The second installment in our “Hold v. Sell” series discusses the importance of understanding the risk associated with mineral rights ownership. The full series is available 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 ever 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. A mineral sale does not always make sense, just like holding does not always make sense. We live and operate in a world colored by shades of gray; it is not black-and-white.
My aim for this series is not to convince owners that they should sell or hold, rather it’s to provide the ammunition for informed decisions. I present information from the perspective of both a mineral owner and buyer. An informed mineral owner is a powerful one.
With that, let’s talk about risk as it relates to mineral rights.
Types of Risk
Concentration Risk Defined
Concentration risk is the risk that results from having all your eggs in one basket.
Let’s say you believe the U.S. stock market is the best place to have your money invested right now. As such, you put 100% of your retirement savings into Apple, Inc. Strictly speaking, this achieves your objective of being invested in the stock market. However, it is done in a way that creates disproportionate exposure to Apple, Inc. The stock market could go up 20% next year, but Apple could fall 20% during the same period. If you wanted to have broad exposure to the stock market, you would be better served investing in mutual funds. Mutual funds own the stocks of numerous companies in the U.S. stock market. As such, investing in mutual funds is much more akin to investing directly in the U.S. stock market than just buying a single company’s stock.
Concentration Risk in Mineral Rights
Mineral rights come with significant concentration risk.
The Apple, Inc. example above serves as an analogy for mineral rights and oil. Owning mineral to gain exposure to oil prices is like buying Apple stock to gain exposure to the U.S. stock market.
A mineral owner isn’t betting on a rise in oil prices (the stock market) nearly as much as he is betting on the performance of a handful wells and a single operator (Apple). If oil prices were to double during the next year, but his operator goes bankrupt or his wells get shut-in, he does not benefit from increased oil prices. In reality, a mineral owner has much more exposure to the wells that pool his minerals and the operator of those wells, than he does to oil prices
If an owner wants to benefit more directly from increased oil prices, he would be better served selling his minerals and investing the proceeds directly into oil (this strategy is discussed in the next installment of this series, “Investing in Oil“).
Shut-in Risk & Operator Risk
The afore-mentioned risks that wells get shut-in (i.e. turned off) or your operator files for bankruptcy are unfortunately very real in today’s environment (writing as of April 2020). Oil prices are well below their cost to produce right now. This means every barrel produced costs operators money. If an operator decides to shut-in the wells that pool your minerals, your royalty stream falls to $0. Additionally, if oil prices do eventually rebound to profitable levels, there is no guarantee that your wells get turned back on. And even if they do get turned back on, wells may never recover to pre shut-in production levels.
Operators filing for bankruptcy offers a potentially similar unfortunate outcome. While operators often are able to continue paying royalties after they file for bankruptcy, it is not a guarantee. The continued payment of royalties must be approved by the bankruptcy court. If it is not approved, you may not be paid again on your minerals.
Owners can eliminate these risks by transferring them to someone else.
Transferring Risk
As discussed in the first entry in this series, selling minerals is simply a transfer of risk.
Owners that hold on to their minerals have highly concentrated risk. Beyond oil prices, they are basically betting on a handful of individual oil wells and the company that operates them. In finance-speak, we’d say these owners are “long” oil prices, the operator and the wells. (Being “long”means you expect/want/need something to perform well. Being “short” is the opposite and means you are betting on poor performance).
A more common term for this is gambling. Gambling is not a dirty word. Every investment decision, wether it’s buying or selling stocks, bonds, real estate or mineral rights, is a gamble. This is because there’s no such thing as a sure-thing. No matter how well-researched or analyzed an investment is, there is always a chance it blows up. People who are “gamblers” simply prefer to keep risk for themselves. Those who are not prefer to transfer that risk to someone else.
Managing Risk
A mineral owner taking the “wait and see” approach is holding on to the associated risk himself. He is gambler betting on oil prices, his operator and his wells. An owner that chooses to sell may also be a gambler, but prefers to make a different bet. Maybe he understands real estate better than he understands mineral rights and wants to bet on the things he most understands. In this case he could sell his minerals and invest the proceeds tax-free into real estate via a 1031-exchange. Maybe he 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 in the next entry of this series).
People are much better at assessing and managing risks in areas with which they are familiar. A cattle rancher is likely much better at assessing the risks associated with investing in 100 dairy cows than he is at investing in 100 mineral acres. The opposite is also true. A mineral buyer is likely much better at assessing the risks associated with investing in 100 mineral acres than he is at investing in 100 dairy cows. People generally are much better at making and managing investments when they have extensive asset-specific experience and knowledge.
Recap
- There are certain risks inherent to owning minerals.
- Mineral owners aren’t betting on oil prices as much as they are betting on a handful of wells and their operator.
- Wells may never be drilled, get shut-in or underperform.
- Operators may go bankrupt.
- Mineral owners aren’t betting on oil prices as much as they are betting on a handful of wells and their operator.
- These risks can be avoided by selling minerals.
- People often prefer to invest in things they understand. For example, a rancher might want to sell his minerals and invest in cattle. A real estate developer might sell and invest in property (tax-free via a 1031-exchange).
The next article in this series expands on the idea of selling mineral rights and investing the proceeds directly into oil.
I’m a mineral owner in Weld County, CO. I’ve enjoyed a few years of of steady royalty checks… what really happens if my operator goes bankrupt?
johnnyW – this article from the user Wade_Caldwell on mineralrightsforum.com does a good job explaining what happens when an operator files for bankruptcy. Short answer: it’s complicated and obviously not a good thing for mineral owners. Most relevant to most owners is the ‘what happens to my royalties’ section. The salient part here in my view is: “there is no one-size-fits-all outcome on royalty payments, and it can vary from a complete stop of payments, if they have not stopped already, to proportional payments, to full payments. The payment for any royalties overdue at the time the bankruptcy is filed are considered claims against the bankruptcy estate, and may take a substantial amount of time to collect, if at all. If your operator has stopped paying royalties and eventually files a voluntary Chapter 7, your chance of getting 100 cents on the dollar is poor.”
Why is the threat of “risk” always used as an angle by mineral acquirers? I’ve enjoyed my royalty checks and while they do fluctuate, I’ve gotten nice bumps every now and again. If it’s so risky why would you invest in them?
Risk certainly shouldn’t be levied as a threat…it’s a reality. Every investment is simply the decision of if the risk is worth the potential reward. Oil and gas is a volatile, and thus inherently risky, asset class. As such, buyers will require a higher reward (i.e. return on investment) than other asset classes (like an apartment building, for example). High risk = high return, but it also means a higher risk of losing your investment.