Hold v. Sell: Part #3 – Skip Minerals, Invest in Oil

The third installment in our “Hold v. Sell” series proposes the idea of selling minerals and investing directly in oil.  It builds directly on our last entry, which discussed the risks inherent to mineral 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 are doing 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, 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 colored in shades of gray, not black-and-white.

My aim with this series is not to convince owners that they should sell or hold, rather it’s to provide the ammunition for informed decisions.  I’ll present information from the perspective of both a mineral owner and buyer.  An informed mineral owner is a powerful one.

Building directly off of the last installment in this series, this article focuses how a mineral owner can sell minerals, but still benefit from future rises in oil prices.

Selling in any Market Conditions

Entertaining the idea of a mineral sale in a depressed oil market like the current one (writing as of early 2020) may seem strange at first, but hear me out.  Oil price, drill timing and well-performance are the variables that most impact directly mineral values.  The geopolitical climate, the strength of economy and international relations also have an impact, but do more so indirectly.  It should follow then that when oil prices go up, mineral values go up.  Is this the case?  Short answer: Yes.  Longer answer: It’s a little complicated.

Pricing in Risk & Uncertainty

It’s no surprise that mineral values are highly correlated with oil prices. It is not a perfect 1:1 correlation, however.  In other words, a 50% rise in oil prices will not lead to a 50% increase in the value of minerals.  Why?  In the first article in this series, we discussed the fact that (spoiler alert!) the future is uncertain.  As such, mineral buyers price in several risks when valuing minerals.  Some examples include: future well-performance, well shut-in risk, operator bankruptcy risk, political risk (Colorado is a prime example), future drilling risk and oil and gas price risk.  Because oil prices are only one piece of the puzzle, mineral values will not move lock-step with oil prices.  That said, owners can benefit one-to-one with oil prices movements via the strategy discussed below.

owners CAN benefit 1:1 with oil prices movements: sell minerals, Invest in oil

Invest Sale Proceeds Directly into Oil

As discussed in our last article, mineral rights are not the most efficient way to invest in oil and gas.  Mineral owners are significantly more exposed to individual well-performance, drilling risk and operator risk than they are to oil prices.  Oil prices could double, but if an operator goes bankrupt or wells get shut-in, the mineral owner does not benefit from it if the wells aren’t producing.

When oil prices are historically low like the are today (sub $10 in April 2020), well shut-in and operator bankruptcy risks significantly increase.  At the same time, oil prices are almost guaranteed to go back up since the world is still deeply oil-dependent.

Risk v. Reward

With this in mind, mineral owners need to weigh the risks and rewards of a sale.  If an owner holds on to his minerals and oil prices double, his minerals will be worth more.  Not 100% more, keep in mind, as minerals and oil prices do not move in lock-step, but significantly more nonetheless.  The owner needs to weigh this reward against the risk that his operator could go bankrupt or his wells shut-in, significantly diminishing, if not destroying, the value of his minerals.

But what if a mineral owner wants to have his cake and eat it too?  He could potentially employ the following strategy: He sells his minerals, removing 100% of the well shut-in, future drilling and operator risk.  He then invests his (very tax-advantaged, as discussed in our next installment) proceeds directly a stock that tracks the price of oil.

Investing in Oil

As noted above, minerals subject the owner to several additional risks.  Primary of these are individual well-performance, future drilling risk and single operator exposure.  This means several things have to go “right” in order for the mineral owner to participate in oil price movements.  It would be much more efficient if the owner could instead just “buy oil”.

But how does someone go about buying oil?  It’s not like people can head down to their local drugstore and buy up oil (although, funny enough, this is exactly is this way it worked when people used kerosene as their primary lighting source).

It’s actually surprisingly simple.  People can “buy oil” by buying stocks called exchange traded funds, or ETFs.  ETFs can be purchased in any run-of-the-mill brokerage account (eTrade, Charles Schwab, etc).  There are dozens of ETFs that mimic the price movements of oil.  The United States Oil Fund, or USO, is the largest and most well known.  Oil prices are down 61% during the last year.  USO is down 61% during the same period.

WTI Versus “Real” Price of Oil

The oil price scrolling along the bottom of the TV screen on CNBC is West Texas Intermediate Crude, or “WTI”.  In its simplest form, it is an approximation for oil prices in the United States.  It is the price that oil sells for in Cushing, OK.  More precisely, it is the price paid in Cushing, OK for a specific quality of oil produced in Texas that is to be delivered next month  There several locations in the U.S. where oil is bought and sold, but quoting all of them is impractical.  As such, WTI became the standard reference price. Actual oil prices can vary significantly across the country.  Quality, transportation costs and storage capacity all impact local pricing.  Collectively, these variables are referred to as price-differentials.  In other words, the difference between the price actually being paid for oil and WTI.  For mineral owners, this means an increase in WTI price does not necessarily translate to increased royalty revenue.  Local oil prices and WTI can vary wildly.

Liquidity

An oft-overlooked benefit of selling minerals is that it provides liquidity.  If an owner sells his minerals and buys an ETF, he is just buying a stock.  Stocks are incredibly liquid.  This means you can instantaneously turn them in to cash.  In uncertain times, having immediate access to cash in the event of unplanned emergencies or once-in-a-lifetime business opportunities is hugely powerful.

monetizing minerals provides liquidity

Recap

• The world is still dependent on oil, so prices will rebound.  It’s just a matter of when.
  • The value of minerals are more directly influenced by individual well-performance, future drilling and operator financial health than oil prices.
• Mineral owners can choose to sell their minerals, which eliminates the risks arising from exposure to individual well-performance, future drilling and operator health and invest proceeds into an oil price-tracking ETF.
  • This allows owners to participate in the future rise in oil prices, without maintaining any of the risks associated with owning minerals.

The next installment in this series looks at the tax implications of holding v. selling minerals.