Mineral rights have value because they entitle the owner to the underlying resources. For the underlying resources to have value, they have to be able to be extracted profitably. You could be sitting on the largest gold mine in the world, but if it costs more than the gold is worth to get it out of the ground, the gold is worthless and will remain in the ground forever.
The Decline Curve
Production of oil and gas follows a path known a decline curve. This is an unavoidable fact as it’s the result of physics and geology. When oil is first struck, there is significant pent-up pressure pushing it towards the surface. Over time, as oil is extracted, this pressure dissipates. Less pressure means less oil pushed to the surface.
Because royalty checks are a function of the (price of oil & gas) x (production of oil and gas), this is the same path that your royalty checks will follow, all else equal. Changing commodity prices will influence the specific shape, but the trend will persist regardless.
Impact on Value
Because oil production, and thus royalty checks, decline over time, it follows logically that the value of the minerals decreases over time too. Buyers pay for minerals based on future cashflows. This is how all investments are analyzed. With each passing month, these future cashflows shrink.
If a buyer is willing to offer the equivalent of 3 years worth of royalties for the minerals, it’s obvious that this amount will be significantly higher if we start counting in month 1 versus month 36. If an owner anchors his valuation on historical royalties while the buyer is basing his on future ones, a disconnect emerges. The buyer will not pay the owner for past production.
Mineral owners should overlay their royalty checks on a decline curve to estimate what they will be in the future. Doing this, along with an assumption about future oil prices, is the basic math establishing mineral values.
This article is a basic primer on valuation. To dive deeper into this topic, the following provide much more in-depth analyses:
