Publications

- January 1, 2022: Vol. 9, Number 1

The opportunity zone and 1031 energy plays

by Matt Iak

The real estate sector has not skipped a beat as the United States continues its COVID-19 recovery. Investors in the sector remain resilient, but we are now seeing heightened cap rate compression resulting from significant investor demand coupled with narrow supply. This raises an essential question going forward: Will investors continue their discipline or are we in a bubble in the making? Now is the time to consider portfolio diversification by taking a position in energy via qualified opportunity zone (QOZ) and 1031 investments.

Although oil prices are hovering near $70 per barrel, a significant increase year-over-year, we are nowhere near the all-time highs of $145 per barrel seen in July 2008 (not inflation adjusted). Drowning out all the short-term media hype around energy prices, including the administration’s discussion about the release of strategic oil reserves and OPEC-plus discussions about production, we believe oil prices will remain higher due to systemic imbalances despite any temporary “fixes.” These temporary fixes do not influence the oil market supply and demand fundamentals long term.

The United States is the only remaining swing oil producer (those who have the ability to add more supply), and because both publicly traded companies and private companies will and have had less capital to invest in the space, there is without doubt less supply coming to market. Large public exploration and production (E&P) companies are being pressured by Wall Street to reduce debt, increase dividends, and buy back stock while keeping production flat, ultimately reducing the amount of capital being deployed to the patch. With the major E&P companies focused away from growing their production, the supply deficit will continue pushing prices higher.

This raises the question: Will the oil market remain strong over the next five to seven years? The consensus is “yes” but the answer is multidimensional. Many analysts are predicting we are at the beginning of a material repricing that will drive oil prices higher. Many factors — including Wall Street discipline, lack of new capital, decarbonization of majors and divestiture of U.S. fields by European majors — all point to a significant strain on supply. Oil prices have a strong positive relationship to inflation and, in fact, high oil prices cause inflation, which will likely remain high for some time. Many would say to make a successful push into renewables, we need substantially higher prices in fossil fuels for the next 20 years to allow renewables to be economically competitive. Thus, even if there were not natural pressure on oil prices, there is likely to be pressure exerted by global policy alone.

Now is the time to preserve the significant gains achieved in real estate and diversify your portfolio by investing in energy via qualified opportunity zones and the 1031 exchange. Both investment structures provide significant benefits. Energy opportunity zones allow direct investment into oil and gas while providing substantial tax benefits such as the deferral of short- or long-term capital gains, tax-free income due to depletion and depreciate and tax-free gains after 10 years. Energy 1031s invest in real property with direct asset ownership as working interest in wells or royalties/minerals. Additionally, they provide long-term taxefficient income as depletion allows for tax efficiencies of income, even after basis drops to zero.

Aside from the significant tax benefits of energy opportunity zones and 1031s, oil and gas investments also provide a wide array of additional benefits that make for a great asset mix. In its most simple form, utilizing an asset that is a long-term bull may create an arbitrage versus an asset that has just run through one of its best cycles in history. This may allow investors to diversify and create opportunities using the same tax laws historically used for real estate investors. Is it time to consider alternatives in the mix as a solution to traditional tax problems?

 

Matt Iak is executive vice president of U.S. Energy Development Corp.

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