Hold v. Sell: Part #6 – A Win-Win Transaction

The sixth installment of our “Hold v. Sell” series discusses how a mineral transaction can often be beneficial to both parties involved.  You can read the full series here.

Introduction

“I’m never selling my minerals.  Period.  Full Stop.”  I believe people who hold this rigid belief do themselves a disservice.  This advice often comes from a well-intentioned friend or relative and subsequently becomes gospel, never given further consideration.  But to take this view without considering the pros and cons of selling versus holding is, to be blunt, lazy.  It is easier to say “I’m never selling” and move on with your life.  Mineral rights can be very valuable assets.  You owe it to yourself to hunker down, do the research, and determine for yourself what the right decision is.  Everyone’s situation is unique.  Selling does not always make sense; just like holding does not always make sense.  The world is colored by shades of gray, not black-and-white.

My goal is not to convince owners that they should sell or hold.  Rather it is to provide the ammunition for informed decisions.  I provide information from the perspective of both a mineral owner and buyer.  After all, an informed mineral owner is a powerful one.

This entry focuses on how a transaction is often a win-win for both parties involved.

Win-Win Transaction

Trading Risk & Reward

As discussed in the second entry of this series, a mineral transaction boils down to a transfer of risk.  Owners offload the oil price, future drilling, operator bankruptcy and well-performance/shut-in risks to buyers.  Buyers (the smart ones, at least) take all these risks into account when calculating their offer price.  The offer will be commiserate with the perceived risk/reward potential.  A deal is reached when buyer and seller feel the price is a fair representation of the risk/reward transfer that takes place.

The owner benefits from receiving cash and eliminating the risks inherent to mineral owners.  The buyer benefits from the (potential*) rewards that are due to the risk-taker. (*There are only rewards if the investment performs as-expected for buyer.)

Free-Markets = Fair Market Value

Many owners’ default assumption is to never sell because a buyer must know something they do not…why else would the buyer want to buy?  In other words, owners fear there is information asymmetry in the transaction.  As discussed in the first entry of this series, this should not be a concern.  A sophisticated buyer may have some information the owner does not, but guess what, all other mineral buyers also have that same information.  The United States is a capitalist society, which leads to competition.  Competition leads to fair-market value pricing.  This is a basic tenant of the free-market system.  Mineral Buyer A isn’t going to let Mineral Buyer B acquire all the minerals if they are both in the market.  So, they will compete with each other on price to the benefit of the mineral owner.

This competition is happening in the background even if owners do not actively see it.  It should provide owners peace of mind that they are receiving a fair price for their minerals.

The Unites States free-market, capitalist system ensures transactions are not one-sided.  No one can be compelled or otherwise forced to transact if they do not want to.  An agreement is reached only when both sides feel it is in their best interest, and thus, is a win-win.

Swap Minerals for Other Assets

People tend to prefer to invest in the things they best understand.  A mineral owner that is a cattle rancher is likely much better at assessing and managing an investment in 100 cattle than he is at 100 mineral acres.  The opposite is also true.  A mineral buyer is likely much better at assessing and managing an investment of 100 mineral acres than he is at investing in 100 cattle.  A deal between these two parties will likely be mutually beneficial as the cattle rancher can take the proceeds and invest in something in his domain of expertise.

Perhaps the mineral owner wants to invest in real estate, an asset class many people are very familiar with.  In this case, he could sell his minerals and invest the proceeds tax-free into real estate via a 1031-exchange.

Maybe the mineral wants to just bet on oil prices and not the operator or the few wells drilled on his lands.  In this case he sells his minerals and invests in an oil-tracking ETF stock (this strategy is discussed more in depth here).

People are generally much better at making and managing investments when they have extensive asset-specific experience and knowledge.  A sale allows mineral owners to take the proceeds and invest in an asset they have experience with.  The buyer is likely well-versed in minerals.  This is a mutually-beneficial exchange as both parties end up with investments in which they have expertise, and thus a higher likelihood of success.

From a Mineral Buyer Perspective

Exposure to Oil

The focus of this series has been on how and when a transaction can be beneficial to mineral owners.  But what about mineral buyers…why don’t they just invest in oil directly and skip minerals altogether?

This is a valid question.  As I am writing this in April 2020, oil prices are under $10 per barrel. COVID-19 has absolutely decimated oil demand.  The world is swimming in oil and traders fear prices will actually turn negative as we run out of storage.  $10 oil is not sustainable; no U.S. oil producers are profitable at this price. So why would people still want to invest in minerals?

If and when the world restarts, oil consumption will return to somewhere around its pre-coronavirus levels of 100 million barrels per day.  In order to meet this demand, prices need to be at a level high enough for U.S. producers to justify producing oil.  This breakeven price varies by operator, but is somewhere in the neighborhood of $45-$50 per barrel.  Because the world still runs on oil, it is near-certainty that oil prices return to those levels at some point in order to meet demand.

This still doesn’t answer the question of why someone would want to buy minerals.  It seems they would be better-served buying oil and skipping minerals altogether. This is true.  However, most mineral buying companies are not setup this way.  A company is usually authorized to pursue only certain defined activities. 

Acceptable Activities

A company charter establishes what a company can and cannot do.  For mineral-buying companies, the charter usually says something to the effect of “the company may only use investor capital to fund the acquisition of mineral rights and related operating expenses.”  The company is almost certainly not authorized to invest in oil directly by purchasing oil-tracking, or similar-type stocks.  As such, the only way the mineral buying company can participate in rising oil prices is through minerals. 

Because owners don’t have this restriction, they have the option to sell their minerals and invest directly in oil through an oil-tracking ETF or other oil & gas stocks.  Both parties thus benefit from a transaction.  Mineral buyers get oil exposure the only way they can, and mineral owners get direct-exposure by being able to invest proceeds directly into oil & gas stocks.  A win-win.

Diversified Risk

Mineral companies that own a large portfolio have significantly less concentration risk compared to individual mineral owners.  If a mineral owner has his wells shut-in, his revenue goes to $0.  Those wells getting in shut-in means the mineral company also loses royalty revenue, but the company likely owns in hundreds of other wells, so while their revenue will go down, it won’t be all the way to $0.  The mineral company also likely owns under dozens of operators, so they aren’t exposed to a single operator going bankrupt.

A mineral sale allows an owner to offload this very-concentrated risk to a buyer, where it becomes much-less concentrated.  Another example of a win-win.

Recap

• A mineral sale is often a mutually beneficial transaction.  A win-win.
• Owners transfer highly-concentrated risks to buyers, who accept it in hopes of rewards commiserate with the risk.
• Mineral buyers are usually much more diversified, so risks are spread out across hundreds or thousands of wells and operators.
  • A handful of wells getting shut-in or a single operator going bankrupt is devastating to an individual owner, but much less so to a diversified company.
• Mineral owners can take proceeds and invest in other asset classes with which they have more expertise, or oil directly if they so choose.
• Mineral buyers gain exposure to oil through minerals.