The dramatic decline in oil and gas prices during the past 15 months has obviously impacted mineral and royalty property1 valuations. Clearly, royalty owners’ monthly check receipts are much lower than in 2014, so presumably valuations are lower. But how much lower? Are the current valuations down in direct proportion to the decline in commodity prices?
As appraisers, we observe the gamut of oil and gas property transactions—from small, undiversified mineral tracts with a few mature producing properties to broadly diversified mineral portfolios with significant undeveloped acreage involving numerous counties, states, and operators. We are engaged by trusts, endowments, hedge funds, and private equity backed or publicly traded companies. While some of our clients are highly sophisticated, many are not active in the oil and gas industry and do not have an in-depth knowledge of what they actually own; they rarely have the sophistication, resources, or time to understand the cash flow outlook of the properties and thus rarely understand what their properties are worth.
The primary drivers of mineral and royalty property values are: 1) expected oil and gas commodity prices, 2) the expected pace of drilling or development activity on the subject minerals (as well as the decline of the producing properties), and 3) supply and demand of mineral properties and alternative investments. As with any financial asset, the market value of an oil and gas property or portfolio is that portfolio’s expected cash flows discounted to the present at an appropriate discount rate.
In this article, we will analyze how these three variables have changed during the price collapse and infer how property values have responded.
At June 30, 2014, probably the peak of mineral and royalty valuations, the spot price of crude oil (WTI) was over $100 per barrel and, based on the NYMEX futures market, was expected to remain within an approximate $90 to $100 per barrel band for the next few years, while natural gas (Henry Hub) was trading near $4.50 per MMBtu at June 30, 2014, and was expected to remain within an approximate $4.00 to $4.50 per MMBtu band for the next few years based on the NYMEX strip.
By the end of 2014, unprecedented U.S. production, as well as record Russian production, a strengthening U.S. dollar, and strategic OPEC production decisions pushed prices down significantly.
At year-end 2015, the spot price of oil (WTI) was about $37 per barrel and, based on the NYMEX strip, was expected to remain within an approximate $40 to $50 per barrel band for the next few years, while natural gas was near $2.30 per MMBtu and was expected to remain within an approximate $2.50 to $3.00 per MMBtu band for the next few years based on the NYMEX strip2. See Figure 1. Thus, expected oil and gas prices had declined approximately 50% and 35%, respectively, from mid-2014 to year-end 2015.
Whereas significant development drilling was occurring in mid-2014, operator capital constraints and the current price environment have resulted in many undeveloped locations not being drilled. Many locations that were expected to be drilled in 2014 have become ‘uneconomic’ because of commodity price. Thus, cash flows initially expected by the royalty owner will either not occur in the foreseeable future or will be slowed dramatically. Locations that might still be considered economic have significantly decreased, and drilling to hold acreage is occurring at a slower pace than in mid-2014. This trend is verified by the dramatic decline in the U.S. rig count during this time. Thus, the drill or development pace has slowed dramatically. The time value of money concept says that, if a given level of cash flow is pushed out further into the projection period, that asset is less valuable.
Fortunately, supply and demand issues have remained favorable. Sellers generally don’t want to sell into a weak commodity price environment, so the supply of properties has been low. While supply has been weak, demand has been strong in this low-interest-rate environment where there are few alternatives to gain high yields. Huge amounts of private equity, family office, and other capital have flooded into the mineral and royalty investment category over the past five years resulting in strong competition. The highly successful IPO of Viper Energy Partners LP in June 2014 showed how favorably mineral and royalty properties could be valued in the public marketplace. Black Stone Minerals LP followed with its IPO in April 2015.
So how have property values reacted to these changes?
Royalty trusts are publicly traded portfolios of mineral and royalty properties that pay out all available cash flow on a monthly or quarterly basis. Royalty trusts do not employ debt or hedges. Their portfolios are diversified, static (additional mineral properties cannot be acquired), and passively managed. Royalty trusts are pass-through entities for income tax purposes and are typically priced on a yield basis. Therefore, based on these characteristics, the change in the stock price of royalty trusts should be a reasonable proxy3 for the change in value of a relatively diversified, producing mineral portfolio from mid-2014 to year-end 2015.
Figure 2 below shows that between June 30, 2014, and December 31, 2015, the stock prices of royalty trusts declined dramatically between 60% and 80%. The royalty trusts that primarily owned traditional royalty interests (Permian Basin and Sabine Royalty Trusts) declined less (about 60%) than the royalty trusts which primarily held net profits interests (which declined about 80%) during this period. The former category is more akin to direct mineral and royalty properties (the subject of this article) because the economics of the latter (those with net profits interests) are subject to well operating costs which traditional royalties are not. Thus, the royalty trusts imply an approximate 60% decline in mineral and royalty values from mid-2014 to year-end 2015.
Since royalty trusts are yield-oriented securities, one would expect the decline in price to be driven by a decline in expected distributions4. As investors expect a certain yield and distributions are declining, prices will have to fall to maintain the yield. Indeed, as shown in Figure 3, average annualized distributions (indexed to June 30, 2014, at $1.00 per unit) have fallen by 75% (the median decrease is almost 80%). As prices have fallen by an average of “only” 70%, yields have actually declined from an average of 8.5% at June 30, 2014, to 7.0% at year-end 2015. This decline in yield is somewhat counterintuitive. Relative to mid-2014, investors are placing more value on the trusts at the given distribution level. Possible reasons include a change is risk assessment (reduced price risk as the market is perceived to be at the bottom), increased growth potential (as commodity prices rebound, so will distributions), lower required yields for alternative investments, or increased value placed on the liquidity of royalty trusts versus alternative investments.
We couldn’t make such a clean comparison for the prices of directly held mineral and royalty properties, but we could analyze whether there had been any change in cash flow multiples paid for mineral and royalty properties during this time. We turned to EnergyNet, a leading marketer of mineral and royalty properties in the U.S., to help us gather the analytical data. EnergyNet isolated 24 oil-weighted royalty and overriding royalty properties they sold from June 2014 to October 2014 (Pre Collapse). Most of these properties were located in the mid-continent area such as Oklahoma and Kansas. The average monthly cash flow multiple (based on the most recent month prior to sale) on Pre Collapse transactions was 67.8x. EnergyNet then isolated 21 oil-weighted royalty and overriding royalty properties they sold from June 2015 to October 2015 (Post Collapse). The average monthly cash flow multiple for these Post Collapse transactions declined to 63.1x. Thus, the cash flow multiple declined approximately 7% from the Pre Collapse period to the Post Collapse period. This data implies that there has been a double whammy on valuation—not only did the property-level monthly cash flow decline during the period because of the price collapse, but the multiple declined also. We believe the Post Collapse data is a reflection of an increase in the risk level perceived by investors (after suffering through the dramatic commodity price declines during late 2014 and 2015) and, to some degree, investors’ view of a slower expected development pace5. If the change in commodity price is also considered (estimated earlier at 35% to 50%), the overall implied decline in value would approximate 50%, slightly lower than the decline implied by the revenue royalty trusts.
Oil and gas mineral and royalty values have declined substantially as a result of the commodity price collapse. In general, properties appear to have declined approximately 50% to 60% since peak valuations in mid-2014, slightly greater than the decline in expected commodity prices during this period.