Private Asset Management: Family Offices Eye West Texas Mineral Rights featuring Jeff Eaton

Eaton Partners Apr 18, 2017
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PAM examines the rush into West Texas petroleum mineral rights and what the outlook is for family offices in the energy space

by Max Viscio
4th April, 2017

"Come and listen to a story ‘bout a man named Jed
Poor mountaineer barely kept his family fed

Then one day he was shooting for some food,
And up through the ground come a bubbling crude"

If you’re not from oil country, The Beverly Hillbilliesmay have been your first introduction to the concept of mineral rights. But more than 40 years after that show went off the air, there is a rising interest in buying up these assets in the deserts of West Texas.

PAMtalked with oil and gas experts to get a bird’s eye view of the mineral rights market in the legendary Permian Basin to find out what’s drawing money to the region and what should investors consider before they jump into the space.

An attractive geology

The Permian Basin is a large sedimentary geologic formation located in West Texas and the southern portion of New Mexico. It gets its name from its abundance of rocks formed during the Permian period, which lasted from 300m to 250m years ago.

The region is the most prolific oil-producing area in the US, with production reaching 2.2m barrels per day in 2017, according to the Energy Information Administration. The basin has produced 29bn barrels of oil since drilling began, while retaining recoverable deposits exceeding that amount despite nearly a century of extraction. "The Permian is a large, well-defined, well-derisked and well-delineated geology," David Scott, managing director at Duff and Phelps, told PAM. "It’s one of the oldest, most economic hydrocarbon plays in North America and potentially the world for decades."

It is this long history of production that makes the Permian a relatively safe play in the hydrocarbon market and an attractive formation for investors. "What people see now from the Permian is that, especially in lower commodity price environments, there is certainty of knowing the hydrocarbon under the surfaces is well-defined and knowing that the infrastructure to get that commodity from the wellhead to the market is in place," Scott added.

"The Permian Basin is what you read about every day," Jeff Eaton, partner and head of global origination at Eaton Partners, told PAM. "It’s where the most activity is and it’s where the public capital markets are allocating their money." In addition to its historical advantages, the Permian’s unique geology makes it particularly attractive to investors. "One well can access multiple reservoirs and so, for the same cost, you can have drilling in other basins, you get a lot more out of that well," he said. "That’s why you see a lot of this money flocking to the Permian."

In early March, Case Energy Partnersannounced a new family office-backed venture aimed at buying up mineral rights in the Permian Basin. Charles Matter, partner at Case, told PAMthat the firm likes the potential upside. "It’s one of the places where you can still drill at $50," he said. "There are minerals out there that have been provisioned for thirty years and then a new technology comes along that can access another formation or further develop an already producing field."

The region’s stacked pay formation is unique, he added. "Not every basin is like that," he said. "So it creates a serendipity and just a romance that you can place a lot of value on the acreage."

The backstory on mineral rights

Scott recalled his upbringing in Oklahoma to highlight the importance of mineral rights to the rural economy. "Mineral interests help subsidize small farmers and ranchers," he said. "Typically, the way they work are that if you own the land and own the underlying mineral interests, then the company will come in and lease that interest from you for a dollar amount per acre. They will typically give you a royalty interest associated with any hydrocarbon production." Scott added the rights can be worth anywhere between $100 to $50,000 per acre, depending on the underlying geology and the delineation of the reserves.

Besides being a mainstay for farmers and ranchers, the concept behind mineral rights is also attractive for non-locals as well. "There’s kind of a uniqueness in that it’s a hard asset and if you have the ability to buy a legacy asset like this, then you can build a nice portfolio," Matter said. "In the mineral royalty space, oil and gas minerals are considered real property and they can be exchanged in a 1031 exchange. If they’re sold after a year, they have deferred capital gains tax. They’re lower interest than a working interest, like oil wells, and it’s just a yield vehicle. It’s got the serendipity because you own them forever."

Families and mineral rights

How family offices buy up mineral rights is dependent on the assets of the family. "The biggest and most sophisticated families can go out and try to buy these directly. You’ll see a lot of the oil and gas families do that," Eaton said. "They either already own mineral interest or they’ll go out into their network to try to acquire these interests directly." For less sophisticated but still relatively asset-rich families, there are ways to tap more knowledgeable sources, such as brokers. "There are also asset managers that families can invest with who aggregate these positions in the form of a fund or a separately managed account. We’re seeing an increase of those types of vehicles being out in the market."

Across all asset totals there is a wide swath of family office interest in the Permian Basin. "It’s pretty diverse," Eaton said. "We know of couple large families that didn’t make their money from energy at all who are now pursuing these things pretty aggressively. We also see a lot of smaller families committing to funds that do this too."

An attractive geography

The US is one of the most attractive nations for investing in oil and gas mineral rights. "The reality is that we have not seen a lot of interest in owning minerals internationally," Eaton said. "The revenue that comes from a barrel of oil or gas is dollar denominated. So why take all the risk of going outside of the US when we know we’ve got stable government here, we know we’ve got the rule of law in place? It’s tough for a law to come in and change the way things are done, so it’s just easier for people to invest in their backyard versus going abroad."

