The short answer is, it’s complicated.
The Income Approach
Mineral rights are (potentially) income-producing property. So the commonly accepted method of valuing oil and gas interests is the income approach, similar to the method used to evaluate commercial real estate. This method estimates the present value of the future cash flows that the oil and gas mineral interests are expected to generate.
To use the income approach, the first step is to estimate the expected production of the oil and gas interests. Expected production is the sum of expected future production from (1) wells that are already producing (sometimes called “Proven Developed Producing” or “PDP”) and (2) wells that will start producing in the future.
For PDP wells, the expected future production can be predicted based on historical production for those wells. Production from a well tends to decline in a predictable fashion, with some variation from well to well. So given enough historical data on a given well, it’s fairly easy to predict its future production with reasonable (but not perfect!) accuracy.
For wells that aren’t yet producing or haven’t been producing long enough to make reasonably accurate predictions, it’s harder to determine the expected future production. Doing so involves analyzing geological data, operator spacing data, drilling reports, the performance of nearby wells, etc. Indeed, until the permits are filed and the drilling begins, you can’t be sure how many wells there will even be. This process can be imprecise because there are so many variables.
The second step is to calculate the cash flows on expected production. Mineral owners aren’t paid a fraction of the oil and gas produced, they’re paid a fraction of the revenue on the sale of oil and gas. That means figuring out not just (1) what it will produce but (2) when it will produce it and (3) what the regional price of oil and gas will be at the time. Especially for non-producing wells, this can involve a lot of guesswork. Will the well come online in the next few months? Or will it be a few years? What will the price of oil be at that time? What about gas?
The third step is to apply the discount rate. It’s common to discount the expected cash flows using the net present value calculation. That’s because money today is worth more than money in the future, because of inflation and the opportunity cost of not having that money to invest elsewhere in the meantime.
Net present value is a framework to measure the value of an investment in today’s dollars. It takes into account the expected future cash flows from the investment and discounts them back to their present value, based on the time value of money.
Here’s an example of how NPV works: let’s say you have an investment opportunity that will generate $1,000 in cash flow in one year, and you estimate a discount rate of 10% (which is your expected rate of return on other investments with similar risk). The present value of that future cash flow would be $909.09 (i.e., $1,000 / (1 + 0.10)^1). Your own discount rate depends on what other investment opportunities are available to you and prevailing market conditions.
So (1) having estimated your production and (2) the timing and commodity prices, and (3) used that to calculated the discounted cash flows, you know the value of the well itself. Do that same calculation for all the wells.
The final step is to calculate your division of interest (“DOI”) in those wells. Division of Interest (DOI) is a term used in the oil and gas industry to describe a fractional ownership interests in a well. That’s a function of (1) how many acres you own in the pooling/spacing unit that well is allocated to, (2) how much is allocated to that unit, and (3) your lease royalty. Assuming the wells are producing (or soon will be), you should have a division order from the operator with your DOI. If you don’t, you’ll have to calculate it yourself.
Finally, multiply the number you got from steps (1)-(3) by the fraction in step (4). That’s the income approach.
The Market/Buyer Approach
As you can tell, there’s a lot of estimation and guess work in the income approach. So another common way to value your minerals is just to ask “What is someone else willing to pay for them?”
This method is more like when you auction off your house during a standard home real estate transaction. If you solicit offers from four mineral buyers, and three offer $75,000 but one offers $100,000, then the market value of those minerals is about $100,000. This number may be higher or lower than the number derived from the income method.