Because of the historical popularity of this post, we revisit it this week. Originally published earlier this year, this post helps you, the reader, think through important issues when considering selling your oil and gas royalty interest.
There are many reasons that you may want to sell your oil and gas royalty interest, but a lack of knowledge regarding the worth of your royalty interest could be very costly. Whether an inflow of cash would help you make ends meet or finance a large purchase; you no longer want to deal with the administrative paperwork or accounting cost of reconciling monthly revenue payments; or you would prefer to diversify your portfolio or move your investments to a less volatile industry, understanding how royalty interests are valued will ensure that you maximize the value.
There is a market for royalty interests, making them fairly liquid; therefore, most of the time, the difficulty is not finding a buyer, but determining whether the buyer’s offer is appropriate.
Understanding how royalty interests are valued will ensure that you maximize the value.
Given that many royalty owners have little connection with the oil and gas industry aside from the monthly payments they receive, buyers may bid substantially below a royalty’s fair market value hoping to earn a profit at the expense of an uninformed seller. As such, it is critical that royalty owners looking to liquidate their interest understand its value to ensure that they can identify legitimate bids.
Before attempting to sell your mineral interest, understand these issues.
Understand What You Are Selling
A royalty interest represents a percent ownership in the revenue of an E&P company. Royalty interest owners have no control over the drilling activity of the operator and do not bear any costs of production. Royalty interest owners only receive revenue checks when their operator is producing minerals but see no monthly payments when production is suspended.1
Recognize Production and Price as Value Drivers
The value of a royalty interest is based on the present value of expected future cash flows, which are a percentage of an operator’s revenue.
An operator’s revenue is dependent upon production and price. Thus, when determining the value of a royalty interest, it is critical to understand a well’s future potential for production and the market forces that affect price.
Production: The Decline Curve’s Impact
As oil and gas is extracted from a well, its production declines over time. Every well has a unique decline curve which dictates production. A decline curve graphs crude oil and natural gas production and allows us to determine a well’s Estimated Ultimate Recovery (EUR). A variety of factors can affect the shape of a well’s decline curve. For example, decline curves are generally much steeper if the well is drilled using unconventional techniques, like horizontal drilling, or hydraulic fracturing. When determining the value of an oil and gas royalty interest, it is critical to understand a well’s EUR because the value of your royalty interest is dependent upon future production.
Price: Local and Global Market Forces
Oil and gas prices are affected by both global and local supply and demand factors. The oil and gas industry is characterized by high price volatility. The size and global nature of this market mean that these prices are influenced by countless economic – and sometimes political – factors affecting individual producers, consumers, and other entities that comprise the global market. Most operators, however, sell their oil and gas at a slight discount or premium to the NYMEX because of local surpluses or shortfalls. Thus, it is important to understand the local market as well.
Understand Location’s Impact
Drilling economics vary by region. There are geological differences between oilfields and reserves that make it harder to drill in some places than others. Whereas some wells can be drilled using traditional, conventional techniques like vertical drilling, less permeable shale wells must be drilled using unconventional methods, like horizontal drilling or hydraulic fracturing. These unconventional methods tend to bear higher operating costs. Location also tends to influence drilling and transportation costs, ultimately making breakeven prices and profits vary across and within regions. Although a royalty interest owner is paid before any operating expenses are accrued, an operator considers break-even pricing when determining whether to continue operating a well or suspending operations. Accordingly, the value of any royalty interest is strongly influenced by its location, and it is important to consider geological differences when valuing any mineral interest.
Proceed with Caution
While there are legitimate online brokers who will buy your royalty interest for a fair price, it is important to be on the lookout for those who aim to profit at your expense.
Beware of online royalty brokers who only consider rules of thumb such as 4x to 6x annual revenue. While industry benchmarks can be a helpful aid, they should not be relied upon solely to determine value, as they do not consider specific well economics.
A lack of knowledge regarding the worth of your royalty interest could be very costly.
If the entity valuing your interest is also an interested party, it is critical to remember that they have an incentive to quote a low value.
Mercer Capital is an employee-owned independent financial advisory firm with significant experience (both nationally and internationally) valuing assets and companies in the energy industry (primarily oil and gas, bio fuels and other minerals). Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors.
As a disinterested party, we can help you understand the fair market value of your royalty interest and ensure that you get a fair price for your interest. Contact anyone on Mercer Capital’s Oil & Gas team to discuss your royalty interest valuation questions in confidence.
1 For more information on mineral interests see our post, Three Types of Mineral Interests.