The fifth installment in our “Hold v. Sell” series discussed some oft-overlooked concepts important to mineral rights. We discuss breakeven oil price, asset management and future drilling uncertainties. 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, so 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 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.
Asset Management
People often refer to royalty income as “mailbox money.” Checks just show up and they didn’t even have to do anything. Most owners just assume operators handle everything correctly. This creates a fall sense of security. I can’t tell you how many times I found operators incorrectly crediting my ownership. Operators are not your accountant. They are in the business of producing oil, not ensuring your asset is properly managed.
Mineral rights are not a passive investment. At least not when managed properly. Proper asset management requires ongoing maintenance. It includes confirming ownership, monitoring oil price and drilling activity and confirming proper payment, to name only a few requisites.
Confirming Ownership
Despite the digital age we live in, most documents and records establishing mineral rights ownership still only live on paper. Many states do not tax mineral rights like traditional real estate. This means you cannot simply go to the tax-roll to find current ownership information. Even in states like Texas where you can, it does not mean that ownership is actually correct.
Mineral rights title is a unique beast. Conveyances, reservations, affidavits and probates, often dating back over one hundred years, are researched and interpreted to determine ownership. An owner can hire a land professional to research and interpret their title. The operator does the same. Their findings may not be the same, however. There often isn’t a “correct” interpretation of title. Three separate skilled professionals can look at the same chain of title and come to three entirely different conclusions.
Dealing with Operators
An owner that disagrees with the operator’s title is often subject to non-productive arguments. Operators are notoriously difficult to deal with. They want to spend their time and resources looking and drilling for oil, not ensuring they are correctly crediting mineral owners. This misalignment of incentives causes endless frustration for mineral owners. Payments are often wrong, late or missing entirely. When problems arise, communication from the operator side is often non-existent. This can be a very frustrating experience for mineral owners.
Breakeven Oil Price
Oil and gas is a capital-intensive business. Modern horizontal wells cost anywhere from $4MM – $15MM to drill. And that is just the cost of a the well. Operators also carry significant overhead costs. These include employees, offices and research and development. The oil price an operator requires to breakeven is: total expenses divided by barrels of oil produced (over an equivalent timeframe).
According to a Dallas Federal Energy survey, the average breakeven oil price in the U.S. is a little under $50 per barrel. This means at a $20 oil price, operators lose $30 on every barrel produced. The U.S. produces approximately 13 million barrels of oil per day, which means operators lose $390 million per day day. Clearly, this is not sustainable. It makes more sense for operators to simply shut-in their wells than to continue to produce them at a loss. However, shutting-in wells means revenue dries up, which in turn leads to bankruptcy. Damned if you do. Damned if you don’t.
Operators are in a bad way at the moment and because of that, mineral owners need to monitor oil prices as extended periods of low price result in well shut-ins and operator bankruptcies.
Oil Price + Future Drilling
Operators only drill wells if they believe it is a profitable venture. For most operators, this means oil price needs to be above $50 per barrel. As noted above, oil prices below $50 mean it costs the operator more to produce the oil than it’s worth. There is no incentive for the operator to produce. Even wells that are drilled, but uncompleted (“DUC”) will likely stay dormant until prices rebound.
If you own minerals in a “core” geological area, it is possible they were scheduled to be drilled in the near-future, once-upon-a-time. In the world of a $20 oil price, however, this is far less likely. U.S. producers already cut $13 billion dollars from their 2020 drilling budgets, which represents a 28% drop in planned spending. The likelihood of near-term drilling is further reduced as, once demand returns, operators will bring shut-in wells back online prior to investing in any additional new wells.
Recap
- Royalty income is often referred to as “mailbox money”.
- Like any investment, minerals should be closely monitored and scrutinized. If you want a strictly passive investment, sell your minerals and go buy stocks. This exact strategy is outlined in installment #3 of this series titled “Skip Minerals, Invest in Oil.”
- It’s important to consider the potential of future drilling when weighing a mineral sale. If you already get paid on numerous horizontal wells, your minerals are likely fully-developed and means additional future drilling is unlikely. If there is potential for additional development, owners need to consider the current oil price environment. A low-price environment means near-term drilling is much less likely. At a sub-$50 oil price most operators lose money, so they will only drill if absolutely necessary (i.e. to perpetuate/hold leases).
- Future drilling uncertainty is another factor to consider in the shifting of risk resulting from a mineral sale. Installment #2 discusses the risks inherent to minerals more in-depth. To avoid these risks, an owner could sell minerals and put the proceeds into an oil price tracking ETF. The owner monetizes now instead of waiting for oil prices to rebound and hoping the operator drills. Further, the owner benefits from rising oil prices and shifts the risk of future drilling uncertainty from herself to the buyer.
The next installment discusses how a mineral sale can be a win-win for buyer and seller.
