Understanding the Importance of Investment Grades

A bond is simply a promise by the issuer of the bond to repay the face value of the bond. The issuer treats the proceeds from the sale of a bond as debt as opposed to stocks which are treated as equity in a company. Governments, financial institutions and companies use bonds to finance their long term borrowing needs. (More than a year)

Bonds which are investment grade are considered fairly certain to be repaid. In fact financial institutions are legally bound to only invest in investment grade bonds. Companies issuing bonds endeavour to obtain the highest credit rating they can acquire in order to help the sale of their bonds in terms of quantity and the lowest price possible.

It doesn’t matter how high an investment grade bond is rated when compared to a bond issued by a government, the non-government bond will always be considered riskier than the government issued bond. The difference between the rates of an investment grade bond and a government bond is called the spread. The spread is an indication of the economic climate in the country issuing the bonds. If the spread is low the economy is believed to be more stable by the forex markets. The higher the spread the more unstable the economy is deemed to be.

This phenomenon can be seen on the highest yield bonds more commonly known as Junk Bonds. Investors are always on the look out for the greatest return possible and a high yield bond would present an opportunity for a big return. The higher the yield of the bond, the greater the risk an investor faces when the bond matures, that he won’t receive the face value of the bond. Junk bonds are rated much lower than investment grade bonds specifically because of the nature of their risk.

Of course every investment has inherent risks. With bonds however, the risk is subject to the term to maturity of the bond and to its value. Many bonds are issued with maturities that can be 10 to 20 years from the issue date. This means that there is plenty of time for the economic situation of a country or a company to change and affect the value of a bond. Bonds which have many years to maturity are a more risky investment for the investor.

Another risk for the investor is interest rates. Bond yields move inversely with interest rates so that the higher the interest rate, the bonds value is lower and the lower the interest rate, the bonds value is higher. The longer the maturity of a bond the more affect interest rates will have on its value.

That is why it is important that investors check a bonds rating when considering investing. The rating indicates how experts have assessed the risk of a bond issue.

Currency Trading Basics

The foreign exchange market is the term given to the worldwide financial market which is both decentralized and over-the-counter, which specializes in trading back and forth between different types of currencies. This market is also known as the Forex market. In recent times, both investors and traders located all around the world have begun to notice and recognize the foreign exchange market as an area of interest, which is speculated to contain opportunity.

However, before considering treading these waters, it is important to first understand how transactions are conducted within the foreign exchange market. It is also necessary to first explain what the basics are of trading foreign currency. Failure to fully and completely understand this art prior to journeying off into this market would render a person lost in a matter of minutes, just where they would never expect it. Thus, this article has been presented, intending to explain currency trading basics thoroughly.

What is traded within the foreign exchange market?

The one instrument that foreign exchange market investors and traders constantly utilize are currency pairs. This is a term used to describe what the rate of exchange for one currency is over another currency. In the whole of the market, the following are the currency pairs that of which are traded most often:

• EUR / USD – Euro
• GBP / USD – Pound
• USD / CAD – Canadian Dollar
• USD / JPY – Yen
• USD / CHF – Swiss Franc and
• AUD / USD – Aussie

In the whole of the foreign exchange market, the previously listed currency pairs generate up to 85% of the volume.

If a trader ends up going long or goes ahead and buys the Euro, he or she is also, at the same time, buying Euro and selling the United States Dollar. In the event that this same trader ends up going short or goes ahead and buys the Aussie, he or she will also, at the same time, be selling the Aussie and purchasing the United States Dollar.

In each currency pair, the former currency is the base currency, where the latter currency is typically in reference to the quote or the counter currency. Each pair is generally expressed in units of the quote or the counter currency that of which are needed in order to receive a single unit of the base currency.

To illustrate, if the quote or the price of a EUR / USD currency pair is 1.2545, this would mean that one would require 1.2545 United States Dollars in order to receive a single Euro.

