Remember oil and gas investments? Remember the tempting income potential and the surefire tax benefits? Before you get too nostalgic, remember, too, how soft energy markets and the Internal Revenue Service's crackdown on tax shelters gummed up more than a few petroleum-based investment portfolios. Recently, it seems, only the hardy or the foolish have been venturing into the mine field of drilling partnerships.

But appearances deceive. In fact, says John A. Hill, "some of the savviest investors around" are buying into oil and gas right now. Of whom is he thinking? Institutions and pension funds, he says, both domestic and foreign, heavy hitters all. The oil industry itself will spend almost $35 billion to develop wells this year, according to Oil & Gas Journal, a weekly trade publication. And then, there are takeover artists like Carl Icahn and T. Boone Pickens hungering for oil companies. Do they know something the rest of us don't?

Hill thinks they do. Formerly the number-two man in the Federal Energy Administration, he is currently president of First Reserve Capital Management Corp., a New York City firm that has raised $280 million from institutional clients for oil and gas investments. First Reserve doesn't offer any drilling programs to individual investors -- but individuals, Hill believes, may be wondering why their bigger colleagues are treading such apparently dangerous ground.

INC: contributor Heidi S. Fiske, a New York City writer, talked with Hill earlier this year:

INC.: From the investor's perspective -- although certainly not from the consumer's -- the news on oil prices continues to be bleak. So why are institutions getting interested now?

HILL: What they see is that drilling costs are down and that, looking beyond the current glut, our oil supplies are diminishing and our energy needs are continuing to grow. Then, too, oil investors are getting a good deal now precisely because so much money has been scared away by the low prices and disastrous results of earlier shelters.

INC.: Shelters, you said. Aren't the tax benefits of oil and gas investing about to vanish?

HILL: Not all of them. I don't believe the depletion allowance will be eliminated, because that affects all minerals and is really a recovery of capital. The deduction for intangible drilling expenses is at risk in Washington, but I suspect that it will also remain largely intact. And none of the benefits are likely to disappear right away; before leaving the Treasury Department, Donald Regan said that this year's tax benefits would be grandfathered. Since the entire benefit of the intangible drilling-cost deduction is usually taken in the first year, 1985 is a good year to buy in.

INC.: What level of tax benefits should you look for in these deals?

HILL: As a rule of thumb, you want a tax break equal to 75% or 80% of your investment. The bulk of that should come in the first year through the intangible drilling-cost deduction.

INC.: All right, let's say you are looking for a deal. What's the pitch you are likely to hear this time around? And how do you sort out truth from hype?

HILL: One thing promoters like to say is, "We've had a terrific year. For each $1,000 you might have invested, we found 5,000 barrels of oil. Since buyers are paying $8 a barrel net, you would have $40,000 in your account for every thousand dollars you put in."

What the promoter isn't telling you is that some of these 5,000 barrels are "proved producing," some are "proved nonproducing," some are "probable," and some are "possible."

Proved means that there is so much oil that an engineer has determined can be profitably recovered.We value proved producing at 100%. Proved nonproducing, which is the oil not yet being pumped, is valued at 75%. Probable means that theoretically we could recover so much oil.We used to value probable reserves at 25%, but at current prices they won't be developed, so now we value them at zero. Possible means just that: possible. We always value possible reserves at zero.

Now let's take another look at those 5,000 barrels of oil that the promoter claims to have found. If 250 were proved producing, 750 were proved nonproducing, 2,000 were probable, and the rest were possible -- a not unlikely mixture -- then we calculate it like this: Proved producing: 250 barrels at $8, or $2,000; proved nonproducing: 750 barrels at $8 times 75%, or $4,500; probable and possible: 4,000 barrels at zero.

Add it up and you have $6,500 worth of oil, not $40,000.

INC.: How do you find out what the breakdown is?

HILL: Ask to see the engineer's report.

INC.: What else should investors watch out for?

HILL: Let's say you put up $1,000 in year one. During year two, you get four checks totaling $500. Then the driller comes looking for more money. "Wow," he says, "look at your 50% return! How about investing in our next program?" That's where most people get bamboozled; what the driller isn't saying is that the well just watered out and you've just gotten the only $500 you'll ever see. That's not a 50% return, it's a 50% loss of capital.

