How can the Opportunity Zone incentive be applied to energy investments in the oil and gas sector?

Matthew Iak is executive vice president of U.S. Energy Development Corporation and has overseen the capital raise of $1.5 billion since 2005.

Click the play button above to listen to my conversation with Matt.

Episode Highlights

• The appeal of the Opportunity Zone tax incentive in the energy industry, and why it works so well.
• Marketplace trends within the oil and gas sector, and the headwinds that the energy industry is currently facing.
• Why cost compression and lack of capital may create an investment opportunity in the energy sector not seen in decades.
• How oil well development on leased or purchased land meets the original use provision for Opportunity Zone compliance.
• How an energy investment can generate cash flow early in the development life cycle and take advantage of traditional oil and gas tax benefits in addition to the OZ incentive.
• How oil and gas exposure can create diversification in an investor’s portfolio.
• How the delay in receiving regulatory guidance and COVID resulted in a lackluster buy-in from the investment community.
• Why an Opportunity Zone investment can be likened to a “Super Roth” IRA.
• Why the Opportunity Zone exclusion benefit is so much more important than the deferral benefit.
• The composition of the capital base for USEDC’s Qualified Opportunity Fund and why they are having more success raising from RIAs and direct investors versus the broker-dealer channel.

Featured on This Episode

• Matthew Iak on LinkedIn
• U.S. Energy Development Corporation
• ADISA Spring Conference 2021 – Scottsdale
• ADISA Annual Conference 2021 – Las Vegas

Industry Spotlight: U.S. Energy Development Corporation

U.S. Energy Development Corporation is a privately held oil and gas operator established in 1980 that provides direct investments in energy for accredited investors and institutional partners. For 40 years, U.S. Energy has invested in, operated and/or drilled more than 2,400 wells in 13 states and Canada. The firm has deployed more than $1.5 billion on behalf of its partners. Today, U.S. Energy is one of the largest sponsors of direct energy investments and offers one of the only oil and gas Opportunity Zone funds.

Learn More About U.S. Energy:

• Visit USEDC.com

About the Opportunity Zones Podcast

Hosted by OpportunityDb.com founder Jimmy Atkinson, the Opportunity Zones Podcast features guest interviews from fund managers, advisors, policymakers, tax professionals, and other foremost experts in opportunity zones.

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Show Transcript

Jimmy: Welcome to the Opportunity Zones Podcast. I’m your host, Jimmy Atkinson, coming to you today from the ADISA Conference in Scottsdale, AZ. I’m joined by the executive vice president of U.S. Energy Development Corporation, Matthew Iak.

Matt, thanks for coming on the show today. Welcome!

Matt: Thank you so much for having me.

Jimmy: Absolutely. So your Qualified Opportunity Fund is a little bit of a different flavor than a lot of others that I’ve interviewed on this podcast. You’re not a real estate fund. You are investing in the energy space. So to start us off, I’m going to ask you — I think it’s a softball question — why did you set up this fund in the energy space? Tell us a little about it.

Matt: That’s a great question. That is a softball question. So I think what’s unique is many of your listeners — all of your listeners probably — will know about Opportunity Zones in general. So we are an investment company that tries to bring the best direct energy investments to direct investors. And when we look at the world, as an energy company we’re constantly going for the best arbitrage in both performance in tax, because we believe it’s not just what you earn but it’s what you keep, and when the Opportunity Zone tax law came into effect, it had an immediate appeal to us because we look for that type of investor — large, accredited investors — to invest in our company alongside of us.

And so, through the original genesis of that tax law, it turned out that the law worked extremely well in the energy space. And since we already have access to a very large network of investors, the pairing just became this really unique arbitrage in a way that most people haven’t thought of Opportunity Zones.

And I’m sure most will know that options are much more wide sweeping than real estate, but it appears that most of the law is utilized around real estate.

