[Editor’s Note: This is a guest post from Howard Klemmer, ([email protected]) who is a partner with Royalty Lending Financial Services, LLC. We have no financial relationship. Financial professionals submit guest posts like this both to educate readers about financial products and opportunities, and of course because they hope to build their business by recruiting investors or clients. I always try to ensure these posts are heavy on the education, and light on the sales, but be sure to let me know what you think about them by email or in the comments section. I thought this opportunity for a private investment was pretty interesting, and perhaps even worthwhile for a small percentage of a portfolio, but you should be aware that I have not done any due diligence of any kind on Mr. Klemmer’s company, nor invested a dime with them. Don’t take the publication of this post as some kind of endorsement. There are lots of good private investments out there, but it’s on you to separate the good from the bad, if you want to use them at all. They are certainly optional.]
There is an alternative to Peer to Peer lending; a process I call Royalty Based Lending (“RBL”). It is an investment vehicle that doesn’t risk a large amount of cash, has no correlation with the stock market or most alternative investments and is easy to understand. RBL loans are made to owners of oil and gas mineral rights who are currently receiving monthly royalty payments from oil and gas companies. RBL is akin to buying lottery winnings at a discount; in this case RBL loans high interest cash and is repaid from oil and gas monthly cash royalty payments.
The investment instrument is a Limited Partnership consisting of a General Partner (“GP”) and Limited Partners (“LP”). LPs make investment in the Partnership/Fund; the GP finds borrowers, does due diligence, prepares paperwork and manages the cash repayment of the loan. Most RBL companies are generally small specialty loan companies or family funds. The loan pool is from personal or close family investors; when the loan pool is fully exhausted, the operation goes into a suspense mode till principal can be replenished. Few if any of these operations offer a Limited Partnership for investors to earn a high return.
Our RBL company does invite investors at large, and has a target return of 12% annually; cash distribution of interest is paid each quarter and principal is reinvested. Although 12% is not a guarantee, the typical RBL business model definitely supports it.
Mineral Rights Ownership – What Is It?
The most fundamental level of mineral ownership (MRO) is a “fee mineral interest.” This is an absolute and perpetual ownership of the minerals beneath the surface of a tract of land. In virtually all countries around the world, the owner of the surface estate – be it a house or farmland – has absolutely no rights with regards to the mineral estate. Generally, it is the central governments or monarchs who own such rights.
Not so in the USA where private citizens can own both a mineral estate and a surface estate. In a large number of instances, these two estates have been separated (“severed”) from each other so they may be bought and sold separately. Where the estates have been severed, the MRO’s right to drill and explore for minerals overrides the land owner’s surface rights, meaning the MRO has an almost unfettered right to explore and seek his mineral rights revenues.
To bring oil and gas reserves to market, the mineral rights are leased to oil companies through a lease contract with an MRO. The MRO and the oil company agree to certain terms regarding the rights, privileges and obligations of the respective parties during the exploration and possible production stages.
Usually, in exchange for providing the oil company the right to drill for a period of time, the MRO gets an up-front lease bonus payment plus a royalty percentage of the value of any production. If no drilling occurs, the lease simply expires.
The duration of the lease may be extended when drilling or production starts. This enters into the period of time known as the secondary term, which applies for as long as oil and gas is produced in paying quantities or commercial quantity.
Oil and gas royalties and the underlying minerals rights are valuable property in addition to being an excellent source of consistent and reliable income. In fact, these properties are commonly bought and sold through the Internet at specialty auctions for oil and gas properties. These auctions provide a lively secondary market to further promote the liquidity of these mineral properties. It is not uncommon for mineral properties to sell for 50X to 80X the average monthly cash royalty payment.
Market for Lending
The market for RBL is made up of MROs who have urgent cash flow needs such as medical issues, vacations, large purchase, home remodel, school debt, etc. They don’t necessarily want to sell their royalties (but will in a pinch), but are willing to pay a high interest rate for a short term loan.
