Updated: Oct 12, 2020
Denver is an oil town. Not only is it home to many oil and gas companies (117 to be exact, according to Oilmonster.com), but there are literally oil and gas reservoirs within the limits of the greater Denver area. Most of this oil and gas production has occurred within the Wattenberg Field, a large hydrocarbon accumulation that spans from Thornton to Greeley. More recently there has also been oil drilling south of the Denver International Airport and east of Aurora. For the last 15 years, drilling activity has targeted the Niobrara Formation, a Cretaceous aged marl (a type of rock made up of chalk and shale) that is buried approximately 7,000 feet below ground and is saturated with hydrocarbons. The Niobrara is a prolific reservoir and improved extraction methods, particularly horizontal drilling and multi-stage hydraulic fracture stimulation (better known as “fracking”), have made it a profitable investment for most energy companies. Not anymore. The COVID-19 pandemic has resulted in a sharp drop in the demand for oil as people drive and fly less. Additionally, energy companies kept pumping out oil, resulting in too much supply for too little demand and a resulting collapse in oil price. Low oil prices mean many reservoirs, such as the Niobrara, are no longer profitable to drill. This has different implications for people that live in the greater Denver area. For those that support setback rules that require oil and gas drilling to take place far from homes, their worries may resolve themselves. Those that own the right to extract of oil and gas may see their royalty checks decrease and the value of their mineral rights go to zero.
Oil and gas setback rules are generally established at the state or municipal level and are regulations that prohibit oil and gas drilling activity within a certain distance of homes, parks, schools, and/or environmentally sensitive areas. Over the last few years, discussions over setbacks in Colorado have increased in intensity. They grabbed the general public’s interest during 2018’s vote on Proposition 112 which aimed to establish 2,500-foot setbacks from existing structures and failed to pass by over 10 percentage points. Even though most Coloradoans voted against Proposition 112, on November 6 of this year, state regulators will vote to establish a 2,000-foot setback from existing building anyways. It is anticipated that this measure will pass. This is the biggest statewide oil and gas drilling ban in the nation. The next largest being the community of Flower Mound, Texas which has a setback of 1,500 feet but the vast majority of states and cities have setback rules of only a few hundred feet.
For those that have been in favor of stricter setback rules for oil drilling, it looks like their concerns could resolve themselves. According to BakerHughes, an energy service company, the number of drilling rigs in the Denver Basin has decreased from 20 at the start of 2020 to only four today. This is a precipitous drop that indicates fewer wells are being drilled at current oil prices. Petroleum Evaluations Group estimates that the typical energy company operating within the Denver Basin needs the price of oil to be at least $50 to break even and make a profit on a Niobrara well. The current price of oil is close to $40. We can expect that even the four rigs still drilling will shut down if commodity prices do not come back up soon. This lack of drilling makes the discussion around setbacks something of a moot point for the time being. It also provides legislatures an opportunity to continuing discussing the best way forward with setback regulations without the pressure of ongoing drilling heating up the conversation.
The right to extract oil and gas from a tract of land is referred to as the “mineral right.” The owners of these rights are called “mineral owners.” Often, individuals that own the surface of a property (where they may have a farm or a house) also own the mineral rights. But that is not always the case. Mineral rights can be split (or “severed”) from surface rights, resulting in one person having the rights to oil and gas extraction while someone else owns the surface. Splitting the surface rights from the mineral rights often happens when a property is sold, and the seller reserves the mineral rights in the transaction. In the Wattenberg Field, a large portion of mineral rights have overt time been split from the surface ownership.
The owner of mineral rights will often lease these to an energy company that has the capital and expertise to drill for oil and gas. As part of this lease agreement, the mineral owner will receive a royalty from any oil and gas produced and sold from their land. A typical royalty rate is somewhere between 12.5% and 20% of gross revenue. There are thousands of mineral rights owners in the greater Denver area and outskirts. For them, the value of their mineral rights has significantly decreased with the drop in oil price.
Properties containing the oil-rich Niobrara formation can generally be divided into two types: those that are “drilled-out” and already have as many wells as they are ever likely to see, and those that may have a well or two but still have a lot of proven, but as of yet undeveloped, potential. Owners of both types of properties have seen a significant decrease in the royalty checks they receive from energy companies. But owners of mostly undeveloped acreage – those whose property value was mostly based on speculation that additional drilling would happen in the future – have seen a much larger drop in the value of their mineral rights. After all, if wells are producing, they will be worth something. But a hypothetical well location that is uncommercial to drill at today’s oil prices can essentially be worthless. Petroleum Evaluations Group specializes in valuing oil and gas properties and regularly works with mineral owners in Colorado. Recently, some of our work has required helping mineral owners adjust their expectations of what their mineral rights are worth.
If oil prices were to rebound over $50 a barrel, and stay above this price for a prolonged period, we can expect to see the number of drilling rigs in the Denver Basin go back up. This will once again heat up the debate around setbacks. It will also increase the value of mineral rights. There is the possibility that stricter setback rules, paired with higher oil prices, will result in mineral owners seeking compensation from the State of Colorado. They can claim that large setbacks are akin to a government taking and seek just compensation – a similar situation to when a government uses eminent domain to build a road through private land.
Our recommendation to setback supporters is that they take this time of low oil prices to continue studying the impact of oil and gas drilling in the greater Denver area without the added pressure of significant ongoing drilling activity. Particular consideration should be made to the possibility that, if oil prices increase, then the settlement costs for any potential lawsuits associated with oil and gas takings will also go up. But if oil and gas prices stay low, then these settlements could be minimal. This wouldn’t be a bad time for environmental groups to potentially even offer to purchase mineral rights as an active approach to minimizing oil and gas drilling.
Our recommendation to mineral owners is that they consider selling their mineral rights. With the combination of low oil prices and a tougher regulatory regime, the risk of deeply buried oil and gas never being brought to the surface has never been higher. These so called “stranded assets” would be worthless. Energy companies with large investment funds are generally much more willing to take that risk than your typical mineral owner.
To both setback supporters and mineral rights owners, we recommend that they consider hiring a professional to help them establish the value of mineral rights before they consider selling or buying them. A mineral rights owner would also need a valuation if they aim to sue the State of Colorado for compensation associated with new setback regulations. Most negotiations around mineral rights begin with a fair market valuation and a company such as Petroleum Evaluations Group can help provide these.