Jimmy: Yeah, and we can get into why that is. A lot of the reason why is the real estate industry has a kind of muscle memory in terms of going through the motions in terms of — this isn’t a tax credit program — but it can be likened to a tax credit program and the fact that it’s a place-based program, which lends itself well to being utilized by real estate developers.

Matt: Right, and the fact that it’s a fund, the law’s really designed for those who invest in funds. That is really the genesis of the way it’s written, which usually fits well to those who raise capital, which happens to be real estate, and also works very well for oil and gas.

Jimmy: Right. So, talk to us about oil and gas. I want to hear more about your fund later and your investing strategy and what it is you’re doing exactly. But first, let’s get the 30,000-foot view of the oil and gas sector. What are some trends and marketplace trends that you’re seeing lately?

Matt: So there’s awful lot of backdrop that we can go through on the oil and gas sector. So, as many people probably realize that we’re facing a lot of headwinds in the energy space. Although a lot of the risks have abated over the last couple of years like lower prices and you name it, there’s still an overall issue with energy in terms of the public eyes. So, you have the overall ESG movement and a lot of political backlash, you have the climate change, you have regulation, you have a significant amount of forces that are working I would say contrary to the benefit of traditional oil and gas.

At the same point in time, you have some of the greatest technologies that have advanced over the last five years like hydraulic fracturing, the ability to access and bring product to market and create energy independence. So, you have all this positivity in direct juxtaposition to all the negativity.

And I think the most interesting overall comment I can make about the space is what has happened in last three to four years is through a combination of every factor you can imagine. I would say relatively poor performance from debt, equity, stock market in traditional energy coupled with the inability now for them to get new capital, it’s partly because of that and partly because of the ESG movement. What you’ve seen is so much less capital in space that is super capital intensive. To drill and to keep up with pace, you need to constantly put new production online.

And when those two forces meet, the need for constant capital and then the lack thereof, what’s actually really happened in the last couple of years is you’ve had so much cost compression and technology change the industry in terms of its profitability and no capital coming into space at the same time which has created really phenomenal investment opportunities and arbitrages we haven’t seen in 40 years. And part of it in the simplest asset is because there’s just not that much capital in the space.

Jimmy: And now comes along the Qualified Opportunity Zone program and it effectively lowers the cost of capital, right?

Matt: It does pretty substantially. So, anytime you have a significant additional tax benefit on top of all the tax benefits that exist in an asset class, obviously, it creates a greater economic benefit. And then, with the fact that you can construct the funds in a very cost-efficient manner, it’s a lower cost of capital to enter into the space, probably a third of what it normally costs to have in a fund structure through at least what we’ve designed and I hope what others do in the Qualified Opportunity Zone Fund space in direct energy.

Jimmy: Yeah. And that makes perfect sense to me. It seems like the Opportunity Zone program came around just at the right time for the oil and gas sector in a way. Talk to me about your fund now. What makes your fund unique? Well, what is it exactly? What are you doing? You’re buying up oil fields and installing wells or what are you doing exactly?

Matt: So, again, great question for me. Specifically, what we do in the fund is obviously you’re going to raise a pool of capital in the Opportunity Zone Fund and comply with the different nuances of the law. Whether it’d be original use or substantial improvement or a Qualified Opportunity Zone business, one of the sub-entities. And what you’re ultimately going to invest in is a field. You’re going to purchase the land or lease the land and you’re going to develop the reserves. The easiest way to comply with the law is original use. So, actually just taking the lease and developing the wells qualifies you immediately. You don’t have to chase down the normal rules.

Jimmy: There’s no substantial improvement.

Matt: There’s no substantial improvement.

Jimmy: You just install the well and you’re good to go.

Matt: And you’re good to go. The timeframe that you’re spending the capital extremely rapidly within a couple of months. And to answer your question, outside of the ease of complying with the law, which is unique, the one big difference in oil and gas Opportunity Zones is you’re able to generate a ton of cash flow in the early years and distribute out cash flow because you don’t have to wait for debt refinance distributions which you have to wait for an extremely long period of time in most development, one, because how do you develop something to generate cash flow if you’re substantially improving it?

