style, in fees, in design.
I think one of the hardest things is there’s no set rubric that we all understand as a standard, right? In private equity, it’s a two and twenty with some hurdles, right? Everyone knows, right, that there’s a structure, there’s a format, and that component of oil and gas when private equity is involved, at least that’s flat, but when you open up the surface, you get deeper, who’s doing the drilling, who’s doing the activity, who’s the operator, what are the fees, it becomes, I think, overwhelming.
And then you tie that with the history of, I’ll call it relatively poor performance as a sector for a long period of time. I think people avoided it for a long time. And then you add on to that all the complexities, all these tax nuances. Man, it becomes a question of really just getting people to understand that if you bucket ties, the styles, you can compare them and contrast them.
And you do get some sense of formality of how to review these things. But it’s hard at first, it almost becomes like drinking through a firehose because there’s too many options. And I think if you take the white noise out, you actually find there is a much closer parallel between them. And then you could start to do analysis. But I think at first it’s drinking through a firehose, to be honest with you.
Andy: Well, okay, on that firehose, I think a lot of these family offices and RAA’s, they’re used to doing due diligence, or at least going through due diligence, analyzing it with multifamily deals, with industrial deals, you know, with more of these sticks and bricks type deals where they may not have as much familiarity with energy. So, how do you get started?
I mean, if you’re an RAA, and you know, you’ve already taken the dive, and you’re researching private placement offerings in the real estate world. How do you get started in saying, “Okay, now, I’m also going to do that and enter?” Is this something that you really need to be a specialist to even look at?
Matt: I don’t think so. It’s a great question. I think, obviously, trust is one easy way, right? You know, someone who does this, you trust them, you find out who they utilize, it opens the door. So, you know, we and others have hundreds of relationships with large RAI’s, family offices, X, Y, Z. You can ask your friends and peers for their review. It’s probably an easy way to enter in it.
But not to pitch for any of these third-party due diligence firms, there’s really good third-party due diligence firms that don’t represent us or other sponsors, they represent the RAAs, broker-dealers, investment houses. And you can go to those specialists and say, “Hey, who do you review? What fund structures? Tell me who I should be talking to, based on our needs?”
And I think if someone’s not doing a third-party review, they’re probably not scalable. Right, they probably don’t have the scale, that really…it doesn’t mean they’re not good, it just means they’re not scalable in a real repeatable sense. And they probably know…
Andy: What does that mean, just they’re not big enough economically to invest in the third-party due diligence, so…
Matt: Yeah, the cost that’s going to be prohibitive, and they’re not used to getting the sturt looked up in an uncomfortable fashion where someone’s doing background checks all the way to data testing, and [inaudible] privacy and security, and all the, I call it the G [inaudible] ESG, all those governance things, independent audits, and all the stuff that you would want to see in a best in class product, probably isn’t there on a smaller scale.
So, you know, if they’re going through those bigger reviews, they probably have all that in place. There’s a lot of cost mirrors to get there, it doesn’t mean that products aren’t good, or they’re not good. It’s just not repeatable and scalable because they don’t have all that built in.
Andy: And those kinds of deals, they might be very profitable. But then you’re going to have to rely on your own connections, your own knowledge, your own, you know, experience…
Matt: My only advice to anyone who would be in this space for as long as I am, I wouldn’t do it unless I personally know and trust the other side because too much can go wrong in that transaction, right? So, it’s got to be, like, a one degree of separation, and then go with it because it can be better larger structure product. It doesn’t have all the fees and costs, right? And that’s a [inaudible], but it is 100% trust in the other party. So, if it’s not going through those channels where they have independent reviews, I would probably say, if it’s not a direct one degree of separation, no matter how good it is, just let someone else do it who knows them, right?
Keep it a one-to-one.
Andy: So, then it sounds like due diligence in this world, in the energy world, you’re more diligencing the people involved as much as the project.
Matt: I think there’s too much focus on the project because the reality is, it’s paper, you can model anything you want, right? And I think there’s just too much diligence on the paper. And so the process and repeatability, and the partner, those are things that you can control. Now, obviously, you should know their process in choosing the right property.
But I think too many people get blinded by the idea of a property, and unfortunately, it doesn’t work out when either the geology, the operation, something doesn’t go to play. So, I do think you want to take a 30,000 foot to go and then test if the property works, right, but that’s probably the least important part of due diligence.
Andy: Interesting. Okay. So, let’s dive in then to the types of investments and I think largely we’re talking about private placement offerings. That’s a big focus of our show here. That’s mainly what we cover. And I know in our notes that we talked about, we’re going to cover four different, you know, product structures broadly, and three of them are very tax-advantaged.
