Money For Nothing - Competition Heats Up for Margin-Boosting Oil and Gas Mineral Rights

Monday, 07/31/2023  Published by: Tom Biracree  rbnenergy.com

https://rbnenergy.com/money-for-nothing-competition-heats-up-for-ma...

On average, the landowners and other entities that own mineral and royalty interests in producing oil and gas wells receive about 20% of the gross revenues generated by those wells — and do so without any responsibility for the significant costs and complications associated with well development and production. Mineral and royalty interests have traditionally been a highly fragmented market, with most held and passed down through generations by landowners or purchased by individual investors. However, competition for these interests has become more heated in recent years with the creation of large publicly owned and private-equity-funded consolidators and a new emphasis by E&P companies on adding these higher-margin slices of revenue from leases they own and operate. In today’s RBN blog, we explain mineral and royalty interests and analyze the developments in this massive $700 billion market.

As the oil and gas industry has evolved from a growth-at-any-cost strategy to a laser focus on generating free cash flow, it’s not surprising to learn that there has also been an increase in competition for the highest-margin portions of the revenue produced by every well — the average 20% paid to holders of mineral and royalty interests by producers of lease acreage. Because E&Ps agree to fund 100% of development and production costs, the mineral and royalty interest holders receive a much higher percentage of the gross revenues of each well while remaining free of development/production costs and shielded from the impact of inflation. That has helped to make mineral and royalty interests hot commodities pursued by a variety of entities looking to boost returns on oil and gas investments.

Before we dive deeper on this, let’s quickly define a few key terms and explain the financial side of well development and who gets what money-wise from a producing well.

• Mineral interests are the exclusive rights to the minerals — including oil and natural gas — found on or beneath a piece of land. These rights are leased to companies that extract oil and gas, most commonly in deals that include a signing bonus or lease payments. But the rights are retained in perpetuity and survive the lease.  *
• Royalty interests are claims on a portion of the revenues or produced oil and gas volumes negotiated as part of the lease from the mineral interest holders. Royalty holders are not responsible for the costs associated with oil and gas production except applicable taxes on revenue and have no abandonment or environmental liabilities. Royalty interests are terminated when the lease ends.
• Working interests constitute ownership of the remaining production from a lease after royalties are paid. Working interest owners are responsible for 100% of the costs of finding, developing and producing oil and gas on the leasehold as well as funding abandonment of the well and any environmental liabilities. In describing assets, E&P companies often identify their relative working interest (e.g., 100% WI) and the net revenue interest (81.4% NRI), which reflects the total royalties paid. Working interest owners may be operators of the wells responsible for the decision making regarding the well or they may be non-operated (non-op) owners, meaning that they participate in the working interest but do not make day-to-day decisions.

Because they don’t share in costs, royalty owners are largely immune from the effects of cost inflation. The margin advantage of mineral/royalty interests expands when costs rise quickly or when the prices of commodities fall. However, the primary risks for mineral/royalty interests are the level of operator activity on their leases and the level of revenue generated, which in turn are a function of commodity prices, the productivity of the acreage, and the strategy of the working-interest owner.

Mineral/royalty interests have traditionally been attractive to investors because they are passive, generating income with virtually no overhead. They have been sold by many landowners for the same reasons people cash in annuities — namely, because they receive an upfront lump-sum payment rather than receiving income that is paid over a decade or more. This is especially true in the case of interests fragmented when passed down to heirs in an estate. Some E&P companies have sought to take advantage of the higher multiples afforded mineral/royalty rights to generate quick cash to help fund aggressive development programs and forego the long-term higher margins. They have spun off mineral/royalty interests in specific assets in initial public offerings (IPOs) of royalty trusts, which pay out income from specific assets until they are depleted and dissolved. A few examples are Chesapeake Granite Wash Trust, BP Prudhoe Bay Trust, and the SandRidge Mississippian Trust.