Bid / Ask Spread

It is common for any currency pair to be quoted with both a bid and an ask price. The former, which is always a lower price than the ask, is the price at which a broker is ready and willing to buy, which is the price at which the trader should sell. The ask price, on the other hand, is the price at which the broker is ready and willing to sell, meaning the trader should jump at that price and buy.

To illustrate, if the following pair were provided as such:

EUR / USD 1.2545/48 OR 1.2545/8
Then the bidding price is set for 1.2545 with the ask price set to 1.2548.

Pip

The minimum incremental move that of which is made possible by a currency pair is otherwise known as a pip, which simply stands for price interest point. For example, a move in the EUR / USD currency pair from 1.2545 to 1.2560 would be equivalent to 15 pips, whereas a move in the USD / JPY currency pair from 112.05 to 113.05 would be equivalent to 105 pips.

Margin Trading (Leverage)

In other financial markets, it would generally be required to have the full deposit of the amount that of which is traded. However, in the foreign exchange market, all that of which is required would be a margin deposit, with the remainder being granted by the broker.

Some brokers will provide leverage that will rise up to 400:1. In essence, this means only 1/400 in balance is required to open a position, or .25%. The majority of brokers, however, will only offer 100:1, meaning 1% is required in balance in order to open a position.

A typical lot size within the foreign exchange market is roughly $100,000 United States Dollars.

When a trader would desire obtaining a long lot within the EUR / USD currency pair, where the leverage amounts to about 100:1, in order to open such a position would require $1,000 United States Dollars in balance, or 1%.

It is not recommended, of course, to open such a position when the trading balance retains such limited funds. In the event that the trade should go against the trader, the broker will close the position. This will bring the focus onto the next term.

Margin Call

In the event that the balance of a trading account should end up falling below the maintenance margin, which is the capital required to open a position (1% in a 100:1 leverage, 2% in a 50:1 leverage, so on and so forth), a margin call will occur. At the moment that this margin call occurs, the broker will either sell off all of the trades or buy back in the event of short positions. This will theoretically leave the trader with the maintenance margin.

Margin calls generally occur in the event that money management is not applied in a proper manner.

What are the mechanics of a foreign exchange market trade?

To illustrate an example, after extensive analysis, a trader concludes it is likely for the British pound to rise in price. This trader decides it is worth going long and risking 30 pips, intending to wind up being rewarded with 60 pips. In the event that the market goes against this traders decision, they will end up losing 30 pips. However, should the market go as intended, they will gain 60 pips.

The British pound has a quote that is precisely 1.8524/27, 4 pips spread. The trader in question will go long at 1.8530, or ask. Once the market either reaches the target or the risk point, the trader will need to sell it at the bid price. To make 40 pips, the profit level would need to be 1.8590. Should the target be hit by the market, then the market has run 64 pips. Otherwise, the market will have run 30 against.

As one may have gathered at this point, it is generally a very good idea in order to fully understand the basics of currency trading, from the very basic concepts to the more complex issues, before deciding to tread the waters of the foreign exchange market. Make sure every single aspect of the subject is mastered, including trading psychology, trade and risk management, as well as everything else, prior to making the decision to opening a live trading account. Best of luck.

Options on Futures

Options on futures began trading in 1983. Today, puts and calls on agricultural, metal, and financial (foreign currency, interest-rate and stock index) futures are traded by open outcry in designated pits. These options pits are usually located near those where the underlying futures trade. Many of the features that apply to stock options apply to futures options.

An option's price, its premium, tracks the price of its underlying futures contract which, in turn, tracks the price of the underlying cash. Therefore, the March T-bond option premium tracks the March T-bond futures price. The December S&P 500 index option follows the December S&P 500 index futures. The May soybean option tracks the May soybean futures contract. Because option prices track futures prices, speculators can use them to take advantage of price changes in the underlying commodity, and hedgers can protect their cash positions with them. Speculators can take outright positions in options. Options can also be used in hedging strategies with futures and cash positions.