One of them, maybe not so much. So, why don’t we start with the relatively non tax-advantaged product type of the total return fund? Could you talk about what is the total return fund as it relates to energy investing?
Matt: So in the world of direct securities, there’s kind of two styles that you’ll see in these total return funds. Again, I’ll call them non tax…there’s four… well, not really designed for some type of arbitrage.
So a lot of them will be called land banking, where companies will go out and purchase an area that they believe has got great geology, and it might currently not be developed or getting developed. And really, what they’re trying to do is as it develops, take the acreage from, say $1,000 an acre to $20,000 an acre as everything, all the work gets done in the geology gets proven up to be fact, right?
So land banking is a big part of this total return style. You’re not really counting on one hour, two hours to make money, sometimes they can lose money, but at the end of the day, it proves up the area’s worth it, right? And you see a lot of that fall into the private equity bucket, right? So when people fund the big NGPs and KKRs and then they drop money down to private equity. It’s really what they’re doing, right?
They’re finding these census tracts in good areas, and they’re acquiring a bit of it, and they’re trying to do a couple wells to increase the value and flip it, right? It’s kind of a total returns down. In the tax sensitive areas that, there’s usually some embedded losses and gains, they don’t kind of offset each other inside of it to create more of an efficiency on the end. Or people will structure them with a blocker corp.
And that blocker corp will pay dividends instead of pass-through income. So, it doesn’t generate what’s called UBTI, unrelated business income, really allowing pensions, endowments, retirement, you name it, to invest in the asset class without UBIT. So that’s kind of the only real tax to see those total return funds, right? And they usually have an idea or a thesis about an area, they’re growing it, and they’re finding an end buyer on the backside. That’s really what’s happening. And a lot of the recently shifted [inaudible] are used to buying production, more so than buying more land, because it generates a little more cash flow for everybody in between.
And so you’re seeing what they call proven, developed producing areas be actively acquired in those areas as well.
Andy: Are you seeing more institutional buyers, you know, interested in those types of investments? I mean, obviously, cash flow has been pretty hard to find, income has been pretty hard to find in the past 36 months, so has that made it more attractive, you think, to those institutional investors?
Matt: It was super interesting. There’s a huge demarcation line. In that institutions, there’s not a lot of oil and gas. And then ESG became a nom de guerre, right? Environmental, social, governance or impact or renewable, whatever want to call it. And what you start to see is a lot of pensions and endowments shy away from oil and gas.
So, actually, there are more sellers than there are buyers right now in that space. For a short period of time here, people have filled the gap. And a lot of private wealth has come in. Probably the largest private wealth funding has been in the last 12 months in oil and gas. So family offices, or really probably RIAs are probably the really biggest participant.
Private equity is dead because they funded all this pre-COVID. And then they have all this acreage that isn’t being developed. They bought kind of out of the money. And there’s no one developing it yet. So private equity obviously has a big tombstone on it, where they have all these great assets, but they can’t monetize it because the public companies aren’t buying anyone.
They’re just drilling their own wells. So you have a lot of people with really good acreage, and no way to monetize it. It’s kind of a weird…so private equity isn’t really competing. It’s really family offices and direct capital in the wealthy part that has come in because the public companies aren’t doing more and private governments are tapped out. It’s really down to this one small subset of quasi quib, right, that really are our main participants in growing oil and gas right now.
Andy: So, you know, that’s really interesting hearing about institutional, you know, being net sellers. And it makes sense, you know, due to a lot of the ESG mandates. I mean, zooming out to the very, you know, 10,000-foot view of portfolio allocation, that should give some sort of premium then to the sector, right?
Because it’s not like they’re not investing because of a economic or financial reason, it’s they’re choosing not to invest based on a frankly subjective value judgment or whatever you want to call it. And so it seems to me that that would give a return premium, you know, at least in the abstract or theoretical sense.
Matt: Yeah. So I mean, I literally think [inaudible] Blackstone. He’s so upset. It’s the single biggest wealth transfer arbitrage he’s overseen. Because now you have, mostly by his lead, you have all these people leaving the space for capital.
And yet the returns are so great. So, the private sector’s getting it, and the public sector and all the big houses are missing out on it. I think it’s awesome. But yeah, it’s, you know, ultimately, if there was more demand, it would be more competitive, and it’d be harder to generate returns. It’s actually easiest…normally when oil is this high, you’re competing for limited resources. And it’s not that way.
There’s still no funding relatively coming in the space. They’re still trillions of dollars short in the energy space for development. And it’s really kind of an unbelievable spot to be in at high prices. Usually, it only happens when oil is 30, it’s doesn’t happen when oil is 100.