Interest in mineral and royalty assets grew exponentially in 2018-19 as these interests provided free cash flow and high yield at a time when traditional E&P operators struggled to do so after the price crash in 2014-15. Although the mineral/royalty market is huge — an estimated $700 billion — it has been (as we said) highly fragmented. The proper strategy for mineral/royalty investment has been described as “buying ahead of the drill bit,” targeting interests in undeveloped acreage that has a line-of-sight to drilling. This strategy requires sophisticated analysis of the geological potential of acreage as well as insights into the investment strategies of the operators.  ** This led to the emergence of publicly traded mineral/royalty entities, which opened this market to the lion’s share of investors who lacked the expertise and substantial capital necessary to build a portfolio on their own. These companies built technical teams that could more accurately assess the development potential and market value of specific properties. In contrast with passively managed public royalty trusts whose resources would deplete over time, their focus was on growing their portfolios to provide commodity and geographic diversification. These entities had aggressive acquisition strategies, with publicly announced acquisitions of mineral and royalty interests more than doubling from $1.4 billion in 2017 to about $3.5 billion in 2018 and 2019.

Let’s look at a few examples. A single, multi-basin publicly traded limited partnership, Dorchester Minerals (DMLP), had been created in 2003 but a charter that prevented it from taking on any debt put a limit on the size of its acquisition targets. Newer entities, which were far more aggressive and better funded, had their roots in managing private oil and gas investment funds. Black Stone Minerals’ (BSM) predecessor company was W.T. Carter & Bro., a lumber company founded in 1876. In 1968, it sold its lumber interests and shifted its focus to the oil and gas mineral and royalty acres it had assembled. Black Stone subsequently shifted its business model from managing private oil and gas funds to making acquisitions on its own and in 2015 completed an IPO to become, at the time, the largest U.S. pure-play oil and gas mineral/royalty owner. Today, the company owns over 7.4 million net mineral and royalty acres with concentrated positions in the Permian, Haynesville and Bakken production areas.

Here are a few more. Kimbell Royalty Partners (KRP) was formed in 1998 by Fort Worth-based investors to conclude a single deal in the Permian Basin and subsequently evolved to become a multi-basin entity after completing an IPO in February 2017. Approximately half of Kimbell’s production is from the Permian and Haynesville, with the remainder from Appalachia, the Mid-Continent, the Eagle Ford, the Bakken, and the Rockies.

Sitio Royalties (STR) was formed in 2022 through the $1.4 billion merger of entities previously owned by investment firms Kimmeridge Energy, Desert Royalty Company, and the Blackstone Group. About 80% of the company’s acreage was in the Permian Basin, with the remainder in the Eagle Ford and Appalachia. Sitio announced in September 2022 it had agreed to merge with publicly traded Brigham Minerals in a $1.9 billion all-stock transaction. Brigham Minerals was founded in 2012 by Bud Brigham, the former CEO and chairman of publicly traded E&Ps Brigham Exploration (acquired by Statoil for $4.7 billion in 2011) and Brigham Resources (acquired by Diamondback Energy for $2.4 billion in 2016), with funding from three private equity firms. Brigham Minerals went public in February 2019 with holdings in the Permian (48%), DJ Basin (20%), Anadarko Basin (12%), and Williston Basin (10%). The combination of the third- and fourth-largest mineral/royalty firms resulted in a Permian-focused entity (70% of output) that had exposure to 34% of all wells drilled in the basin in 2021.

The largest mineral/royalty firm by enterprise value is a hybrid that combines the traditional method of spinning off assets into a separate entity with an acquisition strategy that also targets third-party deals. Viper Energy Partners (VNOM — one of the more clever stock symbols out there) was spun off by Diamondback Energy (FANG — another good one) in a June 2014 IPO to hold some of its Permian mineral/royalty interests. Diamondback has subsequently used dropdowns of assets to Viper as part of its funding of major corporate and asset transactions. However, Viper has also aggressively targeted third-party acquisitions. In Q1 2023, third-party operators accounted for approximately 75% of Viper’s gross wells turned to production and the gross wells in progress. Viper touts its unique relationship with Diamondback, which owns 55% of its common equity, as a factor in reducing uncertainty about the long-term pace of development of its acreage, which is all located in the Permian Basin.

The pace of development is a key factor in the financial success of all mineral/royalty firms. That’s why the plunge in commodity prices in late 2019 and the onset of the pandemic in early 2020 were extremely challenging to these peers, as E&Ps dropped rigs and slashed capital budgets. Cash flows for the mineral/royalty companies plunged with commodity prices and equity prices fell to record lows. M&A activity in the sector plummeted from the elevated 2018-19 levels on the difficulty in financing transactions as well as uncertainty about future prices, which opened a yawning gap between buyer and seller pricing expectations.

