A Primer for Mineral Appraisals.
Overview of Mineral Appraisals
Mineral appraisals are a unique subset of valuation services that are needed for transacting mineral rights. Mineral owners require appraisals for a variety of reasons. Commonly, the requirement is for a transfer of ownership that may be reviewed by the Internal Revenue Service. The IRS has higher standards and expectations for the methods that are used to arrive at the fair market value. Appraisals meet these standards and are different from valuation in that appraisers are bound by appraisal standards. Most appraisers are proficient with and follow the Uniform Standards of Professional Appraisal Practice (USPAP).
Appraisal for IRS Purposes
The IRS is watching and they want their share. Reporting the value of mineral rights to the IRS may be for estate tax purposes, dissolution of marital assets, a sale to a family member or business associate, estate planning, gifting, or any other reason.
Transactions that are not considered “an arm’s length transaction” such as moving assets into a trust or gifting to a relative or other related party will draw additional scrutiny. The IRS seeks to ensure reported values of transacted properties are done so consistent with fair market value standards.
A mineral appraiser providing an independent, third-party appraisal will give you the confidence you need when reporting to the IRS the value of the property as of the effective date. The IRS is less likely to perform an audit if a mineral appraisal is provided which meets the applicable IRS valuation guidelines and is performed in accordance with USPAP and other professional standards.
Appraisal for Selling Mineral Rights
There are endless examples of mineral owners receiving offers in the mail to purchase their mineral rights. How are the offers generated by the buyer? Is the offer fair? Do you continue to collect offers and select the highest one when you are ready to sell?
To answer the preceding questions, we start with advising you not to sell your minerals right away. If you can retain the minerals, it is usually better to do so. However, sometimes mineral owners find themselves in a position where they need cash now rather than the income stream from the royalties. Other circumstances may lead a mineral owner to sell because the interest is too small and the checks are not big enough to justify the time and effort to continue managing the minerals.
Before you sell the minerals to a mineral buyer, have an appraisal performed to be sure you are getting a fair price. This is particularly important if you have a substantial mineral estate. Seeking professional guidance is beneficial even though the mineral owner will have to pay a consulting fee to the appraiser. Accepting a cash offer immediately can be enticing, particularly if the mineral owner needs the money now. Keep in mind that the offers from mineral buyers can virtually always be negotiated upward. With some research on the local sales data and generation of an economic model, appraisers can often justify increasing the offer you have received.
Minerals - Know What You Have
Knowing what you own is the first step in a mineral appraisal. This is called the definition of rights. The definition of rights describes the property that is the subject of the appraisal. For a mineral owner receiving a royalty a typical definition of rights would identify the acreage that is leased and the owner’s interest in production. The owner’s interest is also referred to as a decimal interest which is found on your check stubs, royalty statements, or division orders. Keep in mind that the definition of rights can also include minerals that are not in production and are not generating revenue. These are all part of the mineral estate and carry value.
If you are unsure of what you own, some general land research can be performed at the county clerk’s office in the county where the minerals are located. In more difficult cases it may be necessary to obtain a title opinion.
Approaches to Value for a Mineral Appraisal
The three traditional approaches to value are the Sales Comparison Approach, the Income Approach, and the Cost Approach. The two approaches to value that are most used for appraisals of mineral rights are the Sales Comparison and Income Approaches.
Sales Comparison Approach
The Sales Comparison Approach is used to arrive at benchmarks for transactions that are used to assist with the valuation of the subject property. Benchmarks can be dollars per acre, dollars per barrel of proved reserves, dollars per proved Mcf (thousand cubic feet of gas), or a combination of these.
Public and private sales that have occurred on or before the effective date of the appraisal assignment are analyzed to arrive at the appropriate benchmark data. The benchmark data are analyzed and then adjusted as appropriate to make the sales data more relevant and comparable to the subject interest. Adjustments are made to the benchmark data from each sale based on the date of sale, physical characteristics such as the acreage quantity, state of development, distance to market, and other factors necessary to make the comparable sale more relevant. The resulting adjusted benchmarks are then applied to the subject property to estimate the fair market value.
The Income Approach calculates the future income stream of the subject asset. The income stream is based on modeling the productivity of the oil and gas wells, which is called a decline curve. The economics of the well and the value it will produce are modeled by applying appropriate pricing to future sales of petroleum and scheduling costs (if the lease is not “free of cost” which is more common for gas than oil production).
The future income stream is then calculated as a present value (value as of the effective date) by applying a discount rate to each future period’s cash flow. The discount rate applied is reflective of risk and is generally derived from evaluating other investments with comparable risk along with their associated expected rates of return.
Reconciliation of Approaches
Reconciliation and rendering the final opinion of value is the last step of the appraisal process. The appraiser takes into consideration the appropriateness of each of the valuation methods utilized and weights them based on the quantity, quality, and reliability of the data behind each method. The final opinion should be defensible and accompanied by sufficient narrative to support the opinion.
Unbiased and Independent
A fair market value appraisal can only be prepared by an appraiser who is unbiased. That means that the appraiser must not be advocating for either the mineral owner or any potential buyer or the IRS. The statements of fact must be true and correct. Assumptions and limiting conditions must be clearly identified. The appraiser must also be compensated for his or her work with no contingencies such as closing of the sale or specific results of the appraisal assignment such as a “low value” or “high value”.
Mineral appraisers have a unique skill set that includes business, finance, engineering, geology, and appraisal theory. Their unique knowledge makes them different from surface appraisers and other real estate appraisers. To perform mineral appraisals, the appraiser will need to have specialized experience in mineral development such as an understanding of geologic formations, production forecasts, field operations, capital expenditures, operating expenditures, development plans, well permitting, lease documents, and decimal interests to the owner in the subject property along with the knowledge to find the data. These are not typical skills that are held by the average surface appraiser. Be sure to seek out a qualified and experienced mineral appraiser.
These materials have been prepared solely for educational purposes to contribute to the understanding of oil and gas appraisal. These materials reflect only general concepts in the industry based on Colorado and may not apply to all circumstances. It is understood that each case is fact ‐ specific, and that the appropriate solution in any case will vary. These materials may not be relevant or apply to any particular situation. While every attempt was made to ensure that these materials are accurate, errors or omissions may be contained therein, for which any liability is disclaimed.