Andy: Yeah, it’s crazy. I mean, and meanwhile, you know, United States asking for oil from foreign countries, you know, anyway, we won’t go down that rabbit hole.
Matt: Give me a seven-hour conversation.
Andy: That’s a different podcast. That’s my other podcast. That’s my unofficial podcast. So then let’s talk. We talked about the total return fund, so it makes sense that’s more appropriate, you know, with a lot of institutional investors. And now let’s move on to the drilling funds, which are give you that immediate write off, and oftentimes cash flow.
Tell us about the drilling funds.
Matt: Yeah, so the drill fund structure has been designed for decades and decades and decades. And that structure tends to have large upfront tax benefits. So, investors who look at that vehicle, and I’d say that historically was almost 75% of all the retail capital that came into oil and gas in direct offerings was probably in this bucket, maybe even 100% for a really long time.
So growing, this was kind of the core. And what investors have known that it gives me this massive write-off. And depending on who structures the fund, it can be as little as 25 cents on the dollar, to as much as 90 cents on the dollar, that I get in my first year as the deduction. And that’s just a tax allocation timing unit, eventually, investors get 100% write-off for all the assets.
It’s a timing issue for all these different fund sponsors and how they capital… and how they raise the capital. But there’s a bit [inaudible], right, so one investor might invest in a series of wells, and they get, you know, a 25% write off and one gets a 95%. It doesn’t make one better or worse. It’s just the structure and the architect of what that sponsor is able to do from a tax design, right? It’s big write offs, it’s ordinary income, or passive income or capital use, wherever they want to take it in their capital stack.
And then they own a series of wells that give cash flow but deplete, right, because you only own as many wells as you first drill. It could be a part of one well, it could be 70 wells, depending on how big the portfolio is, or how small the sponsor is, there’s a huge range, right? You can buy in with a partner on just a 1% interest in a well, all the way to investing in, you know, multi-100 million dollar projects.
It’s a huge gambit. But those write-offs tend to be the major driver for the past 25 years, where investors love to come in and get big tax deductions. What shifted on its head under the shale plays is first with oil about four years ago, and now with natural gas and oil, where the economy, economics, probably way outweigh the tax benefits, which is great because that’s what you want, right? It used to be the tax benefits were probably the largest component of success.
And the economics were marginal if you wanted low-risk drilling, right? But now, post advent of horizontal drilling, post changing in a pricey paradigm where, you know, oil is above 40 and 50 a nd natural gas is above $3 and $4 in MCF, now you see the driver being these great economics, but still the same tax benefits they always got. So it’s a nice macro paradigm shift.
And then of course, with good companies, it’s even better, right? So there’s still going to be a big discrepancy between the best and the worst inside of that, but from a macro, the headwinds are really behind you and you’re probably in the inning three of nine of a really good macro success on both sides of the equation. So, really good, I think, opportunity set for investors for the last couple and probably for the next 7 to 10.
Andy: Interesting. So, it sounds like, you know, maybe for a while that the tail was wagging the dog at least a little bit. And then now people are saying, “Wow, look at the dog,” you know, with the price of oil, price of natural gas, where it is, meanwhile, institutional investors are leaving the space. So, yeah, that sounds like some tailwinds.
Matt: The good news is a lot of the bad sponsors are in that space, and most of them went bankrupt last winter. You’ll start to get more of them coming back in as prices are high. So… But what’s left in the industry, I think, is a really good core of great firms that have made it through thick and thin, and really do well. So, you kind of got a lot of…now, it’s gonna get, if you get high prices for, like, seven years, you’re gonna keep adding a stack of not-so-good players in any industry, right?
It’s gonna be there. But I think the core of what’s there is really solid. And I love that. Right? It gives investors a greater probability of success, when both the macro and the specifics are better.
Andy: Are most investors diversifying into, you know, like a family typical family office? Do you see them co-invest into multiple deals and, you know, spread the rest around?
Matt: Yeah, we…I mean, broadly for us, yeah. You see, you know, large family offices, and we tend to back it up, just us, high level, we focus a lot on the individual arbitrage that a family office client needs from a tax perspective, we try to see if one of our designs works better or a combination of designs.
Because we don’t want anyone to be leaving on the table, right? Just because you want to invest in the sector, it’s great. But if one arbitrage is better for you than another, you better use a tool that maximizes the net benefit to your individual tax base because literally, you could have four investors who have four very different needs.
And so, they should be using different styles, they shouldn’t just be coming into one fund because the nets, what you keep, right, not necessarily with one of them. So the net method can be very different in all these different tax structures. So, you know, a drilling fund is cool, great cash flow, great IRR. But if you’re not someone who has a lot of W2 income, or it may not be the best tool for you, right? So you and I know this very well, you know, the opportunity zone test thT we’ll talk about Iin a couple seconds, if you have a capital gain, the best structure might be an op zone and not a drilling fund.