Another advantage for the US is the nature of the mineral rights themselves. "What’s unique about the United States is that most land and mineral interests are owned by individuals rather than the state or the government," Scott said. "There is obviously government-owned land in parts of the United States, but for the most part in the US, individuals own the land and the mineral interests. This has enabled the extraction of oil and gas to be less riddled in regulatory red tape than what you might see in Europe and Asia and other jurisdictions, which might have materially government-owned land and mineral rights."

Within the US, West Texas has its own advantages. "West Texas has been oil country friendly for decades and it’s well accustomed to producing hydrocarbons," Scott said. "The land owners and the communities are used to it and there’s relatively minimal regulatory pressures, there’s general community support relative to other jurisdictions. It’s different than trying to drill for oil and gas in California."

Another draw for West Texas, and the Permian specifically, is the presence of a well-developed infrastructure. This gives it a particularly strong advantage compared to other formations such as the Bakken in North Dakota. "The infrastructure in West Texas to take that commodity from the ground through the wellhead to the market is in place. There’s pipes and there’s gathering and processing infrastructure all in place," Scott said. "So you have a higher realized price than you may have in other jurisdictions like the Bakken because, while prolific, that’s a relatively new development and so there still needs to be quite a bit of infrastructure to take that product to market from the wellhead."

In for the long haul

The dominant view among family offices in the mineral rights space is that these assets are a longterm play. "We see most family offices interested in these for the long-lived current income component and clearly such investors are also long technology, they’re long oil and gas and long price upside movements," Eaton said. "So they’re making an investment where they see a low case scenario where there’s maybe a high single-digit current income component where the high case can be 20%-40% higher returns over the long-term investment, which can be 15-30 years in tenure, which is clearly a very attractive return profile and something that a lot of these families are interested in exposure to."

Of course, there’s always the possibility of a quicker exit if the price is right. "We want to aggregate a position in the Permian Basin where we are meeting our yield. But we wouldn’t be opposed to a liquidation process," Matter said. "For example, there are mineral companies that are trying to get to a large enough portfolio where they can do an MLP [master limited partnership] and exit. So if these mineral companies start an MLP and they’re needing more product to put into their portfolio and offered us a big enough premium, then we would consider exiting."

However, Matter emphasized this outcome was a big ‘if’, while Scott agreed it would be an unlikely scenario at this time. "The upstream MLP market has quieted down a lot," he said. "Early last year and maybe the year before that you saw a little bit of that, but with the MLP structure, people have soured on that a little bit. I don’t see that as prevalent as an exit strategy for upstream companies in the current environment."

The path ahead

The oil and gas space is inherently speculative, so there are plenty of views on where it’s going in the next few years. "You’ll see everything from ‘We’re going to reach peak demand in the next 10 years’ to ‘Who knows what’s going to happen in China and the Mena [Middle East North Africa] regions," Scott said. "I think there’s so many different variables that it’s hard to tell. But the main things to watch out for are obviously price appreciation or depreciation."

While the Organization of Petroleum Producing Countriesis one of the most powerful forces shaping the price of oil, the proliferation of recoverable reserves made possible by advancing technology has reduced its stronghold on the global hydrocarbon market. "In North America, from a price perspective, we have such a glut that I have a feeling any price appreciation will have a ceiling because we can produce relatively large quantities very quickly," Scott said. "On the other side of the equation, necessity is the mother of invention and when times get tough and things get thin, this industry tends to really bear down and be creative on the cost side of the equation." As a result, Scott sees the potential for decent returns in the Permian even with oil at $40 per barrel.

Cautionary notes

Despite the current frenzy of investment into the Permian, there are signs of concern among some investors that market is starting to get a bit crowded as production has more than doubled over the past five years, according to EIA data.

"There’s a lot of money facing these types of deals now, which means things are getting bid up, things are getting more expensive," Eaton said. "That means, in theory, if we don’t have a move to the upside with oil and gas prices, it might be tougher to generate the kinds of returns that people have been able to generate out of there over the past couple of years."

Matter noted institutional capital is finding its way to the Permian and that could pose a problem for private investors. He cited new entrants such as the Canadian Pension Plan, which made a $450m investmentin LongPoint Mineralslast June.

"There’s been a wave of institutional capital. There’s money that’s moved into the space that wasn’t there a couple of years ago," he said. "If we’re private capital with a long-term mindset, we’re having to compete against institutional capital so that’s definitely been a challenge and kind of changing the way the mineral space operates."

As a result, there has been some interest among investors towards formations outside of the Permian Basin. "Some of the more sophisticated investors who have been investing in oil and gas for a while have actually started to look away from the Permian now," Eaton said. "There are other areas and so we’re starting to see people look back at them."He cited formations such as Eagle Ford, Barnette and the Bakken as areas where investors are exploring their options. Eaton added there’s also an increasing interest in natural gas reserves in the Utica and Marcellus formations.

Going outside of the Permian, however, brings its own hurdles. "There are nuances and owning mineral rights is different state by state," Eaton said. "There are certain states where it’s just easier to own minerals and Texas is one of those. So you see a lot of the activity in mineral funds in Texas and Oklahoma versus some of these other areas where it’s just less easy to buy the mineral rights."

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