But in addition to that, so you’re generating actual cash flow but you comply with the law in terms of actually be able to generate and distribute revenue. And then all the traditional benefits of oil and gas, all the tax deductions, the depletion allowance, the intangible drilling costs deductions you actually pass those through as you generate revenue. So, the revenue is tax-free during the lifecycle, in addition to all the other OZ benefits.

Jimmy: That’s pretty good. Hard to beat that. Passing along those types of benefits is huge to the investor at the end of the day.

Matt: Correct. Again, I think we make a great complement to the other Opportunity Zone asset classes because if you want to use the tax law with a large capital gain, mixing and matching oil and gas with real estate we can generate a lot of the cash flow that they can’t and maybe they have more appreciation. So, you can kind of mix and match the funds to generate a better conclusion in financial planning for the end client.

Jimmy: Right. So you wouldn’t necessarily recommend that someone with a huge capital gain pours it all into your fund, although I’m sure you would like that, right? But it’s a good diversifier.

Matt: Yeah. From a capital formation standpoint, I think if I were someone’s financial advisor, I would never allow them to take a single asset class, even real estate, which is safer by nature, and pour it into a single asset. So I think we’re probably the best compliment and we’re a great tool in the quiver. We may not be the single choice nor should we ever be if I was speaking from a financial planner standpoint.

Jimmy: Yeah, that makes perfect sense. Talk to me about some of the biggest challenges that you faced, both in terms of setting up the Qualified Opportunity Fund structure and in terms of raising capital for it.

Matt: So, those actually are probably the two biggest challenges. It’s not the law. It’s not the investment opportunities. It really came down to getting clarity on the law from 2017 to ’19. There was a lot of hanging chads as we all know. So I worked for over two years with Baker McKenzie to draft and come up with a final version of the Opportunity Zone tax law. So, that was kind of one of the major challenges was just all the delays and the inability to get answers from the Treasury and from the IRS and from Congress to actually know how it was going to work down to the final piece. Then I think what happened is actually because of that long delay, amongst other reasons, there was somewhat of a lackluster buy-in from the investment community.

Jimmy: Absolutely.

Matt: And it really prolonged. And then when COVID hit, I think it kicked it one more year, right?

Jimmy: That was really bad timing because we had finally just gotten final regulations at the end of 2019. And then we were humming along nicely for a couple of months and then everything shut down. That was disappointing.

Matt: So, I think there’s capital raise. And I think there’s still an impediment out there that people are missing. And the impediment that I constantly see is people believe that the tax deferral till 2026 is the big event of an Opportunity Zone. That’s a minor benefit compared to the tax-free nature of the 10-year hold and the ability to generate tax-free cash flow during the lifecycle, right? Tax-free. Is tax-free. Is tax-free.

To me, it’s really a super Roth. You’re only limited by the amount you have in capital gains. It’s greatest financial planning tax tool I’ve ever seen in my life if you can find the investment vehicles and the underlying assets that work. I can’t find a better tax structure anywhere in the code. And the problem is, I think the middle audience isn’t really understanding that it’s a super Roth, not a tax deferral. The tax deferral is great. It’s a plus. It’s cherry on top. But it is not the main reason to make the investment. And I think too much impetus has been put on that.

Jimmy: One, I think it’s giving some investors pause, especially with talks of Biden potentially raising capital gains taxes, like he’s talking about doing so into the high 30s, low 40s, something like that.

Matt: Correct.

Jimmy: That is giving people pause because they’re saying, “Wait a second, I get to defer my taxes until 2026 but then I’m paying it at a much higher rate. What’s the point of all this?”

Matt: Correct.

