Remove the Uncertainty of Your Royalties Income

September 18, 2020

Dominick Paoloni, CIMA®
CIO & Founder
Portfolio Manager, IPSAX
Adjunct Professor, University of Denver
& University of Colorado

When oil futures went negative due to Covid-19, I was surprised when I heard one of my interns from Texas talking about his family’s concern. His family was receiving a percentage of oil extracted from their land, based on the spot price at the end of each quarter. It was April 27, 2020, and the West Texas Intermediate crude spot just broke $13 a barrel. As these royalties constitute a primary source of revenue for his family’s estate, I couldn’t believe their money manager wasn’t managing their oil price risk. I asked my intern, “Is this common that landowners don’t hedge their price risk?” He told me most people that he knows do not.

Looking at average royalty rates to generate a prediction of gross royalties due to private mineral owners in 2012, we see that Texas is by far the most important state for generating royalties. In part, this is because it is the largest producing state, but also because it has a high proportion of private minerals and relatively high royalty rates. The aggregate 2012 value of private royalties for the major states considered was about $31 billion. Not a small piece of change.

To Hedge or Not to Hedge

Were oil and gas producers adequately hedged for the Covid-19 price collapse? According to Opportune, as of December 31, 2019, 70% of surveyed companies had crude hedges in place and 60% had gas hedges in place.

It’s important to note that if an oil producer hedges its operation, that does not mean the lessor (landowner) benefits from those hedges. A Louisiana lessee federal court case ruled that a producer does not owe its lessor royalties based on hedging profits, said a federal district court in Cimarex Energy Co. v. Chastant. Cimarex, the lessee, hedged its gas contracts and didn’t pay its lessor, Chastant, earnings from the hedge. This leaves the lessor with the responsibility to hedge their royalties.

Hedging depends on whether you are long or short the commodity or any other asset, be it real estate, investments, etc. My intern’s family is long the oil commodity. What that means is, there is a risk to his family’s cash flow if oil drops in value; conversely, his family benefits if the price of oil rises.

In speaking with my intern, he explained that most people do not hedge because they believe that oil is always in demand, and although the price may fluctuate,  many landowners felt it was just an extra check that can be invested or spent as they see fit. “Free cash” as he put it.

Eating Your Cake and Having It Too

What if we can put on a hedge that benefits from the price of oil rising and from the price of oil falling? That would be too good to be true, wouldn’t it?

My mom, a 30-year high school math teacher always used to say that, “the reason I love math is that it takes the uncertainty out of life”. So, why can’t we use math to reduce the uncertainty out of a family’s income derived from oil?

Oil companies use a variety of hedging strategies from futures, swaps, swaptions, puts, collars, and put spread collars. In the example, we are going to look at a combination of long puts and futures.

The basic setup would be to let 1/3rd of his family’s income float with the market. In other words, just receive spot price on 1/3rd of the family’s oil revenues. The next step is to tie 1/3rd of the family’s oil revenues to short oil futures contracts. The final step would be to tie 1/3rd of the revenue stream to put options on oil futures contracts. (see Chart)

This setup mathematically puts the party receiving oil income in a winning position if the market should move higher or the market will move lower.

Let us break it down. If oil should drop his family will be making less on 1/3rd of their oil revenues which is floating with the market. That is still much better than making less on 100% of the revenue stream.

Next, let’s examine what’s happening on the 2/3rd of his family’s cash flow.  Their short oil futures and the puts will be profitable, holding the value on most of the cash flow. (see Chart)

If oil should rise, the situation looks even better. The floating portion of the cash flow will appreciate the market as will the portion tied to the put option on the futures contract.

This strategy will make the cash flow positive on 2/3rds of the position with unlimited upside.  The 1/3rd short futures contract position, however, will lock in the price oil was trading which is still much better than being short futures contracts on 100% of the cash flow, not benefiting from any price appreciation.

Obviously, where, and how the positions should be placed, and rolled is how a professional manager of money earns a living. The truth is, hedging is a profession that many advisors never learn and are rarely taught but, what every person that hangs a sign whether they call themselves a financial advisor, broker, account executive, money managers, etc., should understand that a true manager of money needs to raise the bar and learn that proper hedging is the future of money management.

