Mineral Evaluation - From a Mineral Investor's Perspective

Hello all, in light of what Skip Peel and others have written about mineral values, buying and selling, I thought it might be interesting to describe the viewpoint from "the other side" as to how we go about evaluating and acquiring minerals.   For reference, I founded Axiom Minerals about two years ago and concentrate the vast majority of our efforts in the Haynesville Shale area of North Louisiana and East Texas.

DISCLAIMER: This post solely reflects the personal opinions and viewpoints of the author and is intended for informational purposes only. 

As Skip alluded to in his second post (Fundamentals of Leasing and Selling Minerals), there are a variety of business models mineral investors may use as their core strategy.  The one I happen to think works best for everyone is a very deep knowledge about a relatively small area.  The only reason I think this one works best is that uncertainty leads to lower prices and lower prices put a mineral buyer at a competitive disadvantage to anyone armed with better information.

To get specific about the Haynesville, our team conducted an analysis of the decline curve of each well on the Louisiana side of the trend. As any landowner knows from their royalty check, the well VOLUME decreases over time.  The check AMOUNT may also decrease, stay relatively constant or even increase but that's a function of prices, which are nearly impossible to predict, except to say that operators cannot drill money-losing wells forever.  This decrease in well VOLUME (molecules of natural gas) from a wellbore is somewhat predictable, and is the basis for estimating the "value" of any given well on any given day.  Below is a typical Haynesville decline curve:

This well has made 2.8 Bcf since 2010 and is on track to make a total of 4.1 Bcf over its life. The well is projected to produce 1.3 Bcf between 2014 and 2178.  Sometime well before that, the well will begin to cost more than it produces every month, and the operator will plug and abandon it.  Keep in mind this well made 2/10ths of a Bcf in its first month of production and has already made almost 3/4ths of its entire production in 1/8th of its life.  We use a commonly available program to determine these decline curves.

Since we are able to predict future volume with some accuracy we now move to price, or how much is that volume going to be worth when it's taken out of the ground and sold.  This is probably the number one scare tactic mineral buyers use and for good reason: it's true, and anyone getting a run check has seen gas go from $8 or more to $3 or less in the six short years since the Haynesville came to town.  Operators can and do avoid a substantial portion of this uncertainty by hedging their gas, or selling it at fixed price in the future.  The published prices they can expect to receive on the open NYMEX Futures prices are what we use to value those forward volumes.  So for the above example, we insert the future price that an operator could get to the corresponding volumes to get REVENUE.

Once we have this estimation of revenue, we can value the well from the operator's shoes.  We estimate how much the well costs and how much revenue the operator could expect to receive fully hedged, and voila, the operator's return on their drilling investment materializes.  The reason every operator with other assets in the world is no longer drilling in the Haynesville is pretty simple: that number is low or even negative, especially when compared to the Eagle Ford or Permian Basin.

However, if we determine that, say $7 gas, would be a high enough price to attract drillers back to the shale, then the question becomes when does gas go to $7.  That is a complicated question that unfortunately for all of us, involves the Marcellus Shale and a whole lot of associated gas from all the high-flying oil plays in the country, shifting power generation from coal, petrochemical feedstocks, LNG export and at least a million other things.  One of the things I personally think is a decent predictor of $7 gas is the forward curve of NYMEX gas prices

In a different thread, one member asked whether Chesapeake will drill in his or her section anytime soon.  I have no idea what the smart people over at CHK are actually thinking, but I suspect they are doing the same analysis I outlined above, and their Haynesville Asset Team is fighting with all the other asset teams for budget dollars to drill more wells.  You can have a look at their investor presentation to get an idea of where the collective attention is focused, or at least where they want Wall Street to focus.  Once we make an estimation timing in the future an operator would be attracted back into the play, we use that to determine how much a mineral acre is worth to us today.  We then tie this amount to a multiple of monthly cash flow to easily adjust across revenue decimals and lease rates and to give the seller some perspective relative to what the minerals are actually yielding currently.

As you might imagine, operators are not in the business of helping you the landowner in any way.  They are in the business of earning the maximum available profit by removing hydrocarbons from the ground and selling them.  If it's more profitable for them to drill one well per section they will do that and leave behind all those other un-drained molecules.   The operator's new goal is the often-used buzzword "optimization" which is a fancy term for "how-many-wells-per-acre-make-us-the-most-money." Right now, that answer for 90% of the Haynesville is One.  However, I don't think that will always be the case, or we certainly wouldn't be buying minerals at the prices we are paying. 

Sometime in the future, we are betting that it will become profitable for operators to drill additional Haynesville wells.  We are also betting that costs come down and yields come up.  These are not Vegas bets, though, we have spent literally years eliminating as much uncertainty as we possibly can (legally), to the point where we can call it speculation.  We are speculating that we can earn a risk-adjusted return on our investment by acquiring minerals at the prices we have to pay for them.  That is our business in a nutshell.

Things that Complicate Our Goal:

1. Unlike stocks and bonds and iPhones, there is a finite amount of mineral acres available to invest in.  Since we cannot create new minerals, we must buy them from existing owners.  For many many reasons, this is very, "complicated."  

2. There is no "market" for minerals.  If you or I wanted to purchase Apple stock, we would buy that on a stock exchange where the price of the stock is determined in an orderly fashion and published for the world to see and use to make their decision.  Despite some interesting efforts at replicating this price-discovery, there is published price for minerals.  Which leads me to...

3.  There is a giant trust gap between most buyers and most sellers.  We very frequently hear "I am not interested in selling at this point." from mineral owners from all walks of life BEFORE they hear our purchase price.  Rationally, the only two reasons not to consider selling are 1. cash does you absolutely no good and 2. the risk-adjusted discounted value of minerals held in your portfolio today is greater than the price being offered for them.  We certainly encounter many cases where one of the two is accurate and it truly does make sense for the owner to hold his or her minerals.  However, the far more likely scenario is that the landowner simply doesn't trust us.  And why should they, if someone called me out of the blue and wanted to buy my car or television for more (hopefully way more) than I paid for it, I would react with suspicion too.  Obviously, this guy is either a liar or he knows something about my car than I don't.  So let me be clear here, IF we are right, and IF drilling resumes in earnest, and IF gas prices creep up above $7 then we will earn a return on our investment.  That is what we know.  Our goal in acquiring minerals is to price them highly enough to actually acquire them (above the typical risk-adjusted discounted value) and low enough to hopefully earn a return on our speculation that satisfies our investors.  

If you would prefer to make the same speculation, great.  If you believe that we are somehow swindling you, then we are doing a poor job and would welcome your thoughts and suggestions.

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Comment by jacob f on September 6, 2014 at 12:54
I liked the article. A question though. Some of these mineral buyers at taking the minerals and making mutual funds out of them. So how about the buyers start offering shares in the mutual fund and cash? The problem with the mistrust is deep rooted and now the buyers have to pay for it. Back when the leases were $500 a month royalties back in the 1920s or so and then a million dollars was coming out of a well. Or even now when someone offers 2k an acre on 500 acres and the poor soul in WV never saw a million bucks in his whole life jumps at the deal only to find 6 legs of a horizontal marcellus pulling in 20 million and that's not including what the Utica may be worth. He got robbed. It's the buyers that you work for that want to turn a 400% profit in 2 years when even the best returns on the stock market are 18%. Any comments?

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