The American Council on Education reported in 2014 that college and university endowments are heavily invested in commodities, natural resources, private equity, and other illiquid assets. In the 1990s, endowments invested over 95% of their assets in traditional stocks and bonds. By 2013, less than 50% of endowment assets were invested in traditional equities. Currently, endowments have approximately 5% of their assets, $22 billion, invested in energy and natural resources. Over the last few years, many university students and church congregations have urged their trustees to consider divesting their endowments from fossil fuels. The Guardian in January 2018 explained “The divestment movement, primarily consisting of climate activists, is urging private and public institutions to rid their portfolios of all oil, gas, and coal stocks to send a financial and ethical message that fossil fuels are harmful and shouldn't be tolerated. So far, it's estimated that funds totaling $6 trillion have committed to divesting from fossil fuels.” Due to the favorable tax benefits of gifting assets to endowments upon death, your endowment may hold illiquid fossil fuel assets, such as mineral and royalty rights. You have received an annuity-like stream of payments every month but are now considering divesting. However, the shortage of a well-organized market for illiquid fossil fuel assets can cause a dilemma for trustees of endowments. How do you sell your royalty and mineral rights and what are they worth? The purpose of an endowment is to provide a permanent source of funding that maintains the operations of colleges, universities, churches, etc. To best serve its fiduciaries, an endowment should achieve the highest return possible. Congruently, when divesting, the endowment must ensure it achieved a fair price for its investments. This post does not weigh in on the discussion of whether endowments should or should not liquidate fossil fuels. Rather, we hope to educate and advise those who have decided to divest their fossil fuel assets and are unsure of how to proceed.
The Growth of Illiquid Assets
The growth of illiquid assets in endowments investment portfolios is not a surprising trend. While illiquid assets garner more downside risk, they also offer the potential for higher returns than those realized in the traditional equity marketplace. A proper fiduciary who weighs the risks and reward of illiquid assets over time will likely like include these assets in their portfolios. However, when it comes time to liquidate these assets, a trustee must act carefully. Selling illiquid assets requires a thorough understanding, and as trustee, it is your fiduciary duty to understand these transactions or seek the advice of someone who does.
Divesting publicly traded fossil fuel stocks and bonds is relatively simple. While it can be beneficial to consider the timing of your sale with movements in the market, generally you can contact your portfolio manager or log onto your trading account directly and liquidate these stocks or ETFs within minutes.
Unlike public equity investments, mineral interests and royalty rights investments cannot be liquidated at known market prices instantaneously. Rather, the price and the terms of the deal must be agreed to by both the buyer and the seller.
What Are Your Mineral and Royalty Rights Worth?
One of the most common methods used to value mineral and royalty rights is a discounted cash flow analysis. The holders of royalty rights receive a monthly payment similar to that of a bond holder or commercial real estate lessor. Thus, future payments can be predicted and then discounted back to the present. However, the payments to a royalty holder can drastically increase or cease entirely without the say of the royalty holder. This makes the prediction of future cash flows used to value the asset much more difficult. Future cash flows must consider the current and future oil price environment, future levels of production, decline curves, the financial strength of current operators, and many other factors. As we explain in our whitepaper, How to Value an Oil and Gas Royalty Interest,
“To perform a royalty’s DCF analysis, production levels must be projected over the well’s useful life. Given that well production decreases at a decreasing rate, these projections can be calculated through deriving a decline rate from historical production. Revenue is a function of both production and price; as such, after developing a legitimate prediction of production volumes, analysts must predict future price. The stream of income (revenue less taxes and deductions) is then discounted back to present value using a discount rate that accounts for risk in the industry.”
The guideline transaction approach can also provide a helpful indication of value. To develop an indication of mineral royalty interest value using the market approach, you can utilize data from market transactions of mineral interests in similar plays. Acquisition data can be utilized to calculate valuation multiples that take into account industry factors (or at least the market participants’ perception of these factors) far more directly than the asset-based approach or income-based approach. In many ways, this approach goes straight to the heart of value: mineral interests and royalty rights are worth what someone is willing to pay for them.
Offer Letters
Adding to the uncertainty surrounding the value of royalty rights, the majority of mineral interest and royalty right owners with whom we work receive a couple, if not dozens, of offer letters every year. While offer letters, like transactions, do provide an indication of what someone is willing to pay for the asset, the definition of fair market value includes both a willing buyer and a willing seller. Since these offers are only half of the equation, they should not be used in isolation as an indication of value. As shown in the excerpt from the offer letter below, the distinction between fair market value and offer prices is critical in order to protect yourself from brokers attempting to profit at your expense.
Offer letters generally offer a multiple of average monthly cash flow on your revenue checks. These multiples can range widely, often from less than 60x to more than 200x monthly cash flow. Unfortunately, there is not one benchmark that can be applied to monthly cash flows across the nation, or even within one basin, so there is not an easy way to determine if you are receiving a fair price.
Especially after the fall in oil prices in mid-2014, we saw many offers that used scare tactics to try to persuade royalty owners to sell their interests at absurdly low prices. Since the crash in oil prices, many royalty owners stopped receiving royalty checks; however, this does not mean their royalty interests are worthless. Even now that oil prices have recovered and production is at an all-time high, some offer letters seek to take advantage of inexperienced royalty owners by suggesting that recent acquisitions, drilling activity, or changes in production have increased the risk, and therefore, decreased the value of their investment. An understanding of royalty and mineral prices is not common to the average and even advanced investor and information about royalty and mineral rights is scare and difficult to find. This, unfortunately, means that these scare tactics often work.
A recent offer letter to one of our clients read,
“As you may know, Hess Corporation has sold their interest in this unit. But there is another risk factor, as well. While it's hard to see on your revenue checks, from 2015 to 2016 the production declined by 10.1%. The decline over the past 30 years has been 1.7%. While the decline has improved this year, it makes one wonder what the decline will be in the future. As a mineral owner in this unit, it certainly has my attention. I'm making this aggressive offer in the belief it will go back to historical declines.”
This offer of 90x monthly cash flow was received in August, following the announcement of the acquisition. By October when the details of the acquisition had been further explained to the investor community, our client had received another offer for approximately 140x monthly cash flow.
While there are legitimate online brokers who will buy your royalty interest for a fair price, the best solution is to know and understand the value of your asset before you start searching for a credible buyer.
The Value of Mineral Interests and Royalty Rights
As explained in our post "Before Selling Your Oil and Gas Royalty Interest Read This," we believe there are three points you need to understand before selling your mineral interest and royalty rights.
- Understand what you are selling
- Recognize production and price as value drivers
- Understand the location’s impact
