In this episode we do a deep dive on the ways you can invest in mineral rights, royalties, and non-operated Working Interests. Both Justin and I have been asked by family members or listeners how they can invest in mineral rights and royalties so we wanted to cover this in more depth to help you understand the different options that are available.
In fact, I share the process that I and other investors have used when making a direct investment in a mineral or royalty interest. We discuss all aspects of investing in this asset class: from learning where you can find these types of investments to the typical steps to follow to help eliminate surprises, to the risks and benefits of each type of investment.
As a reminder, we are sharing this information for educational purposes only and this should not be construed as tax, legal, or investment advice. Get help from your financial advisor to see if investing in mineral rights, royalties, or non-operated working interests make sense for you.
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Why Invest in Mineral Rights and Royalties?
Maybe you inherited mineral rights and want to invest in more or maybe you don’t already own minerals and royalties but want exposure to this asset class and the benefits that come with it as a way to diversify your portfolio. Whatever your reason, we will cover the pros and cons, ways to invest in mineral rights, royalties, and non-operated working interests, and the process for directly investing.
One of the reasons I wanted to cover this today is I had a client recently reach out who sold an investment property and wanted to roll this over into an oil and gas investment with near-term tax benefits as a way to offset his capital gains tax liability.
Ways to Invest
We covered the different ways to invest in mineral rights and royalties in MRP 26: Investing in Mineral Rights and Royalties. In that episode, we talked about investing in publicly traded mineral companies, investing in a mineral rights and royalties fund, and directly purchasing minerals or royalties by auction, broker, or directly from the owner. In this episode we focus on the steps required to directly purchase minerals or royalties or to invest in a mineral fund.
Benefits of Investing in Oil and Gas
There are several benefits you can realize by investing directly in oil and gas mineral rights, royalties, and non-operated working interests. These include:
- Some tax benefits (for now), like the percentage depletion deduction which we cover in depth in Episode 105. We cover taxes on mineral rights and royalties in Episode 20.
- Non-operated Working Interests have other tax benefits like the ability to expense intangible drilling costs in the year they are incurred and the ability to depreciate tangible drilling costs over multiple years. Plus, non-operated Working Interests are classified differently for tax purposes and you may be able to offset other income with these expenses. Check with your CPA for more information.
- By purchasing mineral rights, you are buying real property that you can pass down to future generations. The United States is one of the only countries that allow private ownership of the minerals below the surface of the earth.
Risks Associated with Investing in Oil and Gas
As with any investment, directly investing in oil and gas properties doesn’t come without risk. Some risks include:
- Political risks like the domestic push towards renewables and pressure to phase out the use of fossil fuels.
- Geopolitical risks and global supply & demand which affect price of oil & natural gas.
- Oil and gas investments are very sensitive to the price of the underlying commodities and can be very volatile as evidenced by the market crash in 2020 and subsequent price recovery in 2021.
Step-by-Step Process for Buying Mineral Rights and Royalties
I am going to reveal some of my secrets as it relates to the process that I follow and the underwriting criteria that I use when making these types of investments.
First, you need to identify a potential property or fund to invest in. If you don’t have a relationship with a mineral broker then you can go to on-market / listed properties or auctions on sites like EnergyNet.com.
These steps apply mosty to directly purchasing mineral rights or royalties or non-operated working interests. If you find a prospective mineral fund that you are looking to invest in, this is where you will need to review the paperwork and agreements associated with the investment and do research on the people and the company to make sure they are reputable and follow SEC guidelines around how they manage the investment. We’ll cover that in more detail at the end.
Step 1: Due Diligence
First, we research the property in question and offsetting activity in the surrounding area using our extensive database. If the minerals are leased or if the owner has a royalty interest in producing well(s), this is where we request a copy of the oil and gas lease and three of the most recent check statements so that we can validate Net Revenue Interest (NRI) % as well as the detailed production breakdown. This helps us assign an accurate value to future production revenues. Click here for a sample check statement.
Step 2: Valuation
To perform an accurate valuation, it helps to have knowledge of the basin or play you are interested in investing in. Gaining this expertise helps in performing an efficient analysis and accurate valuation for each unique property.