Futures options have some unique features and a set of jargon all their own.

Puts, Calls, Strikes, etc.

Futures offer the trader two basic choices - buying or selling a contract. Options offer four choices - buying or writing(selling) a call or put. Whereas the futures buyer and seller both assume obligations, the option writer sells certain rights to the option buyer.

A call grants the buyer the right to buy the underlying futures contract at a fixed price the strike price. A put grants the buyer the right to sell the underlying futures contract at a particular strike price. The call and put writers grant the buyers these rights in return for premium payments which they receive up front.

The buyer of a call is bullish on the underlying futures; the buyer of a put is bearish. The call writer (the term used for the seller of options) feels the underlying futures' price will stay the same or fall; the put writer thinks it will stay the same or rise.

Both puts and calls have finite lives and expire prior to the underlying futures contract.

The price of the option, its premium, represents a small percentage of the underlying value of the futures contract. In a moment, we look at what determines premium values. For now, keep in mind that an option's premium moves along with the price of the underlying futures. This movement is the source of profits and losses for option traders.

Who wins? Who loses?

The buyer of an option can profit greatly if his view is correct and the market continues to rise or fall in the direction he expected. If he is wrong, he cannot lose any more money than the premium he paid up front to the option writer.

Most buyers never exercise their option positions, but liquidate them instead. First of all, they may not want to be in the futures market, since they risk losing a few points before reversing their futures position or putting on a spread. Second, It is often more profitable to reverse an option that still has some time before expiration.

Option Prices

An option's price, its premium, depends on three things:

(1) the relationship and distance between the futures price and the strike price;

(2) the time to maturity of the option; and

(3) the volatility of the underlying futures contract.

The Put

Puts are more or less the mirror image of calls. The put buyer expects the price to go down. Therefore, he pays a premium in the hope that the futures price will drop. If it does, he has two choices:

(1) He can close out his long put position at a profit since it will be more valuable; or

(2) he can exercise and obtain a profitable short position in the futures contract since the strike price will be higher than the prevailing futures price.

What are the Functions of the Foreign Exchange Market?

The foreign exchange market is merely a part of the money market in the financial centers is a place where foreign moneys are bought and sold. The buyers and sellers of claims on fore' money and the intermediaries together constitute a foreign exchange market. It is not restricted to any given country or a geographical area.

Thus, the foreign exchange market is the market for a national currency (foreign money) anywhere in the world, as the financial centers of the world are united in a single market.

There is a wide variety of dealers in the foreign exchange market. The most important amongst them are the banks. Banks dealing in foreign exchange have branches with substantial balances in different countries. Through their branches and correspondents the services of such banks, usually called 'Exchange Banks', are available all over the world.

These banks discount and sell foreign bills of exchange, issue bank drafts, effect telegraphic transfers and other credit instruments, and discount and collect amounts for such documents. Other dealers in foreign exchange are bill brokers who help sellers and buyers in foreign bills to come together. They are intermediaries and unlike banks are not direct dealers.

Acceptance houses are another class of dealers in foreign exchange. They help foreign remittances by accepting bills on behalf of customers. The central bank and treasury of a country are also dealers in foreign exchange. Both may intervene in the market occasionally. Today, however, those authorities manage exchange rates and implement exchange controls in various ways. In India, however, where there is a strict exchange control system, there is no foreign exchange market as such.

Functions of the Foreign Exchange Market:

The foreign exchange market performs the following important functions:

(i) to effect transfer of purchasing power between countries- transfer function;

(ii) to provide credit for foreign trade - credit function; and

(iii) to furnish facilities for hedging foreign exchange risks - hedging function.

Transfer Function:

The basic function of the foreign exchange market is to facilitate the conversion of one currency into another, i.e., to accomplish transfers of purchasing power between two countries. This transfer of purchasing power is effected through a variety of credit instruments, such as telegraphic transfers, bank drafts and foreign bills.

