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Maximizing Financial Value

While the approach known as “buy low and sell high,” is generally associated with the stock market, a similar approach holds true for most any financial asset.

February 21, 2008
Sponsored by Noble Royalties Inc.

While the approach known as “buy low and sell high,” is generally associated with the stock market or commodity futures, the same approach holds true for most any financial asset, including oil and natural gas royalties. Unless an asset’s main value to its holder is sentimental, market value ultimately dictates its place in a portfolio.

What’s more, even if a client decides the time is right to liquidate, the deal’s proceeds can vary widely according to the way in which the deal was structured. Of course, the key to buying low and selling high lies with discerning the market’s trajectory — a determination that is only simple in retrospect. Even so, plenty of strong evidence suggests the time may be right to sell oil and gas royalties.

As an ownership interest in a finite deposit of minerals, such as royalty only produces revenue for a balance sheet when its well produces a barrel of oil or an Mcf (thousand cubic feet) of natural gas. While the royalties on a piece of intellectual property, such as a book, film or piece of music, may conceivably generate returns into perpetuity, the royalties associated with oil and gas are in fact limited to an actual amount of producible reserves. Depletion begins the instant a well starts production and continues until operating costs exceed production proceeds. When a well stops producing profit, it also stops producing oil and gas — quite likely forever. Obviously, royalty payments conclude at that point, too.

Financial advisors should therefore make sure their clients recognize that the value of every producing oil and gas royalty will one day diminish to zero. Assuming a client wants to maintain that income, the royalty must eventually be replaced with a new revenue stream before that eventuality.

Just as an individual well’s reserves deplete with time, so have the collective oil and gas reserves of the United States. As the birthplace of the industry and the world’s most mature petroleum province, U.S. reserves of both oil and natural gas continue to decline even as the number of rigs actively drilling for oil and gas increase. Having long ago picked the low-hanging fruit, major integrated oil companies have sold most of their U.S. properties to independent producers who make use of ingenuity, technology and unconventional reservoirs to squeeze more oil and gas from the ground.

Even so, U.S. producers find themselves on a progressively faster treadmill, as the declining rates of production from even brand new wells tend to be significantly steeper than wells drilled in previous decades.

In light of this depletion, it is no wonder that oil and gas commodity prices have soared in less than a decade’s time. While the late 1990s saw crude oil prices drop well below $15 a barrel, oil sold for nearly $80 a barrel on the New York Mercantile Exchange during the summer of 2006. Likewise, while the average wellhead price for a thousand cubic feet of natural gas averaged less than $2 in 1998, it has fetched more than four times that throughout parts of 2007.

As important as timing is to maximizing asset value, the method of sale is comparably essential. If a client concludes the time is indeed right to liquidate all or some of the oil and gas royalties in his portfolio, his CPA must then advise him on the various methods by which to do so. These include auction houses, brokers and corporate royalty purchasers.

Clients educated about their liquidation options will understand the characteristics of each approach. For instance, they will know research indicates that 35 percent of royalties brought to auction in 2006 did not close. Likewise, clients must be apprised of the advantages and disadvantages of broker services, recognizing that although brokers act as middlemen to help a seller get a property in order and to market, they will also take a markup for their services.

Finally, a client interested in dealing with a corporate royalty purchaser must still resolve the key question of which one. Among the criteria a financial advisor should explore with his clients are a buyer’s commitment to best practices within the industry. Those practices include the firm’s history and reputation; whether it will pay for not only proven, but also probable and possible oil and natural gas reserves; and the extent to which it provides a seller with market perspective on what other properties in the area have historically sold for.

The most reputable corporate royalty purchasers also make use of third-party engineering and offer a clear, up-front definition of the properties in a deal.

Lamar Loyd, an engineer now with Noble Royalties Inc., who previously worked for several years at the world class reservoir engineering firm of Netherland, Sewell & Associates Inc., emphasizes the importance of third-party analysis in due-diligence for all parties involved every time an oil and gas property changes hands.

“A third-party engineering report gives sellers confidence they knew the market value of their property,” Loyd explains. “A lot of royalty owners really do not know what they have and third-party engineering gives them confidence they are receiving fair market value and not being taken advantage of.” The same is true for corporate royalty purchasers that take a straightforward approach to their transactions, explains Rex White, a Texas-based oil and gas attorney. “When a person, company or a trust has possession over a rather large amount of royalties — which are sometimes even scattered over more than one state — it strikes me as extremely important to get the assistance of a company that tends to the valuation of them and even management of those royalties. It is a pretty complex business now.”

For more information, visit Noble Royalties Inc.