Putting the Strategy into Practice

Let us see how this strategy works in practice.  For this example, to make the math easy, we are going to assume my intern’s family is getting paid on a percentage of what being extracted from their land. Let us also assume the oil producer is extracting on average 25,000 barrels per quarter and the lessor contract pays spot on a 1/8th or 12.5% of the quarterly extraction which would be approximately 3000 barrels per quarter from their land. So, on December 30th, 2019, West Texas Intermediate crude was trading at $63.05/barrel. They were paid $63.05 price X 1/8th of the flow or 3000 barrels =$189,150 for the quarter.

Seventy percent of Oil companies were using some type of hedging going into 2020. Of the 31 plus billion received in royalties, data is not available as to what percentage of the lessor’s hedge.

So, in Scenario 1, we will assume the landowner does nothing. He lets the market float and receives quarterly revenues based on the spot price of WTI.

Float with the Market

The total revenues received through the third quarter is $479,190.

In Scenario 2, we will use a combination of options and futures as defined above.

*Dec 30th,2019

$63.05 X 3000 Barrels = $189,150 – $3,025 (cost of put) = $185,435

**March 31st,2020

$20.34 X 1000 Barrels = $20,340 (Float)

$20.34 X 1000 Barrels = $20,340+ $37,350 (net profit) = $57,690 (option P/L)

$20.34 X 1000 Barrels = $20,340 + $40.290 (60.58 -20.29) X 1000 = $60,630 (futures P/L)

$20,340 + $57,690 + $60,630 = $138,660

***June 29th, 2020

$40.65 X 1000 Barrels = $40,650 (Float)

$40.65 X 1000 Barrels = $40,650 – ($3,150 +$125) = $37,374 (option P/L)

$40.65 X 1000 Barrels = $40,650 – (30.82 – 39.72) = $31,750 (futures P/L)

$40,650 + $37,374 + $31,750 = $109,774

****Oct 30th, 2020

$35.69 X 1000 Barrels = $35,690 (Float)

$35.69 X 1000 Barrels = $35,690 + ($4,785 – $4,760) = $35,715 (options P/L)

$35.69 X 1000 Barrels = $35,690 + (40.08 – 35.65 ) = $40,120 (futures P?L)

$35,690 + $35,715 + $40,120 = $111,525 

Although this is a small sample from the last three quarters, I believe it shows that by using a simple mathematical hedging solution,  the lessor (landowner) in this example through three quarters has improved his cash flow by $66,204 ($545,394 – $479,190) or 13.28% translating to 17.70% annualized.

The question that must be asked is why landowners don’t use hedging solutions?  One problem is that the exploration companies aren’t as transparent with their lessors as far as the flows the company is expecting or protecting out of the lessors’ land. This can easily be solved by putting in the royalty contract that you have access to and dialog to the engineers to help you understand the correct hedging ratios deployed based on the futures flow the engineers are projecting.

IPS Strategic Capital is a Quant firm that builds hedge solutions for corporations, endowments, pensions, advisors, and individual clients                 

Dominick Paoloni, CIMA is a member of the OIC Advisory Council and the TD Ameritrade Trading Panel. Mr.Paoloni guides future professionals as an Adjunct Professor at the University of Denver and the University of Colorado. He is a published author and is frequently quoted in financial journals and can be reached at dominick@investps.com

DISCLAIMER: The information on this website should not be misconstrued as an offer to buy or sell, or a solicitation to buy or sell securities. With any investment, past performance is not necessarily indicative of future performance.

One should always consult an investment advisor before making any investment decisions as well as consider the investment’s objectives, risks, charges, and expenses carefully before investing or sending money. This and other important information about the Strategy is available upon request.

Please click here to read our Disclosure Notice.

Hedging with oil futures to lock in $60 price per barrel would be giving up gains if oil moved back to resistance to $75/barrel. ($75/barrel – 60$/barrel) X 3000 barrels = $45,000 loss.  Many oil producers and the landowner remained bullish which build a consensus to let the commodity float (not to hedge) their position.

One should always consult an investment advisor before making any investment decisions as well as consider the investment’s objectives, risks, charges and expenses carefully before investing or sending money. This and other important information about the Strategy is available upon request.

Please click here to read our Disclosure Notice.