In performing the transfer function, the foreign exchange market carries out payments internationally by clearing debts in both directions simultaneously, analogous to domestic clearings.

Credit Function:

Another function of the foreign exchange market is to provide credit, both national and international, to promote foreign trade. Obviously, when foreign bills of exchange are used in international payments, a credit for about 3 months, till their maturity, is required.

Hedging Function:

A third function of the foreign exchange market is to hedge foreign exchange risks. In a free exchange market when exchange rates, i.e., the price of one currency in terms of another currency, change, there may be a gain or loss to the party concerned. Under this condition, a person or a firm undertakes a great exchange risk if there are huge amounts of net claims or net liabilities which are to be met in foreign money.

Exchange risk as such should be avoided or reduced. For this the exchange market provides facilities for hedging anticipated or actual claims or liabilities through forward contracts in exchange. A forward contract which is normally for three months is a contract to buy or sell foreign exchange against another currency at some fixed date in the future at a price agreed upon now. No money passes at the time of the contract. But the contract makes it possible to ignore any likely changes in exchange rate.

The existence of a forward market thus makes it possible to hedge an exchange position.

Tips for investing in stocks

Everything you need to know about investing in stocks.

1. Stocks aren't just pieces of paper.

When you buy a share of stock, you are taking a share of ownership in a company. Collectively, the company is owned by all the shareholders, and each share represents a claim on assets and earnings.

2. There are many different kinds of stocks.

The most common ways to divide the market are by company size (measured by market capitalization), sector, and types of growth patterns. Investors may talk about large-cap vs. small-cap stocks, energy vs. technology stocks, or growth vs. value stocks, for example.

3. Stock prices track earnings.

Over the short term, the behavior of the market is based on enthusiasm, fear, rumors and news. Over the long term, though, it is mainly company earnings that determine whether a stock's price will go up, down or sideways.

4. Stocks are your best shot for getting a return over and above the pace of inflation.

Since the end of World War II, through many ups and downs, the average large stock has returned close to 10% a year -- well ahead of inflation, and the return of bonds, real estate and other savings vehicles. As a result, stocks are the best way to save money for long-term goals like retirement.

5. Individual stocks are not the market.

A good stock may go up even when the market is going down, while a stinker can go down even when the market is booming.

6. A great track record does not guarantee strong performance in the future.

Stock prices are based on projections of future earnings. A strong track record bodes well, but even the best companies can slip.

7. You can't tell how expensive a stock is by looking only at its price.

Because a stock's value depends on earnings, a $100 stock can be cheap if the company's earnings prospects are high enough, while a $2 stock can be expensive if earnings potential is dim.

8. Investors compare stock prices to other factors to assess value.

To get a sense of whether a stock is over- or undervalued, investors compare its price to revenue, earnings, cash flow, and other fundamental criteria. Comparing a company's performance expectations to those of its industry is also common -- firms operating in slow-growth industries are judged differently than those whose sectors are more robust.

9. A smart portfolio positioned for long-term growth includes strong stocks from different industries.

As a general rule, it's best to hold stocks from several different industries. That way, if one area of the economy goes into the dumps, you have something to fall back on.

10. It's smarter to buy and hold good stocks than to engage in rapid-fire trading.

The cost of trading has dropped dramatically -- it's easy to find commissions for less than $10 a trade. But there are other costs to trading -- including mark-ups by brokers and higher taxes for short-term trades -- that stack the odds against traders. What's more, active trading requires paying close attention to stock-price fluctuations. That's not so easy to do if you've got a full-time job elsewhere. And it's especially difficult if you are a risk-averse person, in which case the shock of quickly losing a substantial amount of your own money may prove extremely nerve-wracking.