And it can be that different from a tax basis that net return that you want to analyze it pretty specifically.
Andy: Yeah, I mean, you pretty much would want to be at that top marginal tax rate, income tax rate to have that immediate write-off value really be substantial. So that makes sense. We do want to get to opportunity zones. It’s a favorite one of mine. But before we get there, I have that as number four in my notes. So, I want to talk about 1031s next.
And you know, one thing I was wondering there when folks use a 1031, are they always transacting into, you know, a directly owned property? Are any of these structured as, like, a DST or are they all individual…?
Matt: That’s an awesome question. Yeah it’s a great question. So, DST, Delaware Statutory Trust, is pretty tough in oil and gas. There are some companies I’ve seen do it. it gets a little harder because the master lease concept isn’t so valuable in oil and gas. So you don’t want to fail in one of the seven deadly sins.
So I have seen a few companies do a DST historically. I’ve personally done a ton of research on it. I get a little waffly on its success to meet the tax code. So we haven’t really executed on it, but I do know there are companies who do it. So most of the structures are direct title, where people are taking physical deeded title, not a tick to each pro rata share of what they own.
Andy: So it still is…so, sorry, is it still fractionalized then? Because I mean, the benefit of a DST is obviously you can take an institutional-grade asset like a Class A or whatever multifamily building or triple net leases or whatever it is. And then you can basically make shares. So, it sounds like you’re still able to achieve substantially the same thing.
Matt: So, in some ways, better and worse. So there’s two asset classes that work for 1031s in oil and gas. So, mineral rights, which means imagine everything above the ground is your real estate, right, your surface rights, flip it on its head, and everything below the ground is your mineral rights.
So, that is deeded title property. So, when you own those, it’s no different than any other real estate 1031. Simple, I take deeded title property, and you fractionalize those into units where I own one third of 1000 acres, someone else owns…and you do this all over the U.S. and these fractional interests were both existing in new production on it.
And that’s probably the most common 1031 is this… let’s say there’s a pool of 10 to 100 million dollars of assets and you own a fractional interest in all of those areas. The cool part is, technically, you can go and sell any fractional interest on any exchange you want, you could just go trade it and sell it at an auction tomorrow.
You don’t have to hold the whole fund because you own deeded title in each piece. So, it gives you a lot more control, maybe good or bad, you don’t want that kind of control. So, depending on its structure and if they’re a real operator, or if they’re just a syndicator, someone who structures stuff, you might have different control. But the direct title stuff has some pretty cool properties to it.
And it is, you know, cap rates are 11%, 12% in oil and gas, not 3%. So it’s kind of a different…
Andy: I’m listening, you’ve got my attention.
Matt: So, there’s also some negatives, though, because you’re not going to replace debt in oil and gas. So if someone’s doing a $10 million exchange, they might only have to cap out at 2 in oil and gas, because they’ve got to replace the debt with the other 8 somewhere else, right? So you got to…it’s not going to…it’s not a perfect solution for a whole 1031 usually.
What we’d see, you know, just kind of anecdotally is most people do them as part of a diversification in a higher yield portion, just a different return profile, right? But it has other cool tax advantages, like, you know, in real estate, once you get to a zero basis, what happens to the ongoing revenue?
It’s taxed, right? In oil and gas, you still get 15% of your income tax free even after a zero basis. So there’s some really cool parts of the code that exist specifically in energy that don’t exist in other asset classes. And so, marrying those together in a whole big transaction, you often can get a greater net tax benefit for clients than they would in just one single asset.
So, a cool tax code. The problem there is very similar until the pensions and endowments really started divesting a lease, there was too much money competing for too few assets. So, when you look at Harvard and Yale and all these major endowments, mostly what they own are mineral rights, because they’re in perpetuity revenue hawks, right? And they just hold them forever.
Well, now they’re being forced to divest them. So it’s probably a better time to be a buyer, even though prices are high because of all those sellers.
Andy: Interesting. And I guess, what’s the theory behind? I mean, I guess I can guess, but the theory behind energy being so tax-advantaged, is it just, you know, the idea that this is a strategically important industry, even militarily speaking, to have domestic production? That seems to fly in the face of a lot of federal energy policy, you know, right now.
So, do you think that that in the very long term, do you think that’s a risk? Or do you think that, you know, it’s so strategically important that surely they won’t go there, you know?
