Series 3: When Are Your Mineral Rights Most Valuable?
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Introduction
In our Third Series, we're talking about when your mineral rights are most valuable, and how timing can impact their value. So whether you're thinking about selling, you're on the fence, or you just want to understand more about the value of your mineral rights, timing is a critical consideration.
And here's what we've been talking about:
High Prices + High Activity = High Value.
Price and Activity are by far the two most important components to mineral valuation. If you have both high prices and high activity at the same time, then your minerals are most likely at or near their maximal value.
In Part 1 of this series, we talked about what it means for Prices to be high. Today, in Part 2, we'll talk about high Activity, and the types of activity to look for. And, in Part 3, we're going to talk about the interdependence of Price and Activity and how timing drives value.
Let's dive in to Activity...
We also have a YouTube video on this topic. If you don't feel like reading, you can check out the video here:
Part 1: Where is the Activity?
Before we jump into the types of activity to look for, the first thing that you need to think about is where this oil and gas activity is being conducted in relation to your tract of land. And, it goes without saying that activity that's located two miles away from your tract is more meaningful than activity that's located twenty miles away from your tract. Activity that's located on your tract or a pooled tract is most meaningful in terms of mineral valuation.
So, what do we mean by pooling? Well, a well doesn't necessarily need to be on your tract of land in order for you to participate for a share of production.
Pooling is a process where oil and gas companies designate multiple tracts for participation in an oil and gas well.
Why do the companies do this? They do it because the law requires them to; the process is called compulsory pooling. Every oil and gas jurisdiction has laws and regulations that govern (i) where wells can be drilled and (ii) the number of acres that must be included for participation in that well. Rules of compulsory pooling were developed for two primary reasons: (i) to prevent too many wells from being drilled in a given area, and (ii) to make sure that each mineral owner is entitled to her just and equitable share of production.
Now, when tracts are pooled together, we call those pooled tracts a drilling spacing unit (DSU) or unit, which is probably a term that you've heard before. Now, historically, drilling spacing units for horizontal wells using the public land survey system (PLSS; AKA the "section, township, range" system) consisted of 640 acres, or one section. So if you owned a tract within that 640-acre section, then you would participate for a share of production.
As technology advanced and operators began to drill longer and longer laterals (some extending two or even three miles), it became common for DSU's to comprise two sections (1280 acres), or three sections (1920 acres). And, if you own a tract within that larger pooled unit, then you will participate for a share of production.
So, if you're driving down the road and you see a drilling rig within two or three miles from your home, there's a good chance that you could be included in that drilling spacing unit and participate in the production from that well being drilled.
And what this highlights is the importance of understanding where your tract is in relation to the activity.
Part 2: Types of Activity
Let's jump into the types of oil and gas activity to look for. Now, I want you to think about the types of activity as a scale or spectrum (see figure below). As we move further and further down the scale, your minerals become more and more valuable.
1. Leasing Activity
The first step on the activity spectrum is leasing. A landman shows up on your doorstep and asks to buy an oil and gas lease. This is a very good sign.
The oil and gas lease is the operative contract between the mineral owner and the oil and gas operator that allows the operator to drill wells and extract the minerals located in the ground.
As compensation for granting the lease, the mineral owner is typically going to receive a lease bonus (a signing bonus), and a lease royalty which entitles them to a share of production.
2. Pre-Permit and Permit Activity
The next type of activity to look for is pre-permit and permit activity. Permit activity occurs when the oil and gas operator seeks regulatory approval to go in and drill the wells. And Pre-Permit activity typically looks like the operator establishing the drilling spacing units where the wells will be drilled. In the pre-permit phase, the operator may establish the pattern of development and show how many wells they believe they can drill into the reservoir.
While pre-permit activity can happen a year or more (emphasis on more) before a drilling rig ever moves in to drill the well, permit activity typically happens closer in time to the actual drilling of the well (~6 months).