Three Ways to Become a Better Trader

Talking Points:

• Traders should plan their approach, strategies, and risk management before ever placing a trade.
• Risk management protocols should be determined before the entry.
• Trading journals and logs can allow traders to track their progress more efficiently.

Trading isn’t easy… well, I should clarify that. Placing a trade is simple; it’s just a couple of clicks of the mouse and boom: You’re in the trade. But trading profitably isn’t easy, and for most of us that’s the sole and primary reason that we’re in markets in the first place.

In one of the greatest trading books ever penned, Market Wizards, Jack Schwager interviews one of the best traders (and deeper thinkers) of the modern era, Mr. Ed Seykota. In the interview, Seykota offers an eye-opening quote:

“Win or Lose, everybody gets what they want out of the market. Some people seem to like to lose, so they win by losing money.”

While it may initially sound difficult to imagine the trader that likes to lose, think about this for a moment. Trading can be fun, exciting, and potentially profitable; but rarely is it all three at once.

To prioritize profitability is to do all of the little things that so many new traders avoid doing, for whatever reason. In this article, we’re going to address the top three of these, along with showing you how to address each.

The Trading Plan

I’ll be the first to admit, creating a trading plan (and further forcing one’s self to adhere to said plan), is not an exercise in excitement. It’s boring, it can be frustrating, and retaining the discipline to actually adhere to the plan is not easy.

Most new traders will draw up a plan, only to discard it in the next couple of days because something about the plan ‘doesn’t feel right.’

Gut instincts and reactions are probably the most costly risks faced by traders. As humans, we’ve evolved to follow these instincts to keep us out of danger; but modern-day markets are not the Darwinian environment for which your survival instincts are honed. Quite frankly, markets can be dangerous but they’re far from predictable which is what can make reactions such a risky concept.

Think about this for a moment: Markets are unpredictable, and that much is a given. Any trade is, at-best, a simple hypothesis or a probability. How would your gut-instinct be able to predict the future or make any one trade more than a simple probability?

Traders need to build, and adhere to a well-thought out plan-of-attack when approaching a market. This functions like a trader’s constitution to ensure that any position taken on falls within a criteria with which the trader has decided they’d like to speculate. It also helps to eliminate the ‘gut instinct’ reactions that can inevitably cost the trader so much money.

Manage Your Risk Before Your Risk Manages You

The biggest disconnect for most new traders is the conceptualization of risk management. Most traders that come to markets think that you have to have amazingly high winning percentages to be a profitable trader.

This couldn’t be further from the truth.

Not only is having a high ‘hit rate (percentage of profitable trades v/s losing trades),’ difficult; given that markets are unpredictable it’s likely unsustainable.

This topic was investigated in-depth in the article series, The Traits of Successful Traders. In the research, The Number One Mistake Forex Traders Make was found to be inadequate risk-reward ratios. In many cases, such as GBPJPY in the below chart, traders were losing more than $2 on losing positions for every $1 generated on winning positions.

Taken from The Number One Mistake Forex Traders Make, by David Rodriguez

This type of money management is an exercise in futility. Traders would need to be right about 75% of the time to be able to squeak by with a profit; and even then – the risk of slippage or gaps can drain that minimal profit to give the 75% hit rate trader a negative profit line.

Sure, it feels good to close a winning position; even if it’s a small win. But just as Ed Seykota said in The Market Wizards interview: Everybody in markets gets what they want.

If you want to feel good, ok – taking small wins might help you accomplish that.

But if you want to work towards profitability, you’d likely be best suited to follow the advice of some of the best professional traders in the world; advice echoed in The Number One Mistake Forex Traders Make, and look to manage your risk before it manages you.

Traders should look for a minimum risk-reward ratio of 1:1; and are likely best suited looking for even more aggressive risk-reward ratios of 1-to-2 or better.

Track Your Results

An old quote from Yogi Berra goes like this: ‘You’ve got to be very careful if you don’t know where you’re going because you might not get there.’

