You’re thinking about divesting your mineral rights, so you call several different companies to make sure you’re getting the right price. Every company seems to be valuing your minerals in a variety of different ways. As an owner, how do you know who is correctly valuing your minerals? We will look at the two different ways and discuss why each are beneficial in their own way.
Multiples – Some firms are willing to offer you an equation for how they value mineral rights. This often is largely based on a multiple of your last month’s check; or a variation of a much more complex formula. As we discussed in previous blogs the most productive months are the initial months. During this time, the well is in a very steep rate of decline and will produce the most barrels or mcf. Conversely, the same wells are in relatively low states of decline in the later part of their life. We briefly covered well decline in our blog on checks and why they fluctuate here. We will investigate why the age of a well matters when you’re reviewing an offer based on multiples. The other thing we will look into is how these multiple offers can leave money on the table by giving you no credit for upside.
Engineered Offer – Mineral rights firms use three factors when deriving what your mineral rights are worth. We touched on this in previous blogs but wanted to further explain how companies such as Revere underwrite your mineral interest.
1. Quantity - What is the total amount of hydrocarbons that will be produced in a given unit? To answer this question, mineral rights firms enlist the help of reservoir engineers to measure this. They not only look at the current producing well; they closely measure what an additional well drilled in the same unit is estimated to produce by looking at what wells close by have done historically. At Revere, we use a third party engineer so as to separate our own biases on a given unit. The result is an more accurate offer based on reserves and not solely on what you’re currently making.
But how do they know what each wells ultimate recovery will be given horizontal wells are still relatively new? We get this question a lot. The honest answer is they draw on years of schooling, previous experiences, and surrounding wells to give their best estimate. We even have a name for this in the industry, a wells Estimated Ultimate Recovery or (EUR). As it says in the name this is an estimate. It was once believed that each well would produce the same as the parent well. However, recently we have noticed that not every subsequent well drilled will produce that of the original. This “parent child” well relationship is still being understood. Luckily many of the basins in the US have now had production for ten plus years and engineers and geologist have amassed thousands of data points to best refine their estimates.
2. Commodity price – Every barrel that is pulled from the ground is sold for a certain price. Many firms will use a future NYMEX strip to assess the value of your mineral rights. Why people use the NYMEX strip is because this is the best guess for what oil will look like in the future. Some firms will use flat price deck. Or if they have a varied view on oil that say it may increase in the years to come, may even run an escalated price deck. This is more of a gamble given the further in time you get away from today, the harder it is to predict the oil price.
3. Timing- The last major factor is timing, or said simply, “when will the operator return to drill more wells.” This is important because mineral rights companies are seeking to make a return on the dollars they invest. If an operator does not return to your property or does not return in a timely manner the company may lose money. This all comes back to the financial concept of Time Value of Money. If the operator is slow to return to your unit, the investors dollars were better off in another unit that would return back their capital sooner. Investopedia has a great explanation that can be found here. Given mineral rights companies aren’t privey to an operator’s drilling schedule. Many firms are guessing based on historical drilling patterns and the idea that operators will drill their best acreage first. This is not always the case, and swings in commodity prices can vastly change how and when operators return. Therefore permits are incredibly helpful in increasing the value of your mineral rights. A mineral right company can now see that an operator has intent to drill a certain unit. A permit is not however a guarantee. We will cover what a permit means for your value in a later blog.
To better convey this point, we wanted to review a real-life example. The following graphic is what 1 net mineral acre in the Clapton Unit held constant at flat $50 commodity price. Revere will aim to keep this explanation as simple as possible but please note there are economic decline curve analysis programs that are incredibly technical that are used to derive economic limits and mineral payback.
Over the engineered life of the Clapton 1H you would receive $6,429.41. If you got a 60 month pay out on point A of the curve when the well has just come online, you will be gaining a sale value of $13,175.52. This may seem like an incredible offer, as opposed to holding onto the interest for 20 years to only gain 6,249.41. However, when you look at the Clapton unit below you will notice room for 11 more wells to be drilled. If the operator never returns to drill more wells, then the offer is a fair. However, if those wells do get drilled you left a substantial amount of money on the table. To look at how much money simply you can multiply the one well payback of 20 years times 11 wells and come back to an undiscounted price of $70,723.
If you then look at taking a payout of where the curve is on point B (60 months of production) and took a monthly pay out of the same multiple you would be gaining 1,418.23. The remainder engineer value of what’s still left to produce shows that you should garner around $1,922.88. Given where the well is in its relative decline these numbers are close and you may actually be better off taking the money now then waiting many years to get these funds as your checks slowly decline.
Lastly, lets look if you took a 60 month payout in the later part of the wells life. At point C (120 months of production), given the well is in such a low state of decline we see that a 60 month offer is worth $683.33. This is not a fair offer given there is still 1,072.80 of royalties still owed to you.
In all of the above you will notice there is no calculation for upside. Often times companies will increase their multiples to 75 months or even more to “account for changes in the market.” When a company uses economic decline curve analysis you don’t have to worry about is this multiple fair?
So why are two different companies who use engineered values drastically different? This is harder to answer given most companies are not transparent on exact inputs. We will cover a couple of different reasons why an offer from Revere could differ from an offer from another company using engineered values.
EUR Variations - As we stated previously, engineers are estimating the total amount of barrels left to be produced. Thus, one engineer may come back to say 300,000 Barrels and another may come back to a number closer to 250,000. Given these prediction take many years to play out it may take many years to come back to who is right. They also could BOTH be wrong.
Cost of Capital – Many companies have borrowed the money they are paying you for your mineral rights from banks, private equity firms, or friends and family. Given everyone’s interest rates on these funds will differ and have promised their investors a certain return. This will cause every mineral company to pay you a bit differently.
Timing changes- As we discussed, no one knows exactly when an operator will return to drill a well. Thus, some companies may assume that an operator will return tomorrow. However, a more conservative mineral rights company may have a different view on when that operator will return.
Commodity Price Deck – As we stated previously. Many companies use the forward NYMEX Strip given this is the best guess for where oil prices will be. However, some companies may be more bullish on oil prices, or conversely more bearish.
Risk Tolerance – Oil and gas is risky, not every well works out, and not every well warrants additional wells to be drilled in a unit. Because of this different firms may view upside differently across a play. Or a firm could have insight into faulting that may cause severe risk for an operator to return and drill so they may “risk” a wells future.
We hope we have shed some light on a generally opaque part of our industry. We know that the decision to divest is never an easy one but we want to make sure you get the highest value on your divestiture. Remember, always ask questions when reviewing an offer. If the company can’t give you a straight answer, is that the company you want to be engaging with? And as always, we’re here 24/7 to answer any questions on valuation. That is why we even developed RevereNet. A free tool for mineral rights holders in South Texas to review their mineral rights value daily. A blog can be found HERE on the value of RevereNet.