When you receive an offer to purchase your minerals, how do you know if it’s a fair one? As this article explains, several variables impact what someone is willing to pay for your minerals. Chief among them are a buyer’s view on:
- Future drilling
- Oil prices
- Well production
- Operator financial health
Existing Horizontal Production
If your minerals have existing horizontal wells, near-term future drilling is not likely. People often talk about the potential for multiple “pay-zones” at different depths and formations, but this is still more theoretical than practical. Operators have much more incentive to drill their leases that have no existing production in order to “hold” them, as opposed to drilling additional wells on “held” leases. This is because most leases require the operator produce oil within a fixed amount of time or the lease expires. If the acreage is desirable, it is very rare the operator will let the lease lapse since the operated spent significant money and time acquiring the leases in the first place.
Assuming your minerals are currently producing, the most straight-forward way to think about valuation is as a multiple of royalties. In other words, how many months/years of future royalties am I receiving today in exchange for my minerals? Every investment is viewable through this lens. Safe, stable assets will generally trade for higher multiples than riskier ones.
For mineral rights, most people consider a fair offer for minerals to be around 36 months of future royalties. In other words, it will take a buyer at least 3 years to get his money back, before considering taxes, assuming all his assumptions prove correct. A lot can happen in three years, especially in an asset as volatile as oil. One thing that is a certainty, however, is that well production decreases over time.
The Decline Curve
Thanks to physics, it is an absolute certainty that wells produce less and less oil and gas over time. This means, all else equal, royalty checks also decrease over time. Wells follow a production path known as a decline curve, as seen below.
The chart above represents the average decline for all horizontal wells drilled in the Niobrara formation in Colorado. The drop-off in production is steep in the early months and years, before shifting to a much slower decline in outer-years. This is the same general shape all wells follow, regardless of formation or location. There will be some variation in steepness, and the actual monthly results will bounce around, but the overall trend is the same.
This decline curve is important to keep in mind when evaluating an offer. A buyer is not going to base his offer based on past performance. He is only going to consider the future. This is often a huge disconnect for owners. Let’s look at an example to illustrate:
This chart presents the expected royalty payments for a well that paid $20,000 to its owner in its first year of production. It is based on the decline curve above and assumes the price of oil does not fluctuate at all.
The first thing you’ll likely notice is the dramatic drop-off in royalties in the early years. By year 4, royalties are down 88% compared to year 1.
Imagine you receive an offer at the start of year 4. As noted above, a fair offer is generally considered something around 36 months, or 3-years, of royalties. If the offer were based on the last 3 years of royalties, that would suggest a purchase price of $29,707. In years 4-10, the well is only expected to generate $9,582 of (pre-tax) royalties. Because the well will continue to decline into the future, it won’t produce anywhere near $29,707 over its remaining life. Obviously, no one would pay amount that since it is a losing investment.
This is why buyers make offers based on future, not past, performance. They buyer is only entitled to the royalties the well is going to produce, not what it already did. Three years of future royalties in this case suggest a fair price of $5,721.
Price of Oil
Warning: Lots of Charts Below
The example above assumed a flat oil price. In other words, the royalties paid over time were only influenced by the decline curve, and no other factors. Given oil is the most volatile commodity in the world, this will never happen in reality.
Let’s look what happens when we experience a dramatic change in oil prices, like what happened in early 2020 when oil was trading at $60 per barrel to start the year, before nosediving to less than $10 in April.
Building on the example above, let’s assume 2020 is the start of year-4 of production. In year-4, most wells are declining approximately 2% each month. Below is the monthly royalties we can expect in year-4, again assuming a constant price of oil. In this case, $60 per barrel.
As in the initial example, the only thing influencing royalties at this point is physics, i.e. the decline curve. Projected year-4 royalties total $2,412. What happens when we layer in the changes in the price of oil?
This chart assumes oil prices stay at their depressed prices for a few months before rebounding back to $30 by the end of the year. In this case, the royalties paid in year-4 total $1,127. This is less than half of what would have been collected had oil prices remained flat ($2,412).
If we further assume the price of oil rebounds at a rate of $2.50 each month starting in year 5 (i.e. month 49), by the end of year 5 prices are back to $60 per barrel. The chart below plots royalties against oil price for years 5 through 7. We see that once oil prices flatten out, royalties are again only influenced by the decline curve.
Here, the royalties collected in years 4, 5 and 6 total $3,902. The owner in this example should expect an offer for around this amount from interested buyers.
After working through this math, many owners simply want to wait until prices rebound and sell their minerals at that point. They’re confident they will get more than $3,900. The problem is that physics haven’t stopped in the interim. Production continues to decline month-over-month. If it takes 2 years for oil prices to rebound, production is 2 years further down the decline curve.
Using the same decline curve that we’ve been using throughout this example, if we assume $60 flat oil and sum years 5-7 royalties (i.e. 3 years of future cashflow), we get $3,833. So, in terms of value, your minerals are worth roughly the same. You collect an additional year of royalties (year 4) of $1,127, so you’d have $1,127 + your minerals worth $3,833. Keep in mind, however, oil prices need to quadruple for this to happen and there is an opportunity cost.
Taxes
Everyone’s least favorite topic. This article does a deep-dive into the differences into the tax implications of holding v. selling minerals, so we will keep it simple here. We need to remember that the numbers cited here are all pre-tax. This means even though you are selling 3 years worth of future royalties, it will actually take you longer than that to get the same amount of money as if you sold today.
Royalties are taxed at your ordinary income rate. Let’s assume that your average tax rate works out to 25% per year. If you collect $3,900 over the next three years in royalties, as in the scenario above, you will owe $975 in taxes on it. So, net of taxes you actually end up with $2,925. Your after-tax royalties after 4 years in this example is $3,849, so you are actually getting 4 years worth of after-tax royalties when you sell (assuming you owe little or no taxes at sale, which is likely low oil price environments).
Opportunity Cost
When it comes to investments, opportunity cost simply means that you cannot do two things with the same dollar. Mineral owners who do not sell forego the opportunity to take the sale proceeds and do something else with them. They could take the proceeds and put them into a different investment. They could buy a new car, house, more cattle…anything. Whatever the owner is NOT doing with the proceeds from a mineral sale is the opportunity cost.
If the opportunity cost of not selling is greater than selling, the owner should sell. Sometimes this is quantifiable, like when looking at another potential investment. If I have an investment opportunity that will yield me 30% per year, versus my minerals which I think will yield me 10%, I am foregoing 20% more money every year by not selling. Other times opportunity cost is not quantifiable. Like when thinking about purchasing something you have always wanted or needed.
The question owners ultimately have to ask themselves is if they think its worth foregoing the alternative uses for the sale proceeds by holding onto their minerals. There is not a right or wrong here. It depends mostly on each owner’s unique situation and their risk tolerance.
Summary
While opportunity costs are subjective, the math we ran above is not. Owners determine if an offer is fair by making realistic projections about the future and comparing the results to offers they receive. Owners have to be careful to not anchor to the past when doing this analysis, however. Buyers only consider the future royalties minerals might represent. Not fully appreciating this point can cause a large disconnect between the owner and buyer and can sometimes result in sub-optimal decision making.
