In this episode, Justin and I answer questions that a lot of potential mineral and royalty investors have about getting started with investing in mineral rights and royalties. This time we focus mainly on the strategic decisions that mineral rights and royalty investors have to make when considering any investment. We discuss the different structures and investment options, example rates of return for different property types, strategies for the types of properties, and to how to get help with the acquisition process and ongoing management of these assets.
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We’re not going to do an overview of the different ways to invest or the specific step-by-step process for directly purchasing minerals and royalties since we’ve already covered these in other episodes, specifically go back and listen to:
- MRP 26: Investing in Mineral Rights and Royalties
- MRP 126: Deep Dive on Investing in Mineral Rights, Royalties, and Working Interests
- MRP 128: Managing and Investing in Minerals and Royalties with Jarrett Kitch
- MRP 159: Guide to Buying Mineral Rights
Before we dive in just a reminder that this information is being shared for educational purposes only and should not be construed as legal, investment, or tax advice. These types of investments aren’t for everyone.
But first, for someone who doesn’t have experience in oil and gas I know there are a lot of questions that they might have. There are also some specific questions that I’ve gotten from clients who I’ve helped invest in minerals and royalties whether it is directly investing in minerals or investing as a Limited Partner in an mineral fund.
Producing Mineral Rights Rate of Return
First, new investors may be wondering what the returns on a typical mineral rights deal might look like and the best way to say this is it depends. Every investment is unique and the actual returns depend on a lot of factors, several which are out of your control.
For example, the return depends on how much you pay for the interests, if it is fully developed to where you are receiving royalties, when the wells started producing, commodity prices, and for any undeveloped acreage, when a well or wells get drilled.
As an example, you might buy producing minerals in a shale basin that had multiple horizontal wells drilled 2 years before you purchase the interests and it is fully developed, no undeveloped acreage. If you buy the interests based on an NPV @ 10% discount rate depending on commodity prices, you might be looking at a yield starting out possibly above 20% the first year declining down to say 6% in year 10 and a 10 year IRR of 4-5%.
Undeveloped Mineral Rights Rate of Return
In another scenario of non-producing minerals that I valued a few years ago that at the time had pending drilling permits for 16 wells. The original assumption was that these 16 wells would get drilled in 2022 and what actually happened was that 7 wells were drilled in mid 2022. If you had bought these interests based on an NPV @45% discount rate based on 16 wells or more realistically, NPV @30% for the 7 wells then you would have waited 4 years before starting to receive royalties. Even though fewer wells eventually were drilled, if you underwrote the deal conservatively as suggested above, this investment would have reached payback around year 5. To give you a feel for this particular example (non-producing minerals that were drilled 4 years after purchase), the yield in year 4 was around 80% declining down to 8% by year 10 and the 10 year average yield was over 21% and the investment had a 10 year Internal Rate of Return (IRR) of almost 16%. Each investment is different and these examples are being shared for illustration purposes only.
Risk-Return Tradeoff with Mineral Rights
The point of the previous examples of yield/IRR differences for producing vs. non-producing mineral rights is to illustrate the risk-return tradeoff associated with different types of properties. As you can see, with undeveloped properties there is a higher risk but also higher potential rewards if wells get drilled. Timing is everything, buying as close to when the wells get drilled and how you underwrite the deal matters (in terms of well timing, the number of wells, discount rates, well performance estimates, and commodity price forecasts). Just because 16 wells get permitted, if offset well spacing ends up averaging between 8 – 12 wells per drilling spacing unit, I might underwrite the deal at 8 wells with conservative timing assumptions for when the well gets drilled and conservative commodity price assumptions. Keep in mind with mineral rights, you are not in control of your own destiny in terms of when the wells get drilled.
To determine the type of deal that is the best fit for you depends on your risk tolerance and how the deal fits into your overall portfolio of other investments both in the Oil & Gas space and in traditional investments like equities, commodities, or real estate.
Strategy for Investing in Mineral Rights: Chasing Yield
Which brings us to the first point, the first thing you need to decide is what your strategy will be for your mineral and royalty investments because this will dictate the types of deals to look for. For example, if you simply want to focus on yields then buying fully developed acreage with producing wells might be your focus. Then, your cash-on-cash yield will be determined by how much you purchase the asset for relative to the royalty income stream and future commodity prices.