Matt: So, I’ve been in for 20 years. And if you asked me this question years ago, I would have said, “There’s no way anyone’s dumb enough to take something away that’s so strategically important to this country.” I no longer believe that anything is off the table anymore. I definitely believe we’re all dumb enough to do everything wrong in any way that we can. So, it came up first with Obama, where they were going to repeal a lot of these tax benefits.
And they came again, now with Biden, so definitely, it’s an at-risk item. Because anytime there’s an asset that they don’t like that’s getting these tax advantages, it’s going to be fodder. The problem is the economic harm is so great that when you go to the OMB and try to do an analysis to get it in a budget because everything only passes to reconciliation, right, so you have to balance it.
Now, the negative harm is so great, just like when they tried to change the 1031 laws, the negative harm is so great, they can’t get it in the budget, because it would actually require so much more increases in tax base to offset all the economic loss. So, the biggest problem is that they say that’s the budget, but when you balance it out, it actually kills the budget, right?
Because you lose severance taxes and all this revenue, and ultimately higher energy prices destroy everything, cause massive inflation as we’re seeing now, right? So, I think the real problem is people want it off the table. But you are correct. It was originally designed and redesigned in the ’70s again to incentivize because we went through that nasty time where we were dependent globally on some bad actors that, you know, the reason that we created a strategic oil reserve was because of the oil embargo in the ’70s.
And so that when we went to war, we would have enough oil to fight a war, right? And we wouldn’t be based on the market whims of delivering us what we need. We got rid of that sphere, cut it in half, not a wartime, scary, right? It lowered price a little bit, but pretty scary when we look at the backside of now you don’t have enough oil in a emergency.
So a lot of these tax laws, a lot of these things are done to incentivize that domestic production.
Andy: Yeah, and you know, hopefully, the powers that be in a year where we’ve essentially gone to Venezuela and Saudi Arabia and all of these countries to beg, you know, hopefully, cooler heads will prevail. That being said, we have one more tax-advantaged wrapper that we have to discuss, which is opportunity zones, which you already mentioned. If I’m an investor with a large capital gain, and I want to invest into energy, is this just a no-brainer?
Is this just a, you know…?
Matt: I am biased, right? I’m very biased and I preface this, it’s our business, this is what we do for a living. I love tax law. And I gotta tell you, it is by far the single best tax arbitrage just ever designed in the tax code, right, having this mega Roth out there, the Roth that you can grow money tax-free, and turn it into… But in energy, in oil and gas, specifically, it’s so powerful because oil and gas doesn’t have a very high IRR, where you get so much money so quickly.
It doesn’t always have the highest ROI. You might only make one and a half times your money on a well. But you might make 1.2 of it in 3 years, right? And just to kind of think of that paradigm shift when you’re reinvesting that in an op zone, because all the best bases in the U.S. are littered with op zones. The entire Permian is basically an op zone.
It’s crazy, right? So, you might not want to build retail housing in Loving County, Texas, there’s nothing there. But it’s the best oil, right? And same with Lionetti and New Mexico and Reeves and Ward, and they’re all op zones. And there’s trillions of dollars of capital that you don’t have to chase anyone for in these amazing op zones. It’s a little bit less true with natural gas because like in the Marcellus, and a lot of the blue states, they only did urban centers, they didn’t do a lot of rural areas.
So there’s not as many in natural gas as there are in oil, but literally, there’s just so much money. But when you take that well, and you drill it and then you reinvest all the proceeds back in, and you only distribute out a cap rate of a certain percent, right, then you reinvest all the proceeds, that just becomes a monster, right? You’re building an oil company in an op zone, that’s tax-free for 10 years.
And the IRRs are so high.
Andy: So, you’re essentially rolling over the investment so that the OZ fund, the QOF wrapper is like a 10 year minimum wrapper, although, you know, lately talking to family offices, and they’re like, well, they’re like, “We don’t want our money back in 10 years, are you crazy? We…you know,” I forget the exact date. It’s like…
Matt: Twenty forty.
Andy: Yeah, 40 years, it’s so…you’re talking about taking the investment, getting that immediate return over whatever, 24 or 36 months, then rolling it over into new investment all within the same QOF.
Matt: Yeah, your business plan is inside that QOF, you drop down an OB. And you just keep reinvesting in more and more projects over and over and over. And so you just grow this behemoth instead of cash flowing it all out, you’re just compounding it, right? And when you compound at that high of an IRR, it’s amazing what comes on the backside, right? Oh, literally, well, it only does one and a half times return in a 10-year cycle, if you did it again 4 times, it becomes a 4 and a half to 5 times return on the backside.
It’s crazy what happens inside the op-zone tax structure. And it’s literally limitless. There’s just so much of it in op-zones that you don’t have to chase it. So it’s cool.
