I stumbled into oil royalties out of necessity, but they've been a great experience so far, providing the most passive income source I've come across and a high (~10%) rate of return.

I was initially trying to defer taxes on a land sale

In late 2018 I was doing a 1031 exchange, which defers the taxes on a real estate sales gain as long as you invest 100% of the proceeds in another real estate deal (i.e. sell a $100,000 property, buy a $100,000 property).

I had done several exchanges before, and had always bought regular commercial real estate (apartment buildings, office complexes, etc.).

For a few reasons, I ended up buying a property that was only about 95% of the original property's value, meaning I was either going to have to

a) pay full taxes on the 5% remainder

b) invest the 5% remainder in real estate

The dilemma: the 5% was not enough money to buy another property. It was also too much for me to be okay with paying taxes that I didn't need to yet. That's when I stumbled upon "oil royalties".

Oil royalties ARE real estate!

A royalty is a regular payment to a grantor by someone using your "property". If you owned the royalties for a popular song, you would get paid every time Spotify or a radio station plays that song. In the case of oil royalties, you get paid a percentage of the revenues gathered by the oil company that is operating on your "property".

Does this mean you own the actual land where the wells are? Not exactly. Land is made up of two components - a "surface estate" (what we usually think of as land, the part you build on) AND

a "mineral estate" - what you can find (oil, gold, whatever) if you dig below the land. Ownership of this gives you "mineral rights". And it's still considered real estate. Not only that, these rights get priority over surface rights - the operator gets to drill on the land even if the surface holder has plans for an apartment complex. Get outta the way!

Oil royalties refer specifically to the oil portion of the mineral estate, but what you own is typically a portion of the mineral rights including all oil, gas, and other minerals that are present on the land.

Mineral rights are TRULY passive

I own or have owned a variety of real estate assets, from RV parks to office buildings to raw land. Some of these are relatively passive (I have a great property manager for my apartment buildings in San Francisco who handles everything), but in the end...you'll still need to make occasional decisions on capital improvements or adjust based on an upcoming change regulations, or whatever.

The only TRULY passive asset I have found is mineral rights. I own about 2% of the royalty stream for a group of wells in Southern California. Other than giving them my address, there has been nothing for me to do, ever. I simply get checks in my mailbox every month and a year-end tax statement.

How to buy Mineral Rights

As I say for all investments, find a true expert who has lots of experience in mineral rights. This is someone who can give you at least 10 references all of who will give you glowing reviews. Preferably they also invest their own money alongside you.

As with all investments, it's important to understand the asset.

What tends to drive the value of mineral rights is:

1) Price of oil and gas. You get paid based on the oil that is harvested from the well. The higher the price, the more $ flows to you. Pretty simple.

2) Whether the driller continues to invest in the property. If the driller goes from 10 wells to 15, it's free money to you - you get paid on the additional wells as they are generating income from your same mineral rights.

3) How long the well lasts. Wells have a natural rate of decline, so one should prefer wells with longer lives, all else being equal. Many wells in California operate for decades. Fracking wells lose a huge portion of their oil after the first year.

After I bought the mineral rights, oil dropped about 20%. This might have been devastating for returns. Not so much:

Investment 65,000.00

Dec-18 681.75      Jan-19 597.14        Feb-19 597.14        Mar-19 512.62

Apr-19 508.48      May-19 624.86     Jun-19 689.68       Jul-19 707.15  

Aug-19 589.95     Sep-19 591.65       Oct-19 537.18        Nov-19 566.44    

Total 7,204.04

Return 11.08%    

Nominal Real Oil Price 19192.0129.01

Oil Price 201959.7659.76  

CAGR 3.45% 0.73%

I've included here some information on the long term increase in oil prices on both a real and nominal basis. In essence, oil prices do seem to increase at inflation plus a bit, which is a nice hedge.

Keep in mind the oil wells will decline over time...but you also have the potential that the operator invests to increase production if the field is still viable.

Another nice thing is that you have something to celebrate when gas prices at the pump are up - after all, it should usually be flowing into your royalty. A small emotional win.

This investment would be appropriate for people who want ongoing cash flow and don't need principal returned at the end. It also made sense in this particular situation because I would have lost almost 1/3 of the money in taxes at exit.

What are some possible outcomes? Here are some examples:

1) Oil price increases 2% per year, well declines 2% per year, and is terminated at year 16. 8.0% IRR.

2) Same as above, production terminates in year 23. 10.1% IRR.

3) Oil price stays flat, well declines 5% per year, is terminated at year 20. 4.9% IRR.

4) Oil price increases 4% per year, well declines 3% per year, is terminated at year 35. 12.0% IRR.

Overall, this is a generally safe investment, with some potential upside from new wells or renewed investment, and a decent return. If after an oil price dip I have 4% - 12% IRRs, that feels pretty good to me. It would be less appropriate for anyone who wants easy liquidity. This is the kind of thing you'll hold forever. You could sell in a pinch, but the market is not well established at this time.

I am satisfied with this decision, would do it again if I had excess proceeds from a 1031 exchange, and would recommend it for people who value cash flow up front vs. growth and want essentially a zero time investment.

If you want to learn about other types of alternative investments, read my reviews of market-linked CDs, farmland, and litigation financing.

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