Jimmy: They’re missing the bigger picture, I think. And, by the way, that is a reasonable concern. But at the end of the day, it makes the benefit, I think, a lot more attractive, that back end benefit, that exclusion benefit, getting to avoid capital gains taxation on the appreciation, that’s unbelievably huge, right?

Matt: It’s unbelievable, right?

Jimmy: And on the tax-free growth that you were speaking of earlier.

Matt: Correct. So, in oil and gas, what’s really unique is that it’s probably one of the highest IRR investments, internal rate of return. It’s not the highest ROI. When you drill a well, you might only make one and a half times your money on that well, but you get 100% of it within three to four years. And if you’re reinvesting in an Opportunity Zone, the compounding wealth that you’re able to generate, which doesn’t exist in any other oil and gas investment in that nature.

So, to me that the backside of this is so much more powerful than the deferral. And it is in many other asset classes like real estate and you name it. So, I really wish that people would see that and stop worrying about the, “What happens in 2026?” And there’s just so much focus on that because I think even the idea of, “How do I pay the taxes?” “Is there going to be a special debt refinance distribution in 2026?” In oil energy, we don’t have that because we have a stepped-up basis. And if I generate 30% cash flow that year, I can distribute all the 30% tax-free to the investor because of the other tax benefits.

So, from our perspective, we don’t have all the hanging chads of debt refinance distributions or all the different issues that come in the normal real estate Opportunity Zone paradigm that investors think.

Jimmy: Right. No, that makes sense. That makes perfect sense. I think we see eye to eye on that. Probably like everybody else at this conference I would hope, that backend benefit is what is really driving this tax incentive. I want to hear about what you’re learning from your investors, Matt, what are they telling you? What do they like about your fund?

Matt: So, I alluded to a couple of the single biggest benefits that they like. They like that one will have a reduction in tax in 2026, that will have liquidity and cash flow during the lifecycle that you’re generating 6% a year. That, in essence, is tax-deferred but tax-free if you hold it for all 10. They love the unique opportunity of coming into an asset class that isn’t at its peak, it’s at its trough. So, I think a lot of this is the arbitrage that they’re looking at that you have traditional energy at a very low price versus buying in real estate at really high highs.

So, instead of finding the diamond in the rough, the unique part is over half of our inventory that we drill as a company is in Opportunity Zones. We don’t have to chase the inventory. The core of the Permian Basin, several cores of the Eagle Ford, and the Powder River, they’re all in Opportunity Zones.

Jimmy: You were drilling them already anyway.

Matt: You’re drilling them already.

Jimmy: So, it’s not like you’re going out of your way to find wells in Opportunity Zones. But if you happen to be drilling a well in an Opportunity Zone, setting up a well in Opportunity Zone, you put it into the fund. You put it into the QOF structure.

Matt: So, about half of our inventory falls in. They go into the QOF. The other half doesn’t. They go into other funds. It’s just a nice little nuance for us in what we were already doing in our business.

Jimmy: And that makes perfect sense. And you have just one QOF. You don’t have a different QOF for every field, do you?

Matt: No. Right now we just have one Qualified Opportunity Zone Fund for the energy sector.

Jimmy: That makes it easy.

Matt: It does. Yes.

Jimmy: And your investors, typically, I want to hear more about what your capital base looks like. You said larger accredited investors, are we talking about high-net-worth, ultra-high-net-worth, family offices, a lot of IRA, capital in there?

Matt: It’s a great question. So, it’s been a little unique in that we’ve had very large investors on average, much more than the average investor in energy. So on average, probably $800,000 investors that are coming into the fund. And that’s usually only one-fifth of what their asset is or 35%. So, they’re very large investments on average. Now, the mean and median may be very different. Some of the larger ones may skew that. The really interesting thing for us is the end audience has been we’ve had three times the demand from our IRAs and direct clients and family offices than we have from the broker-dealer community.

