2022 Mid-Year Minerals Investment Outlook
Retail minerals investors can easily manage royalties with Enverus MineraliQ software which greatly simplifies analysis and tracking of mineral royalty payments. Hear from expert, Phillip Dunning, Director of Product Enverus MineraliQ, on what minerals investors can expect from the 2nd half of 2022.
As we reflect on the first half of this year, how different the world has become from where it started. After COVID ravaged our personal and business lives during 2020, 2021 was meant to be the year rebirth and 2022 growth. But 2021 turned out to be more of the same, though we did start to see a return to a new normal. 2022 was meant to be the banner year of growth and trying to put the last few years behind us. Instead, new issues arose that have upended global markets and commodities. For mineral owners, this is not all bad. Times of geopolitical unrest and volatility lead to market gains and allow us to hedge a decline in equities and other assets we may own. It also allows those of us that want to sell to do so at a higher price point with our checks increasing in value. Each of these events can be tracked and analyzed by our MineraliQ royalty management platform to help investors make informed decisions. As we sit at this midpoint in year, let’s reflect on some of the trends and insights we are seeing across the mineral space.
Globalization & Geopolitical Unrest Pose Positive Effects on Mineral Investments
If you caught our 2022 minerals outlook, you will remember we discussed the impacts of being in a global commodity market. Events that happen far away from the U.S. impact our monthly royalty checks, both positively and negatively. The U.S. is a net exporter, meaning our production outpaces our need and we export and ship oil, gas and refined products around the world. Participating in a global market allows oil and gas companies to take part in market arbitrage where prices might be higher in another country than in the U.S., allowing for greater profit. This in turn drives activity in the U.S. and grows our royalty checks. In the same way, the collapse of world demand during COVID brought pricing down to the lowest levels in over a decade.
As we began 2022, higher demand was predicted coming from jet fuel demand and the return of developing countries’ growth. As a developed country, our demand is pretty linear. There is a good understanding of the number of cars owned by families, miles driven, airfares booked, etc. Demand growth really comes from countries that are just starting to develop and need access to cheap energy, like India, China, and parts of Africa, where growing wages and cheap energy drive demand for cars, refined fuels, electricity, etc. This comes together into a global demand picture which allows oil and gas companies to understand whether the market is over or undersupplied (Figure 1).
Coal is the cheapest form of energy in many countries. While it is not environmentally friendly, for developing countries, it is the most economical way to provide cheap electricity to a large group of people. While the U.S. and other countries have reduced their use of coal, other countries, like China, have backfilled and grown overall demand. The next cheapest form is natural gas and LNG (liquified natural gas). The U.S. has an abundance of natural gas, both dry and wet (wet gas refers to gas with heavy components that are stripped out such as propane). In Europe, most gas that is used in heating and electric generation comes from outside sources, mainly Russia, a major global supplier. With the war in Ukraine, many EU countries have reduced or ended their use of Russian gas. LNG is created at terminals which have a max capacity, so any disruption to supply and demand creates a near-term shortage that drives prices up. There is no short-term solution to backfill the supply that Russia provided to Europe, so prices have increased exponentially. This is good news for U.S. oil and gas producers as they can produce gas domestically and sell it for multiples more in the global markets. It also raises the commodity prices, increasing our royalty checks.
There is no immediate solution to the European gas crisis, which is forming what is known as a super cycle of commodity prices. In turn, prices will remain high until both supply and demand are better understood. For mineral owners, this is great news on two fronts:
- Larger royalty checks: Oil and gas assets are declining assets. Every month, our wells produce less. There are only a few levers that can be pulled to increase our monthly check income: new wells being drilled, workover on the current well to increase production, and higher commodity prices that offset the decline of production from the well. The final lever is what is occurring today.
- Optimal time to sell: No one likes to sell an asset at a low point. Royalties are worth a multiple of the average of the last 6-12 months of checks. As your checks increase in payment, the value of your producing assets also increases. For many, it is the right time to sell to either invest elsewhere, reduce tax headaches, etc. Selling high is never a negative. Mineral owners can track estimated valuation factors through MineraliQ’s royalty management software.
Activity Outlook for Mineral Investors
Before COVID, U.S. onshore shale companies were known for outspending revenue in a rush to show growth partly fueled by cheap debt. The boom of production subsequently led to an oversupply of the market and put many companies in poor financial situations. Demand destruction from COVID led to a collapse in pricing, resulting in many companies being sold or going bankrupt. Consolidation has plagued the industry for the past few years as the largest companies just keep getting bigger. The new mantra for oil and gas companies is to live within cashflow and return profit to shareholders, a return to being a value sector rather than growth. This transformation has paid dividends (pun intended) as the energy sector has been the one sector with stock prices not declining during the current market situation.
With a move to live within cashflow, pay down debt and return profit to shareholders, operators are not placing as much money into the ground. Today, more than 60% of rigs running belong to private companies that are smaller and more focused on returning cash to their investors through production. With a shift to drilling fewer wells, many companies are focusing on their core areas of lease holdings or areas where they receive the highest return. They are drilling out entire pads instead of a single well at a time. For a mineral owner, this change to less activity can mean a reduction of value placed on the asset.
Valuating Your Mineral Royalties
The value of our minerals is a composite of what is producing today (PDP) and what could be produced tomorrow (PUD). Since buyers are paying up front for future value, a discount must be applied based on the time it would take to drill the additional wells. Time erodes the value of money, especially in a high inflation environment, so if you have the potential for one more well to be drilled but not in the next couple years, there is little to no value placed on the undrilled well. Common today is that producing assets trade hands at ~PV15, drilled uncompleted assets (DUCs) at PV20 and permits around PV30, but these discount rates shift depending on the buyer and their risk profile.
It is important to understand the life cycle of a well and the time it takes to move through the cycle (cycle time) to appreciate the impact activity has on your assets. With fewer wells being drilled, companies file fewer permits. Years ago, operators would file thousands of permits with little intention to drill them all, simply intending to confuse competitors on where they were drilling. Today, many companies file permits just in time and so there is a larger emphasis placed on permits as they are filed. Cycle times from permit to production have also decreased since the shift to less activity as companies need to ensure wells that are drilled are placed online as quick as possible. Many have lowered their DUC inventory during the pandemic since it was cheaper to complete wells then drill new ones (half cycle returns since capex is split evenly between drilling and completion). As a mineral owner, when a well is permitted and then drilled, there is a higher likelihood of being brought into production in the near term, leading to checks coming sooner. With commodity prices where they are for the foreseeable future, this is a benefit to both parties. Luckily, whether you are an Enverus or MineraliQ user, you can find where wells are in their lifecycle and receive notifications using our asset tracking features within the platform.
Summary of 2022 Minerals Investment Outlook
Much has changed since our 2022 outlook. As mineral owners, we are at the mercy of both global commodities and the operator we have signed our leases with making it difficult to always know what is going on. With a super cycle in global commodities due to geopolitical unrest, we can expect larger than normal royalty checks even as our producing wells decline in production. Operators shifting to return cash rather than drill more wells has led to a decline in overall activity but a boom in near-term returns for owners with activity taking place on their property. Both can be a double-edged sword – commodity prices could collapse if supply and demand issues are fixed and no new wells have been drilled. Remember, if prices collapse 20-30%, oil is still $70+ and gas is still $5+. The one thing we can all be happy with is that whether you want to keep collecting checks or sell your asset at a high point in the market; the near-term future is bright.
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