Risks Associated with Mineral Rights

New oil and gas wells decline sharply (especially horizontal wells). The royalties from the first few months of production should not be used to value the property. It is quite common for a 1-year old well to produce 1/2 or even 1/3 of its initial production. Using a rule of thumb and value the minerals using the first 6 to 12 months of production will result in dramatically overpaying for the interest, and you may never get a return on your investment.

Hydrocarbons are finite resources. Successful conventional wells generally produce smaller amounts of oil and gas for long periods of time, while horizontal wells produce large amounts of hydrocarbons but only a few years. Buying interest in a well that is near the end of its life is risky. It may be plugged and abandoned before you get a return on your investment. And if your interest is terminated with the lease, you no longer have the ability to generate income in the future.

More often than not, mineral owners don’t really know what they own. The onus is on the buyer to conduct extensive due diligence before purchasing minerals. Poor due diligence may result in your purchasing minerals from someone who doesn’t actually own any minerals (or who owns only a small fraction of what they thought they owned). It’s risky – especially when buying non-producing mineral rights.

Most mineral owners do not hire an attorney to negotiate lease terms. This is a huge mistake and often results in leaving money on the table. One of the many terrible but common lease terms is giving free gas to the operator to run the well. Some operators have started running their frack fleets on natural gas, and guess who is financing that? Buying mineral rights with poor lease terms exposes you to additional risk.

Oil, gas, and other minerals are finite resources. The delight that accompanies the first few royalty checks is often followed by immense disappointment as royalties drop to 1/3 or less than their initial production and eventually stop producing altogether. Conventional wells can produce for decades, but horizontal wells generally have a 10-year lifespan. In some areas, more wells can be drilled, and in other areas, the oil and gas reserves are quickly depleted. Like so many things involving real estate, location is everything when it comes to mineral rights.

Conventional wells can produce small quantities of oil and gas for decades, while long horizontal wells are more efficient at pulling hydrocarbons from the shale, producing large quantities of oil and gas but only for a short time. Horizontal wells have increasingly steeper decline curves and shorter lives. Some people choose to sell their minerals while the revenue is high enough to warrant a good price. Others prefer to keep their minerals, cashing declining checks throughout the lifespan of the oil or gas well.

The hot new shale plays, such as the Permian Basin, are struggling with infrastructure constraints. Oil can be trucked from the well site to a refinery, but natural gas must be transported via a pipeline. It often takes longer to lease and build pipelines than it does to drill and complete the wells. As a consequence, there are a lot of gas wells in the Permian that are either shut-in, or the operators are flaring the gas. In the case of shut-in wells, the mineral owners are not receiving royalty payments. Operators that are flaring the gas are not paying royalties on what they flare.

Ten years ago, we were concerned about peak oil, but thanks to technological developments in horizontal drilling and fracking, the United States is no longer fully dependent on foreign oil. In fact, we are now an exporter. Excessive drilling, combined with geopolitical situations, can lower oil and gas prices. Lower commodity prices translate to dramatically lower royalty checks. When the price of oil or gas drops too low, wells become uneconomical to operate and are plugged, releasing the lease.

Overriding Royalty Interest (ORRI) can be particularly risky. ORRIs are typically given to geologists and other professionals for their services and are frequently sold as a way for these professionals to convert the asset into cash. ORRIs end when the lease ends, which means that if the wells are plugged, you no longer own mineral rights.

After a well is drilled, the operator will send division orders, which mineral owners must sign in order to receive royalty payments. The division order describes the property, the mineral owner, and the owner’s interest in the property. Many mineral owners sign division orders without verifying their ownership – often because they don’t know how to compute their ownership. Signing an incorrect division order can lead to underpayment. You might not be receiving the correct royalties.

Even if someone drills a well, it may be a dry hole, an unsuccessful well, or a poor performing well. All three of these will discourage further development.

Mineral interest owners often own the minerals for decades, passing the interest from one generation to the next, all hoping that a successful well will eventually be drilled. Sometimes this happens, but often it does not. The value of non-producing minerals is usually considerably lower than it would be if they were producing.

There are many lease terms that benefit the operator to the detriment of the mineral owner. Signing an oil and gas lease without an attorney is extremely risky.

Oil and gas companies are constantly acquiring and divesting assets. Just like banks sell mortgages to be serviced by a different company, operators buy and sell working interest and the obligation to operate the well and pay interest owners. Sometimes information gets mixed up when assets are transferred from one company to another. The new operator may not be paying based on the correct ownership figures, they might be failing to pay for gas the use – assuming your lease allows for the free use of gas. They might be charging you for deductions that are not allowed per your lease terms. They might take you out of pay status, obligating you to prove that you own the minerals via an oil and gas lease and division orders.