Explaining the Oil & Gas Depletion Allowance for Long‑Term Investors

Introduction

Oil and gas wells are natural resources that eventually run out. To encourage drilling and support smaller operators, U.S. tax law lets qualifying producers and royalty owners subtract a portion of their revenue each year to account for the depletion of the resource. This deduction is called the depletion allowance, and it can make a meaningful difference for people investing in energy projects. Understanding how the allowance works can help long‑term investors make informed decisions and decide which structures best fit their goals. The following sections break down the policy’s origin, the two calculation methods, its long‑term benefits, and how BASS EXP helps investors take advantage of it.

How the Tax Allowance Works and Its Policy Origin

The depletion allowance was designed to reflect the fact that oil and gas reservoirs decline over time. The concept first appeared as “discovery depletion” in 1918, when Congress wanted to boost domestic production during World War I. Producers could deduct a portion of the field’s market value to offset the shrinking supply. By 1926 the rules were simplified into a percentage depletion deduction based on sales rather than fair market value. Over the decades the rate changed; by 1984 the allowance settled at 15% of gross income for independent producers and royalty owners. Larger integrated oil companies can no longer use percentage depletion; they must rely on cost depletion, discussed below.

Two important constraints apply when claiming the depletion allowance:

• Who qualifies: Only independent producers and royalty owners (not integrated refiners) may use percentage depletion. Investors must have an ownership interest and a right to the income.
• Income limits: The deduction is capped at the lesser of 100 % of net income from the property or 65 % of taxable income from all sources. Any unused deduction may carry over to future years.

These safeguards were added to curb abuse while still encouraging development of smaller reserves. They ensure that the allowance reflects actual production and does not wipe out a taxpayer’s entire tax liability.

Percentage vs. Cost Depletion: Methods Compared

The tax code allows two ways to calculate depletion. Each year producers can compare them and choose the method that results in the larger deduction. Here’s how they differ:

Percentage Depletion

• Calculation: Multiply 15% by the gross income from the sale of oil or gas produced from the property. Gross income generally refers to revenue from the sale near the wellhead and excludes lease bonuses or pipeline income.
• Eligibility: Available only to independent producers and royalty owners. Larger integrated companies are excluded.
• No basis limitation: The deduction can exceed the property’s adjusted basis and continues as long as the well produces revenue. This means the investor may continue to deduct 15% of gross income even after recovering the original investment.
• Limits: The deduction cannot exceed 100 % of net income from the property, and there is an overall cap of 65 % of the taxpayer’s total taxable income.

Cost Depletion

• Calculation: Start with the property’s adjusted basis (the capital invested). Divide this by the total recoverable units (estimated barrels or cubic feet). Multiply the result by the units sold during the year. A simplified formula is:
  Cost depletion = (Adjusted basis ÷ Total recoverable units) × Units sold.
• Eligibility: Available to any owner of an economic interest in a mineral property, including integrated companies.
• Basis limitation: Once the adjusted basis is recovered, no further cost depletion deduction is allowed. For properties with a low basis or long production life, cost depletion may be small.
• Documentation: To claim cost depletion, investors need reliable data on reserves, production volumes, and purchase price. Many small landowners use percentage depletion because estimating reserves and basis can be challenging.

Choosing Between the Methods

Taxpayers compare cost and percentage depletion each year and claim the larger deduction. In early years, cost depletion may be higher if the investment basis is large relative to reserves. Over time, percentage depletion often yields a greater benefit because it is based on revenue and continues indefinitely. Independent producers and royalty owners typically prefer percentage depletion for this reason.

Long‑Term Investor Advantages

Oil and gas wells can produce income for many years, sometimes decades. The depletion allowance enhances that long‑term income in several ways:

• Tax‑free portion of revenue: For eligible investors, about 15 % of gross income from a producing well is sheltered from federal income tax. This creates a stream of tax‑advantaged cash flow that continues even after the original investment is recovered.
• Synergy with drilling deductions: Investors in working interests may also deduct intangible drilling costs and tangible equipment costs in the early years. When combined with the depletion allowance, these deductions can reduce taxable income substantially. The result is more after‑tax cash available for reinvestment.
• No depreciation recapture: Unlike depreciation for equipment, percentage depletion is not recaptured when the property is sold. This can reduce taxes on exit and improve overall returns.
• Flexibility to adapt: Because investors can compare cost and percentage depletion annually, they can adapt as market conditions change and their basis declines.
• Improved cash flow: Regular revenue from producing wells, combined with tax savings, can provide steady cash flow over long periods. This can make oil and gas assets appealing complements to more traditional portfolios.

Investors should remember that these advantages come with risks. Production volumes and prices fluctuate, reserves may be lower than expected, and tax laws can change. Long‑term success depends on careful project selection and sound management.

How BASS EXP Delivers Access to These Benefits

BASS EXP is structured as an independent producer, which means our investors may qualify for the 15 % percentage depletion allowance on revenue from producing wells. We design our offerings with the following considerations:

• Focus on independence: By maintaining independence from integrated refiners, our partnerships qualify for percentage depletion under current law.
• Selective projects: We evaluate potential wells based on geology, reserve estimates, and operational efficiency. This due diligence aims to align investor interests with long‑term production and tax benefits.
• Transparent reporting: Investors receive regular statements showing production volumes, gross income, and deductions. This information supports accurate depletion calculations and tax filings.
• Educational support: Many investors are new to energy ventures. We explain the difference between cost and percentage depletion and encourage consultation with tax professionals. Investors can then decide which method yields the best result each year.
• Long‑term orientation: Our goal is to develop wells that provide cash flow over many years. The depletion allowance is one of several tools, alongside drilling cost deductions and favorable royalty structures, that enhance after‑tax returns. We also emphasize that exploration carries risks and that we pursue balanced portfolios to manage those risks.

By aligning our structure with the rules for independent producers and providing clear information, we help investors access the tax advantages of the depletion allowance without sacrificing transparency or prudence.

Conclusion

The oil and gas depletion allowance is a century‑old policy designed to support the development of domestic resources. For independent producers and royalty owners, it allows a deduction equal to 15 % of gross income from a well, subject to income limits and eligibility rules. Investors may compare this percentage depletion with the cost depletion method and choose the larger deduction each year. When combined with other energy tax incentives, the depletion allowance can provide a lasting boost to after‑tax returns and make wells a compelling long‑term investment.

BASS EXP leverages its independent structure and disciplined project selection to help investors capture these benefits. Our focus on education and transparency ensures that investors understand the rules and can make informed decisions. As you explore opportunities in the oil and gas sector, consider how the depletion allowance fits into your long‑term strategy and contact BASS EXP to learn more about how our programs can support your goals.