Analyzing one’s progress when trading can be boiled down to a very simple denominator: How profitable have you been?

But to the trader that hasn’t yet been profitable, this can be extremely difficult to analyze because they don’t know the behaviors that are needed to find that profitability.

Keeping a trading journal, and a trading log can be hugely helpful in tracking that progress. It allows for the trader to utilize critical analysis to see what has, or hasn’t worked for them in the past.

In the journal, write down the ‘reason’ for taking each trade, along with your plan for that position. Where are you going to look to exit, or move your stop, or scale into or out-of the position.

When the trade closes, go back and note how the position performed.

The trading log is simpler, and can be done on any spreadsheet software. This is simply you marking each position taken along with initial risk amount, and profit targets; and when the trade closes record the gain or loss.

In time and with enough positions, this can allow you to calculate your winning percentage, you’re average size of win, and average size of loss along with a flurry of other statistical data points.

With this, you can then begin noticing trends or deficiencies that could amount to improvement in the trading plan.

In conclusion

All-in-all, the three things mentioned above aren’t necessarily fun. But – you have to decide why you’re in markets in the first place.

If you’re here to have fun, you should get comfortable with losing. But, if you want to be profitable, you have to prioritize what’s really important, and what should be secondary (like having fun).

In the long run, many professional traders have found being profitable (if not less exciting) is a heck of a lot more fun than continuing to lose money.

Oil: A Big Investment With Big Tax Breaks

When it comes to tax-advantaged investments for wealthy or sophisticated investors, one investment class continues to stand alone above all others: oil. With the U.S. government's backing, domestic energy production has created a litany of tax incentives for both investors and small producers.

Several major tax benefits are available for oil and gas investors that are found nowhere else in the tax code. Read on, as we cover the benefits of these investments and how you can use them to fire up your portfolio.

Striking Oil

The main benefits of investing in oil include:

• Intangible Drilling Costs: These include everything but the actual drilling equipment. Labor, chemicals, mud, grease and other miscellaneous items necessary for drilling are considered intangible. These expenses generally constitute 65-80% of the total cost of drilling a well and are 100% deductible in the year incurred. For example, if it costs 0,000 to drill a well, and if it was determined that 75% of that cost would be considered intangible, the investor would receive a current deduction of 5,000. Furthermore, it doesn't matter whether the well actually produces or even strikes oil. As long as it starts to operate by March 31 of the following year, the deductions will be allowed.

• Tangible Drilling Costs: Tangible costs pertain to the actual direct cost of the drilling equipment. These expenses are also 100% deductible but must be depreciated over seven years. Therefore, in the example above, the remaining ,000 could be written off according to a seven-year schedule.

• Active vs. Passive Income: The tax code specifies that a working interest (as opposed to a royalty interest) in an oil and gas well is not considered to be a passive activity. This means that all net losses are active income incurred in conjunction with well-head production and can be offset against other forms of income such as wages, interest and capital gains.

• Small Producer Tax Exemptions: This is perhaps the most enticing tax break for small producers and investors. This incentive, which is commonly known as the "depletion allowance," excludes from taxation 15% of all gross income from oil and gas wells. This special advantage is limited solely to small companies and investors. Any company that produces or refines more than 50,000 barrels of oil per day is ineligible. Entities that own more than 1,000 barrels of oil per day, or 6 million cubic feet of gas per day, are excluded as well.

• Lease Costs: These include the purchase of lease and mineral rights, lease operating costs and all administrative, legal and accounting expenses. These expenses are 100% deductible in the year they are incurred.

• Alternative Minimum Tax: All excess intangible drilling costs have been specifically exempted as a "preference item" on the alternative minimum tax return.

Developing Energy Infrastructure

This list of tax breaks effectively illustrates how serious the U.S. government is about developing the domestic energy infrastructure. Perhaps most telling is the fact that there are no income or net worth limitations of any kind for any of them other than what is listed above (i.e. the small producer limit). Therefore, even the wealthiest investors could invest directly in oil and gas and receive all of the benefits listed above, as long as they limit their ownership to 1,000 barrels of oil per day. No other investment category in America can compete with the smorgasbord of tax breaks that are available to the oil and gas industry.