These types of mineral properties that provide immediate cash flow through royalty income on producing oil & gas wells are colloquially referred to as PDP interests. This refers to the reserves category of Proved Developed Producing or PDP – in other words, you are buying an interest in producing wells. These PDP properties derive the majority of their value from existing wells and may have limited upside potential from drilling additional wells in the future.
Strategy for Investing in Mineral Rights: Chasing Capital Appreciation
The other side of the strategy equation are properties that can provide significant potential for capital appreciation. This might be mineral rights that are largely undeveloped and in an area of significant oil & gas activity. In this scenario, most mineral buyers look to “buy ahead of the drill bit.” In other words, to target properties where wells have been permitted or are in the process of being drilled as this means that the wells are likely to start production within the next couple of years. Since you don’t get your money back with non-producing mineral rights until wells get drilled & completed, buying “ahead of the drill bit” helps to de-risk the well timing element.
Here are a few other considerations that many mineral investors think about:
- Time value of money – when wells drilled are biggest lever on the value of the acreage
- Quality of the operator – can and will they actually execute, just because there are permits doesn’t necessarily mean the wells get drilled
- Underwriting criteria – theme, don’t overpay. I don’t underwrite investments at $100 oil and $8/MMBtu gas, I underwrite at a lower price as a hedge against prices going lower. NEver know what is going to happen.
- Both types of properties – consider royalty rate as that will dictate your decimal interest in wells and how much you will receive in royalty payments
- Conservative on well timing, in other words, when future wells might get drilled. If you underwrite based on wells getting drilled in the next year and they don’t well you just overpaid for the property.
Diversification
When buying minerals and royalties, many investors also look at how oil and gas interests fit into their overall portfolio. Within oil and gas investments there are also different ways to diversify and mitigate risk.
They include:
- Oil vs. gas properties. Oil prices and gas prices are correlated but there are times when the price of one or the other may be higher than historical averages. By having a mix of properties that produce both oil and natural gas you can take advantage of price increases while mitigating the risk of being overly concentrated in one product in case prices fall.
- Geographic location. There is political risk associated with owning mineral rights and royalties in some jurisdictions that are against fossil fuel development. While you may be able to buy properties at a discount, having all your eggs in one geographical basket may be a bad idea if the jurisdiction bans future oil and gas development.
- Producing vs. non-producing acreage. Many investors look to hold a mix of producing and non-producing properties to take advantage of yield from producing wells and the potential upside associated with future wells getting drilled on your non-producing acreage. Plus, if you are unleased you get the added benefit of receiving a lease bonus when you lease any open acreage.
- Minerals / Royalty Interests vs. Non-Operated Working Interests. in addition to mineral rights and royalties, more sophisticated investors also hold non-operated Working Interests due to the tax benefits like being able to expense Intangible Drilling Costs (IDC’s) when new wells get drilled. Of course, working interest owners are liable for their proportional share of the drilling, completions and operating costs so this tax benefit does come at a cost.
- Time Horizon. Your time preference will also factor into the types of properties you hold. If you intend to hold the properties long-term and pass them down to your heirs, holding a mix of both producing and non-producing properties might make sense. While wells might not get drilled in your lifetime on the undeveloped acreage, your heirs may be able to benefit from any wells that get drilled while they are the caretakers of the property.
Buy & Hold vs. Selling Mineral Rights
Speaking of time horizons, you will need to think about how long you want to hold on to the properties. Ownership can range from the extreme mindset of “we never sell” to getting into mineral broker territory of short-term / high time preference buying & flipping properties to an end-buyer.
I have heard several family offices say that anything is for sale for the right price. Some mineral owners may selectively sell assets in non-core holdings as events warrant, maybe after wells were just drilled and have been producing for a couple of years and still have respectable production in a hot basin or play. In some cases it might make sense to take advantage of high commodity prices to re-invest in non-producing minerals in an area you feel is undervalued. This can be an opportunity to balance your portfolio between producing and non-producing properties if a bunch of wells have been drilled on your non-producing acreage.
Structuring the Deal
How you decide to invest in mineral rights and royalties is another important consideration. We’ve spoken in detail about the different ways you can invest in this space in previous episodes, particularly in MRP 26: Investing in Mineral Rights and Royalties. While we won’t go into detail, here is a recap of some of the ways you can invest:
Direct Investing
This method is the most labor intensive and requires the most knowledge or use of outside help in terms of outsourcing advisors with oil & gas experience. Direct investing is also sometimes called the “ground game”.
