Risks Associated with Buying,
Owning and Selling Mineral Rights
Types of Risks
These risks can be divided into three categories: purchasing, ownership, and selling. Each of these can be further sub-divided into risks associated with producing and non-producing minerals.
Purchasing mineral rights can be really risky - if you don't know what you are doing. As they say, knowledge is power. The more you know, the more you can reduce your risk.
Most people inherit their mineral rights and therefore avoid the risks associated with purchasing minerals. Still, mineral owners assume a lot more risk than they first realize.
Selling your mineral rights can eliminate the risk associated with owning minerals, but it also introduces new risks associated with selling.
Risks to Consider When Purchasing Mineral Rights
Buying Interest in a New Well
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.
Buying Interest in an Old Well
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/or abandoned before you get a return on your investment. And if your interest terminated with the lease, you no longer have the ability to generate income in the future.
Buying Non-Producing Minerals
Non-producing minerals have no active oil or gas wells and therefore, do not generate royalty checks. The biggest risk when purchasing non-producing minerals is that no one every drills a well, or that they drill a dry hole or marginally successfully well. Even if someone drills a successful well, you might have signed an unfavorable lease (always get help from an attorney), or erroneous division orders. Your well might be operated by a bad operator.
Poor Due Diligence
More often than not, mineral owners don't really know what they own. The onus is on the buyer to do 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.
Poor Lease Terms
Most mineral owners do not hire an attorney to negotiate lease terms. This is a huge mistake and causing them to leave money on the table. One of the many terrible, but common lease terms is giving free gas to the operator in order 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.
Bad Operators
Most operators try to do the right thing but there are a few with well-earned bad reputations. Managing minerals operated by one of these companies takes a lot of extra time and effort and can potentially involve attorneys, accountants and royalty audits. It can easily eat away at your revenue and turn into a bad investment.
Risks Associated with Owning Mineral Rights
Declining Reserves
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.
Steep Decline Curves
Conventional wells can produce small quantities of oil and/or 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.
Held By Production (HBP)
You might own minerals that are held by production (HBP). An lease in only in effect until the last well is no longer producing, so operators try to keep an oil well producing - even if it only produces a couple of barrels of oil every so often. As long as the cost of operating the well is less than the revenue generated, it is in the operators best interest to hold the lease. Unfortunately, this often means that another operator cannot drill a well on your tract of land. And if you leased multiple tracts of land in a single lease (a big mistake), then all of that land can be held by the production of a single well that is barely producing.
Lack of Pipeline Infrastructure
The hot new shale plays, such as the Permian Basin, are struggling with < a href ="https://www.worldfinance.com/featured/poor-infrastructure-is-threatening-to-derail-the-us-shale-boom" target ="_blank">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 cause 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.
Low Commodity Prices
Ten years ago, we were concerned about peak oil, but thanks to technological developments in horizontal drilling and fracking, the United States is is no longer dependant on foreign oil. In fact we are now exporting natural gas! The downside is that oil and gas prices have dropped significantly - especially natural gas, which is now selling around two dollars per mcf. The drone attack on a Saudi oil refinery that took 5 million bbl per day out of production had very little impact on oil prices. There is simply a lot more oil and gas than we need and the recent shale drilling slowdown is not helping. 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.
Unfavorable Political Climate
The political climate in the United States is another risk to mineral owners. Concern regarding climate change is leading to the push toward renewable energy. Renewables, such as wind and solar are only economical when:
1. Price of fossil fuels is high (which is not the case right now)
2. Renewables are subsidized
3. Government provides incentives for renewables
4. Anti-drilling/export legislation (or executive orders) are enacted to limit the use of fossil fuels
In 2019, Colorado passed anti-drilling legislation and the top 2020 democratic candidates are promising to not only ban fracking but also ban exporting natural gas outside of the United States, both of which will have a dramatic impact on energy production and royalties.
Overriding Royalty Interest (ORRI)
Overriding Royalty Interest (ORRI) can be particularly risky. ORRI's 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. Operators have been known to release the lease of a well that is not producing very well and re-lease the property in order to remove the obligation to pay an ORRI. It may be cheaper for the operator to release the mineral owners, particularly if there aren't many, and continue to operate the well without having to pay the override. This seems particularly unethical and there are some legal opinions about this practice, but it still a risk.
Incorrect Division Orders
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, 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.
