Posted on March 18, 2012

Royalty Owners And The Depressed Price of Natural Gas – Has Anyone Checked the Mail Lately?

For land and mineral rights owners in Pennsylvania who leased their oil and gas interests in the last three to five years a significant number may have netted a sizeable lump sum payment in exchange for a paid up lease. Hopefully, like an industrious squirrel that accumulates a stockpile of acorns for the winter, the lion’s share of that payday has been invested wisely or applied to a worthy goal such as retirement, children’s higher education or paring back debt to strengthen one’s financial position. 

In counseling clients who were presented with lucrative offers to lease their oil and gas interests, I always recommended that potential lessors evaluate and decide upon whether or not to enter into a long term relationship with a development company based upon the up-front payment for a lease, and, despite the wildly fluctuating estimates of prospective royalties, resist the temptation to bank upon the promise of a future stream of income. Simply put, if one would move forward with a lease based upon the bonus alone, he or she would be less likely to have future regrets. On the other hand, if a lease would only make sense if the client could also count on what has come to be known colloquially as “mailbox money,” this should have been a warning signal that the decision be subjected to a second and maybe a third thought.

Some landowners eventually did receive royalties and the first few checks may have even validated the results generated by those royalty calculators you could find on just about every gas leasing or financial planning website. Like “Watson” obliterating its human competition and racking up piles of cash on Jeopardy, this natural gas rush appeared to be the triumph of technology over nature with no ability to estimate the potential financial windfall.

But then the price of natural gas started to fall. To be sure, the optimistic projections of the extent of and production rates for unconventional shale gas plays generally and the Marcellus Shale in particular are being realized.  However, the glut of natural gas due to a milder than expected winter, the inability of infrastructure development to catch up to production operations and the sluggish economy have combined to create a perfect storm that has cooled, at least in the near term, the prospects of many lessors for predictable and continuous royalty income. The Energy Information Administration has projected that natural gas may not reach $5/Mcf again for 15 years and while that may not be encouraging to lessees and royalty owners it bodes well for the economy and consumers.

It is ironic that several years ago the natural gas industry and investors hailed the predominantly “dry” pipeline-ready Marcellus Shale gas with its high BTU value as the ultimate unconventional gas when compared with the liquids-rich plays with their additional processing requirements and significant attendant costs. But market conditions have changed and a number of the constituents of “wet gas” are now recognized and sought after as high value useful by-products in their own right. This has resulted in a marked shift in the exploration and production plans of many E & Ps and plans by Shell to construct a billion-dollar ethane processing facility in Western Pennsylvania.

Just this month cash-strapped and leveraged Chesapeake Energy has formed another joint venture to double down on its investment in unconventional natural gas, this time partnering with private equity heavyweight Kohlberg Kravis Roberts to purchase, rather than lease, oil and gas rights and buy out the royalty rights held by previously leased land and mineral rights owners. Chesapeake and its majority partner KKR are banking on the eventual resurgence in the price of natural gas and the anticipated present need of many lessors to convert their prospective royalty interest to cash.  According to The Wall Street Journal Chesapeake will do the legwork to identify, acquire and manage royalty interests and KKR will contribute 90% of the initial $250 MM stake to purchase the assets. If the “squirrels” (lessors or unleased mineral owners) have not planned for the mild winter of 2012, Chesapeake and KKR figure their new partnership can pick up long term high-value assets at distressed prices.

If you signed a lease with a small up-front bonus payment and for the minimum royalty of 12.5% percent or slightly higher and your property is located in proven area of the Marcellus Shale, or if you have a lease that is close to expiration with a low royalty rate where production is relatively predictable, you should not be surprised to receive a buy-out offer. It stands to reason that many lessors in this group are more likely to want or need to cash in on the present value of their royalty interest since they may have signed too early and missed the big bonus pay days that more savvy and patient hold outs eventually realized.  From the investor’s standpoint, the smaller initial capital outlay to obtain the lease and the discounted value of natural gas at current prices would be expected to yield the greatest long-term net profit.

I would caution the lessor or mineral rights owner who is the recipient of such an offer to consider the disadvantaged negotiating position he or she will face in this situation. For one thing, the potential purchaser will have most if not all of the necessary data (inside information) to set the optimal purchase price, i.e.- actual production rates in the vicinity of the leasehold (which will be more current than the information required to be reported to state regulators), the cost of processing and shipping the gas (based on proprietary information or private contracts for these services negotiated with subsidiary companies or third parties) and the accounting resources at their disposal (which may be cost-prohibitive for many private parties to engage).

While there are mineral appraisers who hold themselves out as competent to value oil and gas rights, there is no certification in Pennsylvania for such “specialists” and despite the thickness of the reports, I have been generally underwhelmed by the methodology employed to arrive at these valuations. In the end, spending $4,000 to $6,000 for a mineral valuation may not pass a mineral rights owner’s cost-benefit analysis and the same instincts that caused that individual to lease his or her rights for $25 per acre and 12.5% royalty should be held in check.

But in many cases the need for immediate cash may cloud the lessor’s judgment or be too strong to resist.  Keep in mind that the company representative on the other side of the table has made a career of leasing oil and gas rights and negotiating pipeline or other agreements and be especially wary if he happens to be the same land man or agent who signed you to your original lease.

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