How Low Oil Prices Impact the Short-Term & Long-Term Value of Mineral Rights & Overriding Royalties
Updated: Jun 1, 2020
Since the start of 2020, crude oil prices have seen the sharpest drop in the history of the energy industry. Futures contracts of West Texas Intermediate closed at a mind-bending negative 37.63 dollars per barrel on April 20th. Basically, companies that had over-purchased oil were paying others to get it off their hands since they had nowhere to put it. Since then, prices have inched back up to around $20/BBL, but the ongoing Covid-19 pandemic has kept oil consumption low and continued over-production from many countries including Russia, Saudi Arabia, and the United States, is likely to keep oil prices low for most of 2020. Add to this that most crude oil storage facilities are at capacity, and it would not be inconceivable to see sporadic drops in crude oil prices over the next couple months. So, what does this mean for owners of mineral rights and overriding royalty interests?
Royalty Checks Will Get Smaller or Go Away Entirely
In the short term, royalty checks are going to get smaller as crude oil prices continue to be low. In some cases, operators may choose to shut in production due to a lack of buyers. In these cases, most operators are likely to invoke the force-majeure clause of their lease agreements. Most oil and gas lease agreements terminate when the operator ceases to produce oil and gas. The force-majeure clause allows operators to continue holding the lease during periods of extraordinary circumstances that are out of their control such as a hurricane, flood, earthquake, or in this case, a global pandemic.
It is possible that some operators will continue to produce oil and gas at a loss. This is because in some cases shutting-down a well can be very expensive, and in many of the shale reservoirs within the United States, a shut-in well will lose reservoir pressure, and never return to their original flow rate. In the situation that an operator produces a well at a loss, it is possible, but unlikely, that they will pass-along some of those losses to the mineral owners. This would only happen if a mineral owner has a lease agreement that allows operators to discount expenses. These mineral owners wouldn’t be asked to send the oil company a check, however, when oil prices increase, the operator may discount from royalty payments losses from previous months. A mineral owner must scan their revenue statement carefully to make sure they identify if an operator is doing this.
In the long run, prices are likely to return to normal and even increase significantly. The oil industry is cyclical and goes through booms and busts. The bigger the current bust, the bigger the next boom. With oil production being shut-in around the world, drilling activity stopping, and investment for the oil and gas sector drying up, it is very likely that in the next one to three years oil prices will surge again. Expectations for higher oil prices can already be seen in the crude oil futures market, which is trading at a much higher value than current prices, a situation with the quirky name of “contango.” This expectation of long term higher oil prices has a direct impact on oil and gas property valuations. A mineral appraiser should not simply use the current price of oil when valuing mineral rights, but consider the most likely long term trend.
Offers to Purchase Minerals Will Temporarily Stop, Then Come Back with a Vengeance
Like the rest of the energy industry, mineral acquisition companies were thrown a curve ball. They had been sending out offers to purchase mineral rights and overriding royalties based on oil prices being around $40 to $50 a barrel. In a period of a few weeks all their economic models for future revenue went out the window. As a result, many mineral buyers abruptly stopped sending out offers to purchase mineral rights.
Since then, mineral acquisition companies have been re-valuing oil and gas acreage. For many of them, this period of low oil prices is an incredible opportunity to buy mineral rights while they are cheap. Low oil prices give them leverage during negotiations with mineral owners who have seen their royalty checks drop to nothing. Additionally, many mineral owners that may have lost a job or seen a decrease in income as a result of the pandemic, may be struggling to pay bills and feel like they must sell their mineral rights. It is very likely that mineral owners will see a new wave of purchase offers come June or July that are much lower than previous offers. When this happens, we recommend that mineral owners seek either a mineral appraiser or a mineral broker to help them value their mineral rights to avoid significantly underselling their property.
Owners of Natural Gas Acreage are Likely to See an Increase In their Properties Value
One of the silver linings of the drop in oil prices is that it will likely have a positive effect on natural gas prices. A lot of natural gas in the United States is produced in association with oil. In many places, like the Williston Basin of North Dakota, natural gas is relatively worthless and operators either flare it, or process and transport it at a small loss. This so called “associated gas” is simply a by-product of oil production. As oil wells are shut in, all this associated gas is no longer produced. The result is that the natural gas market could see big decreases in production which will help keep natural gas prices up. For mineral owners in regions that exclusively produce natural gas, such as the Marcellus and Utica shales of Ohio, Pennsylvania and West Virginia, this means the value of their oil and gas properties will likely also go up. Granted, natural gas prices are still very low at the moment, and they tend to stay low during summer and spring seasons. But when the 2020-2021 winter comes around, people will once again need to heat their homes and there is some expectation that natural gas prices will significantly increase as a result.
There is a Lot to Stay Positive About
Although there is currently a lot of doom and gloom in the news surrounding the American oil and gas industry, in the long run there is a lot to be positive about. This downturn is forcing many oil companies to consolidate in order to reduce costs. This should get rid of inefficiencies and make American oil companies more competitive on the global stage. Many oil companies are also being forced to file for bankruptcy. This allows companies to restructure, or even wipe out, a lot of their debt. This consolidation of clearing of debt will allow the American energy industry to come out stronger on the other side of this down-turn. For mineral owners, this means being smart when it comes to selling their mineral rights and not taking offers that reflect the current bust, but rather, the upcoming boom.