Energy investments in rural Opportunity Zones

Location is not a factor in profitability  

While some may view investments in low-income areas such as Opportunity Zones as unattractive, the profitability of oil and gas development in opportunity zones is completely uncorrelated and unaffected by the low incomes prevalent in opportunity zones. The profitability of energy-based OZ investments does not depend on the economic health of the OZ as demand for energy is inelastic and exists without regard to its source. Many rural opportunity zones overlay some of the most prolific and growing oil and gas plays in the United States. Many of these OZs are larger than entire states.

Inflation and tax hedge

Forty percent of the U.S. dollars ever created have been printed in the last 12 months. This massive one year increase in the U.S. dollar supply has implications for asset prices and inflation. Commodities, especially oil and gas, typically increase or maintain their value with respect to other assets classes in inflationary environments.

Superior returns

Typical oil and gas investments returns are generally multiples of what is common for most OZ investments. The appreciation and growth potential make them especially well suited to the OZ incentive.

This map shows OZs in blue and drilling rigs on location at present for Texas containing some of the largest and most energy prolific OZs as of October 2021:

Source: EOF map compiled using Enverus and U.S. Dept. of the Treasury, CDFI GIS data 

This map shows OZs in blue and the locations of new wells to be drilled in the next 12 months are represented by a yellow dot as of October 2021:

Source: EOF map compiled using Enverus and U.S. Dept. of the Treasury, CDFI GIS data

Inelastic demand

The map above shows that many wells will be drilled in OZs over the coming months. Each yellow dot represents a planned new horizontal well to be drilled in the next few months. Wise investors are acquiring mineral rights now to position themselves in front of the incoming drilling rigs.

 A significant portion of the U.S. daily production of over 11 million barrels of oil per day is presently sourced from OZs. [1] This will only increase as the U.S. consumes over 19 million barrels of oil per day at present. Each 1 million electric vehicles added to the U.S. vehicle fleet displace less than 40,000 barrels per day of demand, or less than 2/10ths of 1% of current U.S. oil demand. [2]  

Underinvestment in natural gas causing environmental harm 

Natural gas prices continue to rise. Current spot prices are over 250% higher than 2020 levels. Prices have increased from the 2020 average of $2.06/MCF to the current price of over $5.90/MCF. Because of record setting global demand for natural gas, exports are the largest factor in the current domestic natural gas price as U.S. LNG (liquefied natural gas) exports have increased from 4 BCFD at the end of 2020 to a projected average of over 18 BCFD for 2021 and well over 21 BCFD in 2022 as new export facilities are commissioned. LNG exports consume over 15 to 20% of U.S. natural gas production.    [3]

The natural gas price will continue to increase through 2021 to 2022 as Europe and Asia attempt to balance their increasing reliance on intermittent energy sources while at the same time shutting down base load sources, such as nuclear and coal. This rebalancing will likely result in no change to EU carbon policies, which will further increase reliance on intermittent sources, which in turn will increase the price premium paid to secure longer term reliable LNG supplies to backstop the mostly intermittent replacement sources. This is a very positive long term trend that will provide a solid foundation for U.S. natural gas prices which will support highly profitable investments to increase supply, much of which will be sourced from opportunity zones.

While the traditional energy space will enjoy record prices and profits as shortages continue to manifest themselves worldwide, the root cause is underinvestment causing natural gas to be displaced by carbon intensive coal for use in electric generation. According to the EIA (U.S. Energy Information Administration), U.S. coal use is set to increase by 10% from 2020 levels and will increase by over 15% for 2022. Coal is the most damaging traditional fuel in common use in the U.S. with respect to harmful pollution and carbon dioxide emissions. This retrograde market response to ESG pressures has occurred as shortages and price increases manifest themselves as the result of policies that have failed to recognize physical realities. Underinvestment in oil and gas results in more CO2 emissions from coal that cannot be offset by intermittent wind and solar sources at scale.

IEA Graph Showing King Coal’s Rise:

Source: International Energy Agency

Stacked tax incentives

Oil-and-gas assets have additional unique tax benefits such as the ability to shield 15% of gross production income from taxation in most circumstances (statutory depletion); and the availability of the immediate deductibility of intangible drilling costs (IDC’s), which represent a significant portion of the cost of drilling operations neither of which is subject to recapture upon exit. Both of these tax provisions allow ordinary income to be partially shielded from taxation to further improve the asset to maximize the tax free exit value.