Andy: So I had a question then, we talked about that accelerated depreciation or immediate depreciation with these investments. And I know OZs have some benefits relative to depreciation. Are there any tax benefits that, like, stack, like along with the normal, like, QOF…
Matt: Yeah, you get both there, depending on designs, I don’t know how many companies are doing it. From a technical design standpoint, there could be limitations on whether they stay suspended within it and offset revenue or they distributed it out, that’s all dependent on tax code and design because, remember, you have a zero basis coming into an op zone.
So because you have a zero basis, you are limited on what you do with those deductions. So, they always step. The question is do they stay suspend it within the fund and come out with distributions or do you carry them over the other side of the ledger, pass them through as a…unless you have a passive activity loss, you probably don’t need it, right? So kind of pick PAL rules versus ordinary income rules.
But the answers are, they all stack.
Andy: So, in other words, there’s so many tax benefits that are stacking with the already good OZ wrapper, you can actually end up with excess tax benefits that you can’t even use.
Matt: Yeah. So, imagine this, in 2026 we [inaudible] stepped up basis in an OZ. All those suspended losses are eligible to flow through to the investor. So, imagine 2026 rolls around, and you now have, you know, $100 million in a fund, and $90 million of suspended losses that are eligible to the investor.
So they flow through right when they need it. Because then it offsets the tax on the deal. So there’s all this cool design you can do with oil and gas, stacking. The when, and where and why the benefits are going to be who sponsors it, how they structured it, how smart they are, right? The tax law is all there to be taken advantage of. What anyone does with it is up to them.
Andy: Got it. Okay. So I know, you know, let’s, let’s talk macro for a minute. And I know a lot of investors, a lot of families are probably thinking, “Okay, this is a moment for energy investing,” Obviously, some people taking a well-earned victory lap this year, and I’m like, I’m applauding, I’m like, “Hey, you know, take your victory lap.”
But my question is, you know, looking forward past 2022, even past 2023, is there a long-term price floor where oil needs to be to make all of this viable? Or maybe where, you know, the top half of firms survive and the bottom half don’t?
Or, you know, is there; I guess… What is that key number, if it exists, and do you think that we’re going to maintain that over the next 5 or 10 years?
Matt: Awesome stack of questions here. So the one thing to understand in the energy space is that floor shifts. So, this is the hardest part for everyone to understand. You’re drilling new wells every year at a new price deck. So meaning if my underlying costs shift because of inflation, because of cost of goods and services, because of the competition in the space, that means my floor shifts, right?
So if it used to cost me $9 million to drill and now it costs me 12, and the reserves are the same, my economic less, right, and vice versa. So, you can have the same area where the price for one year is $40 a barrel and $55 the next. Right, that’s how much the well by well, year by year can shift.
So the answer is right now, the breakevens compared to current price, are probably at one of their best points in history. Maybe not as good as last year and the year before, but pretty spectacular, right? X, Y, Z in cost, X, Y, Z in profit, big margin. And as long as you get that in the first two years and get flush reserves, you’re really good. Maybe…
Andy: Well, let me ask this, are costs elevated right now? Because on the one hand, we know labor, material, all these input costs are higher, although at least sounds like…sounds to me like the assets themselves, maybe there’s a little bit less competition in the sense that the institutional investors have gotten out. But overall, you’re saying costs are still substantially higher than let’s say 10 years ago?
Matt: Yeah, absolutely, 100%. Costs are a lot higher than they were 2 years ago, 30%, 40% higher.
Andy: Wow, 30% or 40%? How does it get 40% higher? I mean, what input drives that?
Matt: Steel, concrete, labor, competition. All those things, right? How many, how many people are willing to pay for those rates, right, at what cost? So the date rates go up. I mean, the service companies have been starving for seven years, or five, because we live in a profit, right? So, service companies, the Halliburton, Schlumbergers, universities, they’re making their money finally because there’s at least a little competition for their assets.
So they can charge a little bit higher rate. But then underneath all that, steel, concrete, right, sand, all that stuff is harder to get to market because all the labor shortages, you name it, there’s not good crews. So instead of taking 20 days to drill a well, it takes 45. And the day rates stack up because the crews aren’t as good because they’re not as trained.
So, the industry…and again, every company will have their own, hopefully, strategic advantage to abate all of that, but macro, it’s more expensive than it is to drill now than it was three years ago, right?
Andy: But then the ratio you mentioned is still very good relative to the current price of oil.