Investment Options in Oil and Gas

Several different avenues are available for oil and gas investors. These can be broken down into four major categories: mutual funds, partnerships, royalty interests and working interests. Each has a different risk level and separate rules for taxation.

• Mutual Funds: While this investment method contains the least amount of risk for the investor, it also does not provide any of the tax benefits listed above. Investors will pay tax on all dividends and capital gains, just as they would with other funds.

• Partnerships: Several forms of partnerships can be used for oil and gas investments. Limited partnerships are the most common, as they limit the liability of the entire producing project to the amount of the partner's investment. These are sold as securities and must be registered with the Securities and Exchange Commission (SEC). The tax incentives listed above are available on a pass-through basis. The partner will receive a Form K-1 each year detailing his or her share of the revenue and expenses.

• Royalties: This is the compensation received by those who own the land where oil and gas wells are drilled. This income comes "off the top" of the gross revenue generated from the wells. Landowners typically receive anywhere from 12-20% of the gross production. (Obviously, owning land that contains oil and gas reserves can be extremely profitable.) Furthermore, landowners assume no liability of any kind relating to the leases or wells. However, landowners also are not eligible for any of the tax benefits enjoyed by those who own working or partnership interests. All royalty income is reportable on Schedule E of Form 1040.

• Working Interests: This is by far the riskiest and most involved way to participate in an oil and gas investment. All income received in this form is reportable on Schedule C of the 1040. Although it is considered self-employment income and is subject to self-employment tax, most investors who participate in this capacity already have incomes that exceed the taxable wage base for Social Security. Working interests are not considered to be securities and therefore require no license to sell. This type of arrangement is similar to a general partnership in that each participant has unlimited liability. Working interests can quite often be bought and sold by a gentleman's agreement.

Net Revenue Interest (NRI)

For any given project, regardless of how the income is ultimately distributed to the investors, production is broken down into gross and net revenue. Gross revenue is simply the number of barrels of oil or cubic feet of gas per day that are produced, while net revenue subtracts both the royalties paid to the landowners and the severance tax on minerals that is assessed by most states. The value of a royalty or working interest in a project is generally quantified as a multiple of the number of barrels of oil or cubic feet of gas produced each day. For example, if a project is producing 10 barrels of oil per day and the going market rate is $35,000 per barrel (this number varies constantly according to a variety of factors), then the wholesale cost of the project will be $350,000.

Now assume that the price of oil is $60 a barrel, severance taxes are 7.5% and the net revenue interest (the working interest percentage received after royalties have been paid) is 80%. The wells are currently pumping out 10 barrels of oil per day, which comes to $600 per day of gross production. Multiply this by 30 days (the number usually used to compute monthly production), and the project is posting gross revenue of $18,000 per month. Then, to compute net revenue, we subtract 20% of $18,000, which brings us to $14,400.

Then the severance tax is paid, which will be 7.5% of $14,400. (Landowners must pay this tax on their royalty income as well.) This brings the net revenue to about $13,320 per month, or about $159,840 per year. But all operating expenses plus any additional drilling costs must be paid out of this income as well. As a result, the project owner may only receive $125,000 in income from the project per year, assuming no new wells are drilled. Of course, if new wells are drilled, they will provide a substantial tax deduction plus (hopefully) additional production for the project.

The Bottom Line

From a tax perspective, oil and gas investments have never looked better. Of course, they are not suitable for everyone, as drilling for oil and gas can be a risky proposition. Therefore, the SEC requires that investors for many oil and gas partnerships be accredited, which means that they meet certain income and net worth requirements. But for those who qualify, participation in an independent oil and gas project can give them just what they're looking for.