Historically, banks do not recognize the collateral value of royalties earned from producing oil and gas properties. For most banks, there is a substantial amount of paperwork involved with a royalty loan that also requires an appraisal or valuation of the royalty. Such valuations are specialized and require resources outside of the bank’s normal reach. Consequently, it usually is not a cost effective loan product and is not offered by the majority of banks.
In contrast, RBL companies do not require a credit report or personal financial data; they only require from the borrower:
- verification of the monthly royalty payments, well history, multiple royalty sources
- validation of a clean title to the mineral rights and documented audit trail of ownership and
- willingness of borrower to assign cash royalty payments to an RBL company.
The RBL Model
LPs invest in a loan pool; the GP makes loans from the pool to MROs who assign their mineral rights and monthly royalty payments to the Limited Partnership; the GP uses this monthly cash payment to pay down the loan balance until the loan is satisfied; then the mineral right and cash payment is reassigned back to the MRO. Typical terms and specifications:
- Royalty collateral is valued up to 25 times the average monthly cash flow; loan to value (LTV) is 50%; the maximum term is 36 months, although a 4 year amortization with a balloon payment at the end of the loan is possible
- Since the loans are investor financed, the interest rate is 18%; with compounding daily interest the effective interest rate is 19.72%. [Ed. Of this 18%, the GP gets 1/3 and the LP gets 2/3, thus the 12% returns.]
- A 3% loan origination fee is charged to cover the costs of legal expenses associated with the loan, document recording, delivery services and other due diligence costs. The origination fee does not cover the cost of county and state transfer taxes if they apply.
- The first two months re-payments are withheld from the loan proceeds, as it frequently takes this long to get royalties redirected to the RBL Company from the oil and gas operator.
Once the loan is approved and the borrower agrees to the terms, the borrower will execute the following documents:
Borrower Documents to Execute
- Promissory note
- Deed of Trust which will be recorded in the county where the minerals are located. If the state does not recognize deeds of trust a Special Warranty Deed conveying the Mineral interest to the lender will be recorded in the county where the minerals are located. In this case, a letter agreement specifying that the minerals will be returned when the loan is satisfied will be provided.
- A letter to the operators, informing them of the loan and directing them to send borrower’s royalties from the oil and gas company to RBL company until the loan is satisfied.
- As soon as the loan is paid-off, The RBL company will release the Deed of Trust (or convey the property back to borrower, if previously deeded it to the RBL company) and inform the royalty payors that the loan has been satisfied and instruct them to make payment back – directly to the borrower.
The RBL company also anticipates some loan defaults – and with default – the company ends up owning the property at a potentially below-market cost. With defaults, the investors will normally have the option of selling their interest in the foreclosed property or having their share of the royalties and minerals deeded directly to them.
Risk of RBL
The largest risk in the RBL model is the loss of cash flow to repay the loan. The could occur from (a) drop in oil and gas prices or (b) loss of oil and gas production that generates the cash flow. What is the likelihood of these risks occurring?
1) It is highly likely that the price of oil will fluctuate. However; according to oil-price.net and others it is unlikely that the price of oil will drop below $80 per barrel since that is the price necessary for the leader of OPEC, Saudia Arabia, to maintain social stability within its population; and
2) The price of natural gas can also fluctuate. It is currently above $4.50 and based on aggressive marketing of natural gas as an alternative to coal and gas-guzzling cars it is likely natural gas at a price of $4.50 or so seems a continuing reality.
3) Loss of production can occur when the well is forced to shut-in (stop for repairs, etc). Most shut-ins are planned and have no ultimate revenue effect. Occasionally an unexpected shut-in will occur and can lead to full stoppage of that well’s operations (closure), but this is not a common event.
You can mitigate against these risks by ensuring:
1) Multiple sources of monthly cash from prospective borrowers to guard against production loss,
2) Proper valuation of the collateral so that monthly installment repayments are not affected by a drop in prices, and
3) Verification of the collateral cash flow and the clean title to the collateral.
The Bottom Line
Oil and gas investing will be around for many more years. RBL is a boutique business that takes advantage of and lends against the oil and gas revenue streams.
What do you think? Do you invest in oil and gas? How do you do so? Would you consider loaning money to someone with only their royalty payments as collateral? Comment below!