That is, the process of identifying mineral owners, calling and emailing them to find out if they are interested in selling, evaluating their interests, making an offer, doing the due diligence, and closing the deal. You have full control of what you are buying. You control G&A expenses, requires building network of experts in terms of landman, oil & gas attorney, engineer or consultant to run economics, mineral manager. We talk in detail about the “ground game” in MRP 159: Guide to Buying Mineral Rights.
Investing in a Mineral Fund as a Limited Partner
The next way you can invest is the private equity route of investing as a Limited Partner in a mineral fund. This approach is more hands off than direct investing as the general partner does the leg work of locating, buying, and managing the interests.
Of course in this situation you need to make sure that the strategy of the mineral fund matches your strategy. For example, geographic location, types of interests (all PDP vs. mix of PDP, PUD, undeveloped), minerals vs. non-op WI, gas vs. oil, etc.
With any investment, it is important to research the background of the General Partner and principles in the fund. What is their track record for previous funds? You could ask to get a list of references to find out their experience investing in previous funds. You are effectively outsourcing the ground-game to a trusted third-party who does all of the work.
By investing in a mineral fund, you are paying higher G&A than if doing it yourself in most cases and you need to consider the terms. Many have a 2% management fee plus 20% carried interest earned by the General Partner once certain return hurdles have been met (e.g. preferred 8% return to LPs first before they earn interest).
If you find a trusted GP to work with, they often have previous funds where they selectively look to divest interests that are in their prime (e.g. undeveloped acreage that was leased and wells were drilled and have been producing for a year or two but have a lot of life left). If you are looking to directly invest in this type of asset in addition to investing in their current fund, could be a win-win opportunity where you can buy an asset for yield and they get to exit and provide a return for investors of their previous fund.
Investing in Publicly Traded Mineral Company
There are several out there and this is not investment advice on a particular company, just to provide an example their is Viper which is Diamondback Energy’s mineral subsidiary, Texas Pacific Land Corporation is another one.
These generally have the highest G&A expenses and you can end up paying much higher valuations on interests if the stock price runs up but this method is the most hands off. Generally you “set it and forget it” as long as the company is doing well and they are meeting your investment objectives.
Where to go for Help
If you decide to get into directly investing in minerals and royalties, you don’t necessarily need to go out and hire an experienced oil & gas team to execute on your strategy. You can outsource the work until you reach a critical mass of acreage to where it might make financial sense to hire an accountant with oil & gas experience, or a landman / land administrator/negotiator to help manage M&A activity and leasing, etc.
Who you partner with depends on where you are looking to invest. Many consultants in minerals and royalties specialize on certain geographic areas or type of work. Perfect example of this is an oil and gas attorney who is licensed to practice in a particular state.
Find a network of consultants and advisors such as attorney, landman or land services company, engineer for valuations and to run economics on deals, and mineral manager to help with the ongoing management of your interests to make sure you are getting paid what you deserve. My company, Silverheels Investments LLC, provides bespoke consulting services with a focus on oil and gas property valuations and buy and sell-side advisory services.
Over the past several years, the tools and resources available to help you manage interests has grown exponentially, from software to show your interests on a map relative to ongoing oil & gas activity, mineral management and accounting software to keep track of royalty payments to ensure you are getting paid correctly, to document management apps, it is easier than ever to keep track of these.
A familiar term in the minerals and royalties space refers to royalties as “mailbox money” due to the passive nature of these types of interests but in order to get the most from your investment will require at least some active management to make sure there aren’t wells out there on your acreage that you aren’t getting paid on, to stay on top of division orders for new wells to make sure you get paid the correct %, and more.
Other Considerations
Oil & gas properties are depleting assets (“melting ice cube”), once well starts producing, especially in shale basin, very high initial production but very steep initial decline rate that flattens out but the majority of the reserves are produced in the first couple of years in that well’s life.
So in order to generate a specific amount of income will likely require periodically re-investing into additional acreage (or hopefully new wells get drilled on undeveloped acreage) to replace the decline in production that happens with all oil and gas wells.
Resources Mentioned in This Episode
- My Company: Silverheels Investments LLC – Mineral rights coaching, valuations and advisory services
- MRP 26: Investing in Mineral Rights and Royalties
- MRP 126: Deep Dive on Investing in Mineral Rights, Royalties, and Working Interests
- MRP 128: Managing and Investing in Minerals and Royalties with Jarrett Kitch
- MRP 159: Guide to Buying Mineral Rights
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