The role of information asymmetry, future uncertainty and personal beliefs within the context of a mineral sale are discussed in this first installment of our “Hold v. Sell” series. 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 are doing themselves a disservice. The advice often comes from a well-intentioned friend or relative and subsequently becomes gospel, never given further consideration. But holding this view without ever considering the pros and cons of selling versus holding is, to be blunt, lazy. It is far easier to say “I’m never selling” and move on with your life. Mineral rights can be a very valuable asset, 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. A mineral sale does not always make sense, just like holding does not always make sense. We live and operate in a world that is colored by shades of gray, not black-and-white.
The aim of this series is not to convince owners that they should sell or hold. It’s to provide the ammunition for an informed decision. I present information from the perspective of both a mineral owner and buyer. After all, an informed mineral owner is a powerful one.
Information Asymmetry
Information asymmetry occurs when two parties in a transaction do not have the same information. Visit a mineral rights message board and you’ll find a dozen variations of the following conversation:
Mineral Owner: “I recently received offers for my minerals in XYZ County. Should I sell? What is a fair price?”
Respondent: “If you are receiving offers, there must be something going on with your minerals. You should not sell. The buyers know something you don’t and you’re likely being taken advantage of. A mineral sale is never the right decision. Hold on to them.”
Competition Among Buyers
While the above advice is usually well-intentioned, it fails to recognize that the United States is a capitalist economy. Capitalism breeds competition. Competition leads to fair market prices.
There are hundreds, if not thousands, of mineral buyers. While an owner and a mineral buyer may not have perfectly symmetrical information, the minerals buyers do with each other. Mineral Buyers A,D,C and D all compete to purchase minerals. They all have (mostly) the same information. Mineral Buyer A makes the highest offer possible in order to beat Buyers B, C and D. The same goes for each of the other buyers. This competition forces prices up, to the benefit of the owner. The price settles where the market dictates. This is a basic tenant of free-markets.
The existence of competition should give mineral owners peace of mind that they are receiving a fair price.
Capitalism breeds competition…Competition leads to fair market pricing.
The Role of Uncertainty
Offers to purchase minerals are based on assumptions about the future. The future price of oil and gas, drill timing (if more drilling is expected) and well-performance are the primary inputs that determine value. A pricing-model (assuming the mineral buyer is sufficiently sophisticated) takes these inputs and spits out a value, which an offer is then based on.
Garbage-In, Garbage-Out
There is a saying in the financial industry: Garbage-In, Garbage-Out. This refers to the idea that the quality of output is only as good as the inputs. If the inputs, which is based on assumptions of what is going to happen in the future, are wrong (i.e. garbage-in), then the output/valuation is also wrong (i.e. garbage-out). Why is this relevant? Because a mineral buyer may offer to purchase your minerals assuming oil is going to be at $50 per barrel and the wells are going to produce 1,000 barrels per month for the next 5 years. What happens when oil falls to $20 and/or the wells instead produce 500 barrels per month? The answer is it was a bad investment for the buyer. He will likely never recoup his money. Conversely, it was a good decision for the mineral owner to sell.
The Benefit of Hindsight
Determining if a buyers decision to purchase minerals (or a mineral sale from the owner’s perspective) was “good” or “bad” can only be done in hindsight. Can a person who advises you to “never well” see into the future? Was it good advice to “never sell” in January 2020 when buyers were making offers based on $60 oil only to see oil prices fall to sub-$20?
This is not to suggest that reality always underperforms relative to expectations. For mineral buyers, some investments will be winners and some losers. It is impossible to be right 100% of the time.
every individual has his or her own risk-tolerance threshold
A Transfer of Risk
Selling and buying are, at their core, simply a transfer of risk. This is true for any type of investment. If an owner chooses to hold onto her minerals, she hopes oil prices rise, wells get drilled and that they outperform production expectations. If this happens, with the benefit of hindsight we can say not selling was a “good” decision. Conversely, if the oil prices fall and the wells underperform or never get drilled, not selling was a “bad” decision. Someone taking a “I’ll wait and see” approach is simply willing to take these risks on herself. Someone who chooses to sell transfers them to the buyer. Neither position is more “right” than the other at the time of sale. The determination of whether to hold or sell was “good” or “bad” can only be done in the future; and only with the benefit of hindsight.
Personal Considerations
every situation is unique…People are unique
It’s worth saying again: every situation is unique. People are unique. Everyone has their own risk tolerance. Some people have lots of money and do not need more, others aren’t so lucky. Some people don’t want to have to worry about actively managing assets, others revel in it.
There is no such thing as a “one size fits all” answer when it comes to important decisions. Anyone who says “this” is what you should do, regardless of what “this” is referring to, without knowing anything about your personal beliefs, tolerances and circumstances is being presumptuous.
Recap
- The decision to sell or hold minerals is a personal one. Every situation is unique.
- Information asymmetry is a real thing, but is mostly negated by the competition of our free-market.
- A mineral sale is effectively a transfer of risk.
- By holding, an owner takes on the risk that oil prices do not fall, wells are drilled and productive and that operators stay in business.
- By selling, these risks shift to the buyer. Sometimes buyers reap rewards for taking these risks, other times it will cost them.
- Only with the benefit of hindsight can we judge the “rightness” or “wrongness” of a hold v. sell decision. Doing so without the benefit of hindsight implies someone can see into the future.
The next installment in the series explores the risks inherent to owning minerals.
I’m a mineral owner in Wyoming, just north of Colorado border. I got a lease offer from “EOG” … what does that mean?
I’m assuming you own in Laramie County. EOG is an oil and gas company – one of the better ones out there in my opinion. They are offering you a lease, which should include a bonus payment and a royalty (should be 20%), for the right to extract your oil and gas. For most people, signing a lease is the best route to go, unless you want to actually be a full-partner in some oil wells, which costs a lot of money and is obviously very risky.
This seems like an odd topic at a time when there is probably not much interest in buying, however, I was curious to know how the rise (of fall) in value from the time of inheritance to the time of sale is determined when paying capital gains tax
This is a common question, one that warrants a full post (in the works). I am not an accountant or a tax attorney, but the short answer is if you were to sell in this current environment, you’d almost certainly not owe any taxes, assuming you’ve owned for more than a year. Minerals are capital investments and thus subject to the much better capital gains tax as opposed to royalties, which are taxes at your ordinary rate. Keep your eyes peeled for the full post coming soon.