Matt: Yeah, you only need on average $50 a barrel to break even. So you’re in a phenomenal…the margins are up 100%, costs are up 40%, right? So you have a…but your downside is [inaudible], right? Because you don’t…now you don’t need $30 a barrel that break you even, you need 45, right? That’s the kind of underlying and that’ll change every year. If the prices drop, so will the cost to drill. So it actually might be better for you for prices to drop in next year’s drill. It’s an interesting paradigm that people don’t think about. It’s elastic. It’s constantly shifting in the energy space.
Andy: Well, I get that that ratio, it’s elastic, and that it shifts year to year. If I’m hearing you correctly, I don’t want to put words in your mouth, but it sounds like there’s been a little bit of a structural shift that has made that ratio on an ongoing basis shift in favor of investors relative to 10, 20 years, maybe just, I don’t know if it’s the main driver, that’s institutionals getting out or whatever.
But I get… Do you think that there’s been a little bit of an inflection point where, you know, it’s just going to be a better space fundamentally to be in? And it sounds so paradoxical…it sounds so paradoxical that it sounds like it could be true to me, you know…
Matt: This is why, it’s really simple. The source you want to go back to is, really, it’s Wall Street-driven more than anything. So the majors are being forced to operate within cash flow. Right? So even with their cash flow, they’re buying back dividends. They’re either paying dividends, buying back shares, not drilling more wells.
They’re limiting the amount of production.
Andy: Is that from ESG concerns? Or why is that?
Matt: It continued with ESG it was purely economic. It used to be like a tech stock, where you were paid for gross. So, if I went out and bought the most land, no matter what I paid for it, $50,000 an acre, $75,000 an acre, and I booked more reserves, my stock price would go up. So everyone goes out and spends stupid money to acquire every last drop of land in the U.S. because their stock price goes up.
And then Wall Street said, “Well, this is stupid, growth at any price is dumb. Let’s focus on operate within cash flow.” And all these guys were, “Wait, you just rewarded me for years for this buying all the stuff, now I got to operate with a cash flow.” And the whole world just shifted. Now you see all these companies, those that have capital discipline, who stick to their drilling budget, don’t add more inventory, buy back shares, their stock price goes up.
Those who drill more wells, their stock price goes down even though the revenue is going up. It’s a crazy paradigm. And that’s what Wall Street has said, oil and gas majors stick to repeatability and invest in decarbonizing and then we’ll increase your stock share, even if you lose money. That’s what they want to see, right? Because they…it’s the paradigm shift that’s occurred. And it’s opened up the private window to make more money than ever.
It’s just awesome. And it’s really because Wall Street’s forced these major Engine No. 1, you name it, they’ve forced all these companies into these horrible little boxes of operation that really have changed the paradigm to be in favor of private companies over public.
Andy: So is this opportunity, in your view, so big that you know, really every family office, every RIA, should be looking into it? Because that sounds like kind of a generational shift, a generational opportunity. I mean, I’m thinking if there’s an asset class that, independent of its financials, the corporate world hates, and, you know, the endowments hate, again, back to that debt premium, is this something that every family office should be investing in?
Matt: Andy, I’m super biased. So I’m going to keep saying this. I think people are saying that too, especially… look at even the public markets, right? Everyone realizes energy has done really well in the last 12 months. Most of these great companies are still at three times earnings, like it’s stupid how cheap the energy space is because of the perception of the future.
And I just want to give everyone this one thought, we’ll just use natural gas as an example. I think people realize the most environmentally social and responsible thing to do is to invest in U.S. natural gas because we don’t want it coming from Russia, from Saudi Arabia, from Iran, from Venezuela. We are the best, the most transparent, the cleanest. And the reality is that people believe in EVs, the only way to source EVs is through a grid that’s going to be sourced by natural gas, the only energy that there’s enough of to actually create the electricity that people are asking for, right?
So even if we built nuclear electricity, we couldn’t get there. They can’t do it with solar and wind. It’s literally one source, natural gas. So if you’re not on long gas, are you out of your mind? And I don’t mean long from $9 MCF. I mean, if you’re not investing in natural gas in the next 20 years, you’re out of your core, you’re out of your gourd, and especially in the domestic U.S., there’s such a big price arbitrage. It’s still 8 or 9 and it’s 54 Euro right now, right?
There’s this great early inning. And as the U.S. keeps exporting more LNG, especially to support Europe right now, right, then it becomes more globally priced. And then I just put it in terms of I’ll give you 1000 reasons why oil will be 90 and 100, 124 ever going forward. It’ll rock around a lot. But the reality is there’s more demand than we can have supply and we can’t produce enough and the U.S. isn’t producing enough to meet the gap.
So there’s going to be this 10 year supercycle of much higher energy prices. But beside all of that, just the natural gas side alone is if you take the BTO equivalent, which is six to one, in terms of how many [inaudible] energy created, natural gas should currently be 15 in the U.S. And it’s still only nine, right? When you look long term, everything goes back to energy equivalency, there’s that reversion to the mean.