Poor Lease Terms
One of the biggest mistakes that mineral owners make is failing to hire an oil and gas attorney to negotiate the lease on their behalf. By not seeking professional help, mineral owners are leaving money on the table and putting themselves in a position to be taken advantage of. Sometimes owners allow a single lease to to tie up multiple tracts of land and depths above or below where they intend to drill a well. Some leases authorize the operator to use natural gas for free (some operators use this gas to run their frac fleets). There are so many lease terms that benefit the operator to the detriment of the mineral owner. Signing a oil and gas lease without an attorney is extremely risky.
Non-Producing Minerals
Non-producing minerals are challenging. Without one or more producing wells, there will be no royalties. Non-producing mineral owners own the right to develop the minerals but unless they have the knowledge, experience, and finances to drill a well, must wait for someone else to drill.
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 they would be if they were producing.
Incorrect Royalty Checks
One of the biggest mistakes that mineral owners make is failing to hire an oil and gas attorney to negotiate the lease on their behalf. By not seeking professional help, mineral owners are leaving money on the table and putting themselves in a position to be taken advantage of. Sometimes owners allow a single lease to to tie up multiple tracts of land and depths above or below where they intend to drill a well. Some leases authorize the operator to use natural gas for free (allowing operators to use this gas to run their frac fleets).
There are many lease terms that benefit the operator to the detriment of the mineral owner. Signing a oil and gas lease without an attorney is extremely risky.
Poor Management
Managing minerals, especially if you own a lot of interest, can be a time-consuming and labor-intensive job. Not only do you need to know exactly what you own and have meticulous records of deeds, division orders, leases, etc, but you need to verify each royalty check payment is correct. Some mineral owners use software to help with mineral management tasks, while others utilize complex spreadsheets. Still others throw everything in a shoebox and leave the mess for their heirs to one-day sort out. Mismanaging your minerals can lead to reduced royalty payments, missing royalties, ownership returning to the surface owner, and a variety of additional issues. Managing minerals for multiple family members (perhaps in a trust or LLC) is an even bigger responsibility with greater risks. Some mineral owners choose to sell rather than leave obligate heirs to learning curve and management requirements of owning mineral rights.
Trouble Proving Heirship
In order for mineral ownership to be transferred a deed, conveyance or affidavit of heirship needs to be filed with the county clerk where the minerals are located. Landmen use these record to determine who owns the minerals and needs to sign an oil and gas lease before a well can be drilled. If they cannot find you, you might miss out on royalties.
When transferring ownership of producing minerals, the operator and county will need proof of heirship - in the form of a will or affidavit of heirship. If a mineral owner dies without a will and too much time passes, there may not be anyone (unrelated) that can sign the affidavit of heirship. Don't let this happen. When you inherit minerals, get them transferred to your name ASAP.
Aqusition Mix-Up
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. Often 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, the might be failing to pay for gas the use - assuming your lease allows for the free use of gas. The 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. A lot of things can happen when one company buys the assets of another company and you need to be a vigilant mineral manger (or perhaps hire someone to do it for you).
Dormant Minerals Act
Many states have enacted a dormant mineral act. As a mineral owner, you have to register your minerals every so many years (depending on the state) or the ownership reverts back to the surface owner. Dormant mineral acts were intended to resolve the problem of highly fraction minerals (great Uncle John passed his minerals to his eight kids, who each had 3 kids, who each had two kids). It doesn't take long before the minerals are so fractioned that each owner is only entitled to a tiny interest and oil and gas companies are resistant to invest a lot of time in locating several hundreds of fractional mineral owners.
Dormant minerals are another reason to keep detailed and organized records. Many mineral owners are not aware of the non-producing property they own and in some states, mineral ownership reverts to the current surface owner after a specified number of years.
Risks Associated with Selling Mineral Rights
Missing Future Revenue
When you sell your minerals, they are gone forever. You no longer have mineral rights to pass to the next generation. For this reason, a lot of people only sell 1/4 or 1/2 of their mineral and royalty interest. Others sell they royalty interest in the lease, but keep the mineral interest. When the lease ends, they (or their heirs) still own the executive rights and can enter into a new lease and receive royalty payments.
Selling Too Low
Mineral valuation is subjective. Every company has a different formula for valuing minerals and most of them would rather buy minerals on the cheap - so they can flip them at auction. It is always a good idea to get multiple quotes for your mineral rights. You might be surprised by how much they vary.
Not Having all the Facts
Did you get a offer in the mail? The company who sent it may know something that you don't know. Perhaps there is a permitted well that will be drilled in the next 6 months? Maybe there have been successful wells drilled in nearby sections? Before you sell, look at your minerals in your state's oil and gas GIS viewer and see if there is any activity.