The oil and gas industry has been around for a long time and has developed several ways of making rough, back-of-the-envelope, estimates for valuing mineral rights or oil and gas royalties. In some cases, these estimates can be relatively accurate, but they must be used with extreme caution. They are best used simply to validate a more thorough valuation method, or when there is no other alternative. This article will present two rules-of-thumb for oil and gas property valuations and discusses why they should be used with caution.
Rule-of-Thumb #1: The Cash Bonus Multiplier Method
A mineral owner in an oil and gas producing region will often be approached by an energy company to lease their mineral rights. In a lease agreement there are typically three important elements that are considered: 1) a bonus payment for the mineral lease, 2) a royalty rate that defines the percentage of oil and gas revenue that belongs to the mineral owner, and 3) at what point an energy company has to drill and start producing oil and gas before the lease expires. The bonus payment is typically offered as a dollar-per-acre amount and can be as low as $10/acre, or as high as over $10,000/acre. Keep in mind that a higher bonus offer tends to come with a lower royalty rate, while a lower bonus offer tends to come with a higher royalty rate.
The bonus offer for a mineral lease gives a general indication of value for the mineral deed. Remember, when you lease your minerals, it is just a temporary contract that allows an oil company to drill and produce oil and gas on your land. Once oil and gas production ends, the lease is terminated. With a mineral lease, you never give up ownership of your minerals. When you sell your minerals, you give someone else the deed to your mineral rights and from then on it is no longer your property. The $/acre you should receive for selling your minerals should be quite a bit higher than the $/acre you should receive for simply leasing your minerals.
The general rule of thumb is that the value of a mineral deed is about two to three times larger than the value of a mineral lease. So, if the current going rate for leasing minerals in an area is $1,000/acre (say, with a 15% royalty rate), then the value for outright selling those mineral rights should be between $2,000/acre and $3,000/acre.
This rule of thumb usually only works well in areas that do not have a lot of ongoing oil and gas production. These could be regions on the fringe of oil and gas development, where few people have drilled, and the possibility of oil and gas production is still speculative.
THIS IS NOT A GOOD RULE OF THUMB TO APPLY WHEN THERE ARE ALREADY PRODUCING OIL AND GAS WELLS ON A PROPERTY. Usually this method significantly underestimates the value of a mineral deed if there are oil and gas wells that are paying royalties.
To accurately value a mineral deed when there is ongoing oil and gas production, a geologist and petroleum engineer need to be hired to forecast that future production and generate an economic model that establishes the fair market value of future royalty revenue.
Rule-of-Thumb #2: The “Pay-Out” Method
The previous rule of thumb only works if you are looking at a property that does not have any ongoing oil and gas production. A rule of thumb for properties that are paying royalties is the pay-out method. This method involves taking the monthly royalty payments from a property and multiplying it over three years. For example, say that someone is receiving $500 per month in royalty checks and wants to sell their mineral rights. Then the value would be: $500 x 12 months x 3 years, which is $18,000.
Sometimes people will use four, five, or even seven years in their calculation depending on how long they think oil and gas will be produced from wells and if they think the price of oil and gas may go up.
The issue is that THIS METHOD DOES NOT TAKE INTO ACCOUNT FUTURE OIL AND GAS PRODUCTION. Many companies send offer letters to purchase mineral rights right before oil and gas wells are drilled and begin producing. As a result, the pay-out method would significantly underestimate the value of the mineral rights, since it is only based on existing (i.e. ongoing) production, not future production. In shale reservoirs, many companies will regularly come in and drill additional wells every few years, and a mineral owner would not fully capture the value of these future wells when selling their mineral rights.
To accurately value a mineral deed when there is ongoing oil and gas production, a geologist and petroleum engineer need to be hired to establish the future production on the property, especially from wells that have not yet been drilled, and generate an economic model that establishes the fair market value of future royalty revenue.
If you have any questions about valuing oil and gas properties, please contact us at: alex@petroleumevalautionsgroup.com