The substantial rise in energy prices in the mid-2000s attracted many investors seeking aggressive growth and profits in the oil and gas industry. Although many of these investors cashed in on the gains posted by various energy and natural resources equities, exchange-traded funds (ETFs) and mutual funds, there are other alternatives available that provide more direct exposure to the energy markets.

Limited partnerships, working interests and unit investment trusts (UITs) all provide pass-through treatment of both income and deductions derived from oil and gas investments at the wellhead. This article will examine the nature and purpose of oil and gas UITs, their advantages and disadvantages, and help you decide if they should be fueling your portfolio.

SEE: Oil And Gas Industry Primer

Nature and Composition
By definition, oil and gas UITs are very similar to other UITs that invest in stocks or real estate. Each trust is broken down into individual units that are priced and sold to investors. Each unit represents an undivided proportional interest in all of the oil and gas properties held by the trust, and each trust has a set maturity date upon which all gains and losses from the sale of the assets are dispersed to the unit-holders.

Unlike stock unit trusts or real estate investment trusts (REITs), oil and gas UITs invest directly in either production or exploratory drilling oil and gas assets, then pass through the income and expenses realized from the actual production of oil and natural gas.

Who Should Invest in Oil and Gas UITs?
Investors who are seeking more direct, tax-advantaged exposure to oil and gas investments should consider oil and gas UITs, as the UITs can pass through deductible operational expenses and investment income that is eligible for the depletion allowance.

Energy-focused mutual funds may only buy equity interests in various oil, gas and other energy companies, but seldom offer direct participation of any kind. Energy mutual funds cannot offer pass-through treatment, and usually can only post fully taxable dividends and capital gains.

Furthermore, oil and gas UITs will not post taxable capital gains of any kind until the trust matures, unlike mutual funds that pass through capital gains annually. Aggressive investors seeking larger profits in the energy sector may also benefit from the more direct arrangement of oil and gas UITs as opposed to energy mutual funds.

Pros and Cons
One of the main advantages that holders of energy trusts enjoy is the pass-through tax status, similar to that of limited partnerships or direct working interests. As stated previously, income derived from oil and gas UITs can be eligible for the depletion deduction, and a proportional share of deductible operational expenses is passed through as well.

It should be noted that oil and gas UITs are usually riskier by nature than energy mutual funds, as any properties that cease to produce, for whatever reason, during the tenure of the trust cannot be replaced until maturity. Another factor to consider is that oil and gas units are wasting assets, as their value will automatically decline as producing properties within the trust become depleted over time. Furthermore, investor income is reduced by maintenance and operating costs associated with oil and gas production at the wellhead, such as electric fees, pumping fees and parts replacement.

Income realized from oil and gas UITs is also subject to fluctuation with the rise and fall of energy prices. This risk can be at least partially offset with an investment in both oil and gas properties within the same trust, as the prices of oil and gas do not necessarily move in lock-step.

Finally, oil and gas UITs that participate in drilling of any kind include the risk of unsuccessful development, where one or more wells that are drilled produce little or no oil or gas. This occurrence can obviously lower the value of the trust, as well as deprive the investor of income from the anticipated current production that is never realized.

How Do I Pick the Right Oil and Gas UIT?
When choosing a UIT that invests in oil and gas properties, the most important criteria for investors generally will be the level of risk inherent in the trust. Aggressive trusts that focus on exploratory drilling projects are much more speculative in nature than UITs that invest solely in producing properties. However, successful exploratory drilling also offers greater tax deductions and the potential for higher income. Moderate or conservative investors seeking a regular stream of income should probably restrict their investing to UITs that contain mature producing oil and gas fields.

The Bottom Line
Although oil and gas UITs are similar securities to REITs or trusts that invest in stocks or bonds in many respects, they offer a relatively unique set of advantages and risks to investors. Those seeking more direct exposure to the energy sector (as well as those needing tax-advantaged income) can benefit from investing in these trusts. Investors considering UITs should consult with a tax advisor to determine the efficacy of UITs given their individual tax situations.

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