Other energy investments in OZs – negative pricing

Texas produces more wind energy than any other state and more than any other country in the world except China, Germany and India. The majority of this installed wind capacity is located in or near rural Texas OZs, most of which also have oil-and-gas production. All of this wind energy goes into the ERCOT electrical grid which offers some of the lowest interruptible electricity pricing in the world. 

Demand for electricity varies a great deal over the course of the day—it rises as people wake up, turn on the lights, and go to work; peaks in the late afternoon; and then falls off sharply at night. The supply of wind can change a lot too, depending on how much the wind is blowing. So, in the middle of the night, if the wind is strong, wind power can dominate. On March 29 at 2:12 a.m., for example, wind accounted for about 40% of the state’s electricity production. Unlike natural gas or coal, there is no fuel cost. Once a turbine is up and running, the wind is free. But wind operators have another advantage over generators that use coal or natural gas: a federal production tax credit of up to 2.3 cents per kilowatt-hour that applies to every kilowatt of power produced depending on when it was installed. And that means that even if wind operators give the power away or offer the system money to take it, they still receive a tax credit equal to $23 per megawatt-hour. Those tax credits have a monetary value—either to the wind-farm owner or to a third party that might want to buy them.

As a result, in periods of slack overall demand and high wind production, it makes all the economic sense in the world for wind-farm owners to offer to sell power into the system at negative prices.

This is a map of real-time Texas wholesale electric prices on the evening of October 18, 2021:

Source: ERCOT - Electric Reliability Council of Texas

Converting waste energy

As evidenced by the map, most of the large rural OZs in Texas have access to negative electricity prices at night as a result of federal energy subsidies. This waste energy can be used to power AI (artificial intelligence) server farms at extremely low interruptible rates. When power demand is high and the access to below market electricity is curtailed, these server farms can be powered by electrical generators on site powered by natural gas sourced from directly on premises. AI servers can also be used without modification to mine cryptocurrencies or can be rented to commercial users for modeling work. Demand and profitability for both uses is extremely high. All of this can take place in a tax advantaged fashion by locating the facilities within the OZ and taking advantage of the natural strengths of these rural bypassed areas, while helping the environment by increasing the economic viability of intermittent energy sources and decreasing the use of dirty damaging fuels such as coal.

Waste energy conversion to tax free capital gains

While crypto mined under current rules inside an OZ using stranded energy is subject to ordinary income tax rates at the time the tokens are mined, the future scarcity and value of certain cryptos is assured by mathematics. This scarcity should result in significant capital appreciation over the 10-year hold period and would not be subject to capital gains taxes upon exit. This feature, combined with flexibility and pricing power afforded by using energy generated from several stranded sources, results in very low variable costs as well as maximum appreciation during the 10-year operating life of the project. This QOZB business can function well as a part of traditional oil and gas activities conducted in an OZ or as a standalone project depending upon the specifics of the particular site.

What investing in oil and gas in an Opportunity Zone could mean

Operating a QOZB that specializes in traditional oil and gas activities within an opportunity zone on Qualified Opportunity Zone Business Property (QOZBP) allows the investor to access returns that normally would be unattainable in an economically disadvantaged area while at the same time generating tax shielded cash flow that can be reinvested into increasing production as prices continue to appreciate. An additional tax shield is afforded by the eligibility of producing minerals and royalties for a percentage depletion allowance of 15% of the gross royalty revenue.

This is an activity that would not otherwise be generated in the rural bypassed oil and gas opportunity zones, thereby fulfilling the intention and spirit of the OZ tax incentive.

The appreciation potential of the asset occurs as the asset is drilled over its producing life as the reserves are developed and production increases as they are drilled. A hypothetical producing oil or gas unit starts out with only 1 well wellbore. As the property is developed, up to dozen or more additional laterals are drilled to capture additional oil and gas reserves. This is how the appreciation potential of the assets is achieved. The tax free benefit after a 10 year hold comes directly from the Opportunity Zone Tax Benefit afforded to operating businesses inside designated census tracts. The compounding effect of the addition of reserves and production combined with the appreciation afforded by expected overall price inflation maximizes the appreciation potential of the OZ assets which will not be subject to capital gains after the funds exit in 10 years. This combination provides the investor with the rare opportunity to protect against the possibility of future adverse tax and economic conditions while providing an extraordinary return.

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