3. Drilling and Completion
The next type of activity is the drilling and completion of wells, which can be broken into 3 parts: (i) pre-drilling activity, (ii) drilling and (iii) completion. Pre-drilling activity includes land clearing, building drill sites, building roads, digging ponds, and other land construction work that needs to be completed before the drilling rig can be moved onto location. Once the the drill site is prepped, the drilling rig will be moved onto the location, the derrick will be stood up, and actual drilling operations will commence. Drilling operations can take anywhere between five and thirty (or more) days, depending on where you are in the country and the depth of the formation being drilled. Once the well is drilled to total depth (TD), the drilling rig will rig down, logs will be run and the drilling rig will move off of location.
At this point, the operator has what's called a "drilled but uncompleted well" (or DUC) and a completion crew will need to come to the location in order to complete or frac the well before it can produce oil and natural gas.
It can take between three to six months from release of the drilling rig to arrival of a completion crew to frac the well.
4. Production
The final type of activity is actual production. After the well has been fraced, and completion facilities are built (tanks, flow lines, etc.), the well will be turned over to production, and it will commence production of oil and natural gas.
Actual production is a critical stage for any mineral owner because this is when the minerals that you own in the ground are converted from undeveloped to developed, and your cash flow stream actually begins. It is at this point that your minerals become substantially more valuable.
Part 3: Why Does Activity Matter?
Now that we've talked about the types of activity to look for, let's go back to the top of the funnel and talk about why activity matters in the first place.
Activity matters because risk of development is a critical factor in valuing mineral rights.
This is similar to the time value of money concept:
Minerals developed today are worth more than minerals developed tomorrow or ten years from now. Minerals that never get developed have zero value.
It doesn't matter whether we're talking about reserve valuations being conducted by petroleum engineers, or offers being made by mineral buyers: properties that have line of sight to development are worth more.
As we get further down the Scale of Activity, your minerals become more and more valuable because line of sight to production and cash flow becomes more clear. So, let's say you receive a pre-permit application in the mail. This is a good thing--this is one of the types of activity to look for. However, it could still be several years before a well is ever drilled and before you ever receive a royalty check. What this means is that the risk of development is still relatively high. But, as you get further down the Scale of Activity (think permitting and drilling activity), your minerals become substantially more valuable.
When are Your Minerals Most Valuable from an Activity Perspective?
I would argue that your mineral rights are most valuable in the months following first production from a new well or wells. I have two reasons for this. The first is that the reserves that you own in the ground have been converted from undeveloped to developed. Meaning that the risk of development is zero. Line of sight has been determined, and more value is going to be attributed to your properties for that reason. The second is that this is when volume is highest. Now, we're going to cover the concept of depletion or decline in an oil and gas well in another series, but in general, you should understand that oil and gas wells produce more volume earlier in their life than they do later in their life.
A good rule of thumb for a shale well is that it will recover 70-80% of its total volume within the first two (2) years of production.
So, in the first few months following first production from a new well, your royalty checks are going to be the highest because the volume being produced from your well is highest.
In a perfect world, you would wait until your minerals are producing before you consider selling or exiting. But we don't live in a perfect world, and sometimes the best time to consider selling is when you receive a fair offer for your minerals, and that could be prior to production. The offer will be lower, but in that case, you're also shifting the risk of development over to the buyer. What happens if prices crash? What happens if it takes the operator five years to drill that well? What if the well never gets drilled at all?
The question is, what is that risk worth to you?
And remember that a dollar today is worth more than a dollar tomorrow or five years from now.
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Wrap Up
As a mineral and royalty owner, what do you do with this information? In this series, we've been talking about when your mineral rights are most valuable. Today, we talked about ACTIVITY and how activity drives value.
But, remember that Activity is not the only component of mineral valuation.
So go back and read Episode 1 of this Series, where we talked about what it means for Prices to be high. And we hope you'll join us for Episode 3 where we're going to talk about the interdependence of Price and Activity and how Timing is everything.
Until next time…
Steven Hatcher