Frequently Asked Questions About Mineral Rights & Royalties
1. Why Does Caddo Buy Minerals?
Caddo is an investor in oil and gas mineral interests across Texas and elsewhere. Caddo takes a “portfolio approach” to investing, meaning that many similar investments are made to spread the risk across those investments. For this reason, Caddo can more easily afford to take risks. The more investments that Caddo makes effectively reduces its overall risk. Therefore, the risk to Caddo is less than the risk to the individual mineral owner.
2. How Does Caddo Value and Buy Minerals?
Caddo looks at minerals as an investment. Just like any other investment, mineral rights are purchased for the potential return on investment. Ultimately, the value is based on the risk-adjusted cash flow that minerals are expected to generate in the future. Estimating cash flow involves assumptions about when wells may be drilled, the flow rates, oil and gas prices, the operator, and the risks. Caddo considers many factors when valuing mineral rights.
Risks. There are many risks that come into play in determining the overall risk of an investment. Systemic risks include the price of oil and gas, regulatory issues, gas markets, mechanical risks, “play” risks, and drilling costs. Deal risks include title, the leasing situation, area activity, and operator competence. Systemic risks and Deal risks combine to make up the risk component of the discount rate.
Discount Rate. The discount rate is the rate at which the future cash flows are discounted back to the present time, so as to calculate the “present value.” The discount rate takes into account both risk and the time value of money. Greater risk = higher discount rate = lower value; Lower risk = lower discount rate = higher value.
Time Value of Money. This is the concept that “a dollar received today is worth more than a dollar received in the future.” Wells produce reserves over a period of time, so the cash received from the well comes over a number of years. Future cash is not worth as much as present cash. The time value of money is a component of the discount rate.
Present Value. Present value is the application of the discount rate to future cash flows, so as to determine the present worth of an investment.
Decline Rates. The production rates of all wells decline over time as the reserves are produced, so future production will be less than current production. For example, Haynesville wells, because they are shale wells, decline very rapidly over the first year. These decline rates are factored into the projection of future revenues.
Royalty Interest. If the minerals are leased, then the royalty interest has an impact on the value of the minerals. Because a larger royalty interest results in larger royalty payments to the mineral owner, the larger royalty interest means a higher value. Therefore, a tract of land with a 25% royalty will be worth more than if the same tract had a 20% royalty.
Operators. As an example, Haynesville wells vary in their productivity depending on (a) the location of the well relative to the “core”; (b) operator completion practices, and (c) operator production practices. Operators are critical in that some operators utilize superior completion and production practices, which result in better wells and higher values. For this reason, two “core” wells operated by two different operators may have very different values.
3. What is a “Net Mineral Acre?”
A Net Mineral Acre (“NMA”) is net ownership expressed in terms of mineral acres.
The formula is: Tract Size in Acres x Ownership Interest = Net Mineral Acres.
For example, full ownership of a 10-acre tract of land equals 10 Net Mineral Acres (100% X 10 Acres = 10 NMA), while ½ ownership in the same tract of land equals five Net Mineral Acres (1/2 X 10 = 5 NMA). The Net Mineral Acre calculation affects lease bonus payments, the division of interest, and royalty checks.
4. What is a Royalty Check?
Royalty checks normally come monthly and are determined by the division of interest, the production for the month, oil and gas prices, and any operator deductions (e.g. transportation charges). It will take many months after a well goes to production for royalty checks to start. Before the oil company will commence payments, it must establish each owner’s division of interest.
5. What is the Division of Interest (“DOI”)?
The division of interest is the owner’s share of production, expressed in a decimal, from the well or unit. The DOI is usually based on a title opinion, which is drafted by an attorney based on the public records of the county. A division order is the royalty owner’s confirmation of the DOI.
The DOI is calculated by the following formula: Net Mineral Acres / Unit Acres x Royalty Interest = Division of Interest.
6. What is Unitization?
Wells in the Haynesville Shale are subject to unitization, which is the creation of 640-acre sections, called units. All owners within the 640-acre sections are included in that unit, and each owner owns a share of the unit based on the owner’s net mineral acres, the royalty interest and the actual size of the unit.
7. What is an Un-Leased Owner?
A mineral owner who has not leased his land is called an “un-leased owner.” An un-leased owner does not receive any lease bonus or royalty income. However, if the well “pays out,” which means the well earns more money than the production costs, the un-leased owner may share in his pro-rata share of the income from the well.
However, there are two risks to the un-leased owner: (1) that the well never pays out, or (2) that the un-leased owner is unable to prove ownership of the minerals with the oil company. However, the oil company may choose to not cooperate with the un-leased owner, which may make it very difficult for the un-leased owner to receive any revenue from the well. It is often more advantageous to be a royalty owner than an un-leased mineral owner, as the un-leased owner is in a risky position.