The subsequent post-pandemic surge in commodity prices quickly restored EBITDAs of the mineral/royalty firms, which benefited from their lack of exposure to inflation on development and operating costs. Their historically higher margins are reflected in the higher multiples of daily production and reserves afforded to them by equity markets, compared with the valuations of the 41 traditional E&Ps we monitor. As shown in Figure 2, the enterprise value (EV) per daily boe of production for the mineral/royalty group ranges from $82,435 (Kimbell; first column from left) to $139,761/daily boe (Viper; second column from left) versus an average of $47,404/daily boe for the universe of E&Ps we track (far-right column). The advantage of generating higher margins over the entire producing life of an asset is reflected in the higher EV per boe of proved reserves, which ranges from $30 (Kimbell) to $78 (Dorchester) per boe, compared with nearly $12 per boe for our E&P universe. The dividend yields (bottom row) also significantly exceed the average for our E&P universe.

However, those yields don’t reflect the significant share repurchases by major E&Ps, which have aggressively shifted strategy from growth to boosting free cash flow and shareholder returns. The lofty recent dividend yields of certain oil-weighted major producers such as Pioneer Natural Resources and Devon Energy approached 10% at one time. The new competition for yield investors is posing a challenge for mineral/royalty firms, which have more limited methods of boosting cash flows than traditional E&Ps. Because mineral/royalty firms don’t pay operating or development costs, their cost structures are already lean. And they have no direct control over the pace of development on the acreage that they own. Near-term oil production is forecast to be flat and prices, which are down from their 2022 highs, have resulted in cutbacks in natural gas drilling in basins like the Haynesville. These conditions have slowed revenue growth for mineral/royalty owners.

M&A has been the traditional growth option for these entities, but deal value in the sector has yet to recover to pre-pandemic levels. One reason cited by the firms is a still-substantial gap between buyer and seller price expectations. Another significant factor is new competition for mineral/royalty interests. Private equity firms, incentivized by higher commodity prices, have increased investment in the space. For example, EnCap merged two of its portfolio companies into Pegasus Resources in mid-2021, which has been a competitor in the Permian. Also, KKR-backed Crescent Mineral Partners acquired APA Corp.’s Delaware Basin mineral/royalty assets for $805 million in February 2022. Sponsors may seek to eventually monetize these investments but are waiting for the still-difficult energy IPO market to recover.

Another major hurdle has arisen from the laser focus of E&P firms on maximizing cash flow, leading them to focus on retaining or acquiring higher-margin mineral/royalty interests in the acreage they operate and on the land they acquire in routine, bolt-on transactions. APA Corp.’s sale of its entire Delaware portfolio is an exception as it succumbed to an offer that reflected the typical 1.5x value assigned to acreage acquired. But other firms ranging from Occidental Petroleum to Magnolia Oil & Gas have highlighted the attractiveness of boosting total return through mineral/royalty interests. As a result, only two major transactions by publicly traded mineral/royalty firms have been announced since the pandemic.

To counter the volatility of growth through M&A, mineral/royalty firms have begun actively promoting their acreage to major industry operators, using a relatively new tactic: offering operators lower royalty rates in exchange for a commitment to long-term acreage development. For example, Black Stone Minerals had significant acreage in the Haynesville/Bossier Shelby Trough play in East Texas but falling natural gas prices in late 2019 resulted in the two major operators, BP and XTO Energy, abandoning their drilling programs there and shifting to other priorities. Black Stone’s marketing efforts resulted in a development agreement with private Aethon Energy covering the Shelf Trough area. The deal called for increasing well counts annually in exchange for exclusive access to Black Stone’s acreage and preferred royalty rates, a strategy that has resulted in 20 wells being turned to sales through Q1 2023. A similar development deal has resulted in 21 wells coming online to date in the Austin Chalk formation in South Texas. Kimbell Royalty Partners has also focused on organic growth development, seeking agreements with operators to commit to drilling programs on specific acreage within the major unconventional plays.

All the publicly traded mineral/royalty companies have substantial inventories of undeveloped acreage in key unconventional plays that they have the potential to benefit from should inflation moderate or prices rise. The massive mineral/royalties market will likely see additional consolidation prospects for the limited number of publicly traded participants. There is a lot of opportunity in this space and we will continue to monitor those developments as it continues to evolve.

My personal observations.

*  The exception is the Louisiana mineral servitude.

**  In unconventional basins, the need for "sophisticated analysis" of acreage is not necessarily required.