And I just think both sectors, I don’t care how you do it, public, private. If you’re caught up in ESG, your people are missing the point in the sense that the most environmentally sound thing to do is invest in U.S. companies that have the best [inaudible] currency, right? The most socially responsible thing to do is to definitely produce more energy so the world can live better and not be succumbing to Russia and Venezuela and Iran. Like, I don’t care which angles you want to look at it.
It’s imperative that everyone invest more here in the U.S.
Andy: I totally agree. I mean, if you, regardless of your politics, red, blue, I might say when it comes to investing, I’m green, you know. But the EPA, the actual EPA, United States EPA, certainly does a better job than its counterpart organization in Saudi Arabia or Venezuela.
So I really, from even that socially conscious angle, I totally agree. I think there is an ESG argument to invest into energy production in the United States, and especially natural gas. So, you know, if you’re a family office or ultra-high net worth investor, if you want to invest in U.S. energy, would you recommend, you know, splitting the investment between oil production, natural gas production?
I mean, is there…are a lot of people investing purely into one versus the other? I mean, it seems to me, I almost feel like if I invest in both, then I’m hedging my bets, right? I’m investing in good old oil, but in the EV, the infrastructure behind EVs and all that as well.
Matt: Yeah. So again, I’ll make the statement, I think people need to invest in the sector, period, I don’t care what medium you like, what company you like, how you do it, you definitely will be looking at this as an essential part of your portfolio for the here and now, for the next 10, 15 years. It’s just essential.
Find the partner that meets your values the best, right? If you’re super ESG, and you can’t fathom oil, then only do natural gas. You know, there’s no one answer, even if oil is better for your portfolio, or better for the current economics, meet your needs based on your goals, whatever they are, right? So, yeah, and if the partner that you find won’t do it, find one that will, find one that will actually meet your needs.
There’s enough energy companies out there. There’s enough structural opportunities. And then marry the best. If it’s private, the best structural opportunity for your family office, right? Do you need to offset capital gains or do you want an OZ? Do you want tax revenue? Do you need, you know write-offs?
Do you need 1031s? Do you need just pure paid cash flow? Find the partner that can create the best net arbitrage to your situation, don’t just look for, I want this ROI because you can find that ROI anyways, just find it to the best match to your end need. And just come in asking the right questions, right? How do I build this [inaudible]?
Here’s our current issues from tax. Are there any available tools that are a better fit? And then when you find a tool, find out who provides the best assets underneath it and choose that company.
Andy: Absolutely. And I know that USEDC has a lot of resources on your website. I was reviewing that this morning. A lot of information for financial advisors, for RIAs, for family office professionals. So my advice, you know, if you’re an advisor, if you want more information on all the different, you know, tax programs, and how they might interact with a particular situation, would be to visit their website, which…actually, so Matt, that being said, where can our viewers and listeners go to learn more about USEDC?
Is that just the website at usedc.com?
Matt: I think it’s the best spot, usedc.com, go to our website. And then there’s links to, if you’re a financial professional, like there’s a whole bunch of ways to kind of…if you don’t have one, we’ll find you a financial professional. We’re not portfolio managers, right? We’re not asset allocators. We’re not the end source for financial advice to a client. We are the underwriter, the structurer.
So our main goal is to find the best advisors in the U.S. so that we can tell them we’re in portfolio management we can make a good fit for a select amount of clients. That’s kind of our niches. We’re a B2B company that loves the design. And if you have a great idea, and you want to ask if it can be designed in the energy space, call me, it’s the part I love. So if there’s a tax nuance, if there’s a structural nuance that you can’t find in this space, I always beg people to come talk to me directly.
And I’ll let you know if the energy space can meet that need because that to me is the most fun is finding all those little tax arbitrages and designing, you know, things around them.
Andy: Absolutely. Well, Matt, thanks so much for coming on the show. And, you know, sharing all of this information about the space. I think, again, there’s a lot of LPs, RIAs, family offices, who are very, very comfortable with alternatives, but are still maybe getting their feet wet with the energy world.
So this has just been super helpful. So, thanks again.
Matt: All right, great. And again, for any of those professionals, you cibtact us, we’ll also send with you maybe some of the third party companies that you can talk to about all the sponsors, right. So we’re biased [inaudible]. But we can also reveal some of the companies that review, you know, a ton of oil and gas sponsors, so that if you’re finding something that you might need that we don’t provide, you have a third party to go talk to.
Andy: Got it. Thanks again, Matt. And show notes will be available at altsdb.com/podcast.