So part of that is the dislocation of interest that broker-dealers have versus IRAs. IRAs are going to be there for 10 years. And as a client, isn’t always the case in a broker relationship, or at least assumed to be the case. I think also just the very nature of the compliance world of a broker-dealer is a lot more unsure of the Qualified Opportunity Zone Fund. So, there’s this middle market that makes it a little more difficult to distribute than it does in the IRA. So we’ve seen a massive, massive investment from the IRA side and an okay side from the broker-dealer side.

Jimmy: Sure. That makes sense to me. Thanks for the insight there. That’s always a fun question I like to ask the fund managers to come on the show, “Where’s your money coming from?” They tell me similar stories, but little different wrinkle for every one of them it seems.

So, Matt, we’re at ADISA Conference here in Scottsdale. ADISA stands for Alternative and Direct Investment Securities Association. They do two conferences a year. They’re having an annual conference in Vegas later this fall. But this is their first conference they’ve had post-COVID. So, we’re all here in person now. It’s really nice to be able to meet a lot of my industry colleagues that I’ve been getting to know over the last couple of years, but haven’t had a chance to meet them face to face.

Matt, you and I just met on a Zoom call about a week ago. And we’re going to be on a panel tomorrow or by the time you listen to this episode, the panel will have already happened. But we’re looking forward to talking Opportunity Zones with everybody at the conference pretty soon here. Why did you come to the ADISA Conference, Matt? What brings you here to Scottsdale?

Matt: So the weather is great, of course.

Jimmy: It’s hard to beat. A little hot out there.

Matt: It’s a little hot. But ADISA has been an organization that we’ve had a long affiliation with. We really enjoy the benefits through their trade organization that obviously represents alternative investments in Washington and represents alternate investments to different investment networks like broker-dealers and IRAs. So it’s a gathering in a meeting spot for all of us to talk, to go on to interesting panels and discuss unique opportunities like Opportunity Zones amongst other things. It’s a constant forefront of what’s happening from a legislative perspective and what’s really happening in the industry as well.

So it’s just probably one of the premier organizations in terms of the ability for people to get together a meeting of minds who are in the investment community. And the beauty is there’s a wide array of sponsors in the same fields like energy, and a wide array of sponsors in many different fields, like life settlements, to real estate, to insurance. So, the ability to really look at products’ fees, compression, discussion, all of that in one conference is always a benefit. So we’ve been a longtime advocate and part of ADISA and found it extremely valuable for our organization.

Jimmy: This is my first foray into the ADISA world but I’m happy to be here and happy they invited me along and gave me this nice setup where I can record some podcast interviews. So, Matt is my first of many podcast interviews that I hope to be doing here at the ADISA Conference over the next couple of days in Scottsdale. Well, Matt, thank you for joining me today. I appreciate all the time that you’ve given me and your insight into both the Opportunity Zone world and into the oil and gas sector. Before we go, can you tell our listeners where they can go to learn more about you and U.S. Energy Development Corp.?

Matt: Of course. I would recommend probably using our website as the primary site at www.usedc, that’s echo-delta-charlie or U.S. Energy Development Corporation, our name, .com. And there’s a series of links and information about the suite of funds and tax concepts that we do. And then there’ll be a series of numbers to contact us. Or honestly contact your advisor. We’re probably on half the platforms in the U.S. that you can directly access our funds or different nuances of our funds. Not always the QOC. Sometimes it’s a different fund structure, but we’re probably one of the largest, if not the largest direct energy sponsor in the U.S.

Jimmy: That’s impressive. Well, again, Matt, thanks for joining me. And for our listeners out there today, I will have show notes on the Opportunity Zones Database website, as I always do. You can find those show notes at opportunitydb.com/podcast. And there I’ll have links to all of the resources that Matt and I discussed on today’s show. And I’ll be sure to link to usedc echo-delta-charlie .com. usedc.com. Matt, thanks again for joining me. Appreciate it.

Matt: Thank you so much.