Most properties are valued using the income approach where current and future production are forecast based on expected development scenarios and application of a proprietary pricing model (or standard price deck like the EIA Short Term Energy Outlook or NYMEX strip price) to determine the value of the property on a lump sum basis today. This information is often combined with comparable sales information and anticipated risk profile associated with the investment to determine the offer amount.
Step 3: The Offer
After evaluating the property, the mineral buyer will then submit an offer. This is the step where it is helpful to have your accountant and attorney review the language in the offer letter to ensure that it allows you the flexibility to handle any contingencies, like title curative. It is important to document in writing the key terms and conditions of the sale to ensure you are not stuck buying a property that the owner doesn’t actually own and that you have adequate time to perform due diligence, like a title search. Once you come to an agreement on the terms of the offer, this is where a purchase and sale agreement document is used to outline the terms of the agreement. Typically, drafting the deeds and any closing costs or county recording fees are the responsibility of the buyer.
Step 4: Verifying Title
Before most buyers will close, they will verify that the seller owns the property in question. This is done through a mineral rights title search in the county in which the interests are located. This process includes researching the historical ownership of the property to locate any transfers of ownership and/or the separation of the mineral rights from the surface rights. For a single property in one county, the review period can take from a few days to a full week. For more complex title searches, this process can take from a few weeks to up to a month to complete. Assuming the seller has clear and marketable title, you will then have your attorney draft the necessary conveyance documents required for the transaction. If title defects are identified during the title search, these must be cured in order for the seller to have clear and marketable title to properly convey the property. This is not an uncommon issue and you will want to come up with a plan and agree on who will pay for the additional costs of filing probate or other documents that might be required to clear title. In some cases, it may make sense for the buyer to pay for this and in other cases it might fall on the seller.
Step 5: Closing
The final step is the actual closing where a mineral deed is executed and notarized in exchange for payment. When advising sellers, I usually tell them to not hand over the deed until they receive payment. In this case, I would advise you to not pay the seller until you receive a deed! This may sound like quite a conundrum but one way to come to a compromise is to use an escrow service from a neutral third party such as a bank or an attorney to handle closing.
Investing in Non-operated Working Interests
Non-Op Working Interests are a whole other animal and are not usually recommended for someone just getting started with investing in oil and gas. While some working interest investments may enjoy more upside than a producing royalty interest alone, possible tax benefits, and potentially control over investing in additional opportunities, they also come with significantly more risks. Some risks include the risk of a dry hole (non-producing well) being drilled, operator or management mistakes resulting in environmental or safety liability for the non-op partners, and financial liability when it comes time to plug and abandon the well. We talk a lot more about this investment type in this episode so hit Play to listen and find out more.
Investing Through a Mineral or Royalty Fund
One way to realize the benefits of investing in mineral rights, royalties, and non-operated working interests is to invest in a fund that makes these investments on behalf of its partners. Many of these funds are set up as a Limited Partnership with certain rights and responsibilities for investors. They may also handle elements like obtaining liability insurance on behalf of the LP’s for any non-operated Working Interest investments that the General Partner makes.
Mineral funds may handle the legwork around fiding deals, performing due diligence, and purchasing properties.
Like with many other types of investments, there are good investments and bad investments so the best way to find these is through a trusted advisor or through word of mouth from other investors who have invested with the fund manager in the past (perhaps through an earlier fund) and have seen success with the investment.
These types of investments are usually limited to accredited investors. An accredited investor is defined by the SEC as an individual or a business entity that is allowed to trade securities that may not be registered with financial authorities. They are entitled to this privileged access by satisfying at least one requirement regarding their income, net worth, asset size, governance status, or professional experience. For example, an individual or joint (with spouse) with a net worth of $1MM or greater OR individual with annual income of $200k / joint of $300k.
Best in class mineral funds will ensure that an independent entity handles the LP’s funds, hires 3rd party financial and reserves auditors to provide peace of mind that they are actually doing what they say they are doing. Without these controls in place, there is the possibility that you end up investing in a Ponzi Scheme that loses all of your original investment.
Resources Mentioned in This Episode
- MRP 26: Investing in Mineral Rights and Royalties
- MRP 20: Taxes on Mineral Rights and Royalties
- MRP 105: What You Should Know About the Depletion Deduction
- U.S. Energy Information Administration Short-Term Energy Outlook
- NYMEX Crude Oil Futures Quotes
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