INC.: So how do you avoid getting into a deal where the numbers will look as bad as this?

HILL: The first thing you want to determine is how much of your money is actually going into the ground. A lot of charges are slapped onto these deals. There's the selling commission, which may come to 8% or 8.5%. Sometimes there's a onetime management fee. And there's an annual administration fee, which should not exceed 10%. In fact, all three of these charges should not come to more than 15%.

The next thing to look at is the driller's back-end interest, called a promoter's carry. After you have gotten your initial cash out, this should come to no more than 20% of your profits on an ongoing basis.

In both cases, it's worth looking at the five-year history of this driller's deals. It's all very well to know that the administration fee will come to 10% of your investment, for example, but the real question is what percent of revenues it will absorb. Ask the driller: What was the administration fee for the past five years in your deals per dollar returned? If the answer is, "I don't have the data in that form," don't invest. That's hogwash.

INC.: Are there other aspects of the five-year record you should check?

HILL: Yes. The next key question is: "What was your cash-on-cash return to your investors over the past five years?" They'll always offer to tell you how much oil they found and how much that is worth, but that doesn't tell you how much their investors have actually earned.

INC.: Doesn't your proved-probable-possible calculation tell you how much you would make?

HILL: Not quite. The proportion of proved reserves the promoter finds tells you how good an oil man he is. But the cash-on-cash return goes beyond that to tell you, in addition, how good a manager he is, because it indicates what it cost him to get that oil out.

INC.: What's a good cash-on-cash return?

HILL: Two and a half to one.

INC.: Anything else that should be checked?

HILL: You want to see the results of his programs year by year for five years. If you see the results only for the five years as a whole, he may have hit the jackpot in one year. But the odds of your being in the program for the one good year in five are too small. We feel that he should make money at least one year in three before you want to invest with him.

Which brings me to another point. You should not go into just one drilling program, but should try to invest each year for perhaps five years. That way, you materially increase your odds of being around in the years that pay off.

INC.: But if you need to invest every year for five years, and the tax benefits aren't assured beyond 1985?

HILL: Forget the tax benefits. One quarter of the great fortunes in this country were made in oil, many of them without any help from the tax code. I would advise you to invest only with people who have had a positive return over several drilling cycles -- a drilling cycle is about three years -- without reference to the tax benefits.

INC.: If you get satisfactory answers to these questions, can you be sure you have a good deal?

HILL: You're getting close. But you also have to ask about the balance sheet. These spectacular bankruptcies that have been in the headlines lately could have been predicted from the balance sheets. You should invest only with a driller whose balance sheet shows four things. One: positive working capital. Two: long-term debt no greater than half the socalled SEC value of the company's oil and gas reserves (SEC value will be stated in the report). Three: overhead expenditures that don't exceed 30% of revenues for a small company, less for a big one. This criterion alone will disqualify some three quarters of the 10,000 independent drillers out there.

Finally, there should be no hidden liabilities. In some of the recent bankruptcies, for instance, the footnotes showed that there were buy-back provisions at certain prices, where the sponsors offered to make the investors whole if they wanted out of the deal. That looks terrific until you realize that the driller can't deliver on that promise unless he makes money.

INC.: What if the price of oil really tanks -- say to half its current price?

HILL: The risk to your investment from the exploration is far greater than from a collapse in prices. Nine out of 10 wells are dry. On that secondary risk, the price, well, that's hard to answer. I can show you wells that are profitable at $5 a barrel and others that lose money at $25.

INC.: How do you tell which kind your driller is working on?

HILL: You inquire into his philosophy. Is he looking for a large number of wells with small reserves, or a small number with large reserves? The latter are more likely to be economic at lower oil prices, but the financial risk of drilling for this kind of reserve is greater because dry holes are so costly. If he's drilling shallow in this country, it's axiomatic that he's looking for small reserves, because that's all that are left where it's shallow. Generally, it's the larger companies that are drilling the deeper wells, looking for big reserves in each one.