Oil & Gas Royalties
A Straight Forward Opportunity
The picture of world oil supply and demand is clear. What does it mean to you?
#1 Supply
The first half of the world’s oil was easy to extract as it was close to the surface and concentrated in large reservoirs. The other half of the world’s petroleum supply is scattered in small, hard-to-find reservoirs far offshore or deep underground. Estimates of worldwide undiscovered conventional oil and gas resources suggest that The Middle East is likely to hold the greatest volume of undiscovered oil resources. The Russian Federation, Central and South America, and even North America likely hold very significant quantities of undiscovered oil resources.
With most of new oil reserves expected to be found in Iran, Iraq, Kuwait, Saudi Arabia, Algeria, Angola, Libya, Nigeria and Venezuela the question arises what investor returns will be required to inspire the multi-billion dollar investments to produce oil in these geopolitically hostile environments? The Wall Street Journal noted in an article headlined, “Oil Profits Show Signs of Aging,” that investors are bracing for disappointing results in future quarters as the cost of new production rises and output at older fields declines.
#2 Demand
It is now conventional wisdom that world oil demand is likely to keep rising at a rapid tempo and the development of new oil fields is not expected to keep pace resulting in significant shortfalls within five years. The IEA report predicts world economic activity will grow by an average of 4.5 percent per year, driven largely by the growth in China, India and other Asian economies. Global oil demand will rise by about 2.2 percent per year, pushing world oil consumption from an estimated 86.1 million barrels per day in 2007 to 95.8 million barrels by 2012.
The United States passed its own oil peak -- about 11 million barrels a day -- in 1970, and since then production has dropped steadily. In 2004 it ran just above 5 million barrels a day (and a bit more from natural-gas condensates). The United States consumes roughly 20 million barrels daily. So the United States imports about two-thirds of its oil and that ratio continues to worsen.
#3 Enhanced Oil Recovery
According to a report prepared for the Alaska Coalition on April 8, 2002 by W. Thomas Goerold, Ph.D., enhanced oil recovery (EOR) represents the single largest source of future U.S. oil supply with a target of at least 300 billion barrels.
Most EOR oil is usually sited within or close to oil-producing infrastructure. Compared with hypothesized production of 3-9 billion barrels of potential production from the Arctic Refuge, enhanced oil recovery represents the largest source of oil in the U.S.
Most EOR methods involve using advanced geophysical and other information-gathering techniques to obtain a much better picture of the specific location of the remaining oil or using recovery agents such as chemicals, gases, or others to remove oil left behind after primary and secondary recovery. Prior to using EOR, at least half and perhaps as much as 90 to 95 percent of the underground oil still remains in virtually all oil fields in the world.
The most cost effective application of EOR is in identified oil fields that have fully developed oil production and transportation infrastructures, and communities of skilled oil-field workers.
Conclusion
These fundamentals suggest that historically high oil and gas prices will continue due to increasing demand and expensive and modest supply of recoverable oil found in politically friendly world markets. Fundamentals further suggest that a future premium price may be paid for domestic oilfields with existing production and transportation infrastructure. Quite simply there is only one politically secure oil and gas investment whose returns are leveraged by these three main market forces: royalties.
Royalties are the mineral owner’s share of production. A royalty owner is the “landlord” who gets paid as long as the wells produce. Most importantly, royalty owners have no liability or responsibility for costs of production so their profits are not squeezed by the expenses of EOR.
If you believe that oil companies will continue to have a solid economic incentive for maximizing domestic production, royalty owners cash flow returns will have three main drivers of value: price of oil, accessible and safe infrastructure and the possibility of significant enhanced oil recovery.
Usually when an investment is affected by well known structural conditions that suggest stable and increasing future cash flows its market price is often high. But domestic oil & gas royalties with significant reserves can be found that pay 12% cash-on-cash returns.
Historically royalties were sought out by universities, endowments and insurance companies seeking long term stable cash flows that may also provide an inflation hedge. But since 2002, royalties have been assembled for accredited investors into portfolios that were diversified by multiple wells, multiple geologic formations and multiple production companies. While accredited investors bought those royalties for cash flow during a time of low interest rates they may find an energy starved world will make them look very smart for different reasons.
About The Author:
William Cavalier represents King Royalty Corporation to the broker-dealer and institutional markets. He has been in the investment business since 1979 serving as a hedge fund manager, registered investment advisor and member of the Chicago Mercantile Exchange. www.kingroyalty.com
This content is provided for informational purposes only. Information contained in this article is not intended to be a solicitation of any kind. Nothing herein shall be construed as tax, legal or accounting advice. Investing in real estate and oil and gas is highly speculative and could result in substantial losses. Potential investors should consult their attorney, accountant and financial advisors before investing in oil and gas. Past performance is not a guarantee of future performance or returns.