Just as there is more than one way to cook an egg, companies find more than one way to invest in minerals. Some buyers target one or two basins while others diversify to many. Some seek minerals alongside, or even inside, their existing E&P company; others solely have a minerals business, but occasionally take a nonoperated working interest on the mineral acres.

Lessons emanating from the shale renaissance have affected the entire minerals sector, although it’s still early in a new phase fueled by an infusion of public and private equity. This step-change allows all sorts of mineral companies to compete.

“Minerals are a huge part of the value chain now,” said Brendan Fikes, co-founder and vice president of Santa Elena Minerals LP. Based in Midland, it focuses on the Midland and Delaware basins. “The minerals space is evolving rapidly and the value is being recognized, but there’s a lot of chatter out there about who intends to buy, and that drives up the prices. Competitors are showing all of us what the value is.”

Fikes saw that he was making more money on minerals than on nonoperated working interests, so, as the market shifted, he and partner Austen Campbell approached EnCap Investments LP in 2015 to augment the original funding they’d obtained from friends and family. Today, Santa Elena has 30 employees, including geology and engineering staff, although the mineral business leans most heavily on a strong land team.

Fikes views his job as being a professional mineral owner who facilitates drilling of his mineral interests. “It’s in all of our best interests to get these lands developed. I think drilling begets drilling; the risk is mainly how long before the drillbit reaches your mineral acres.” Santa Elena has an affiliated company, OGX Operating LLC.

Sources estimate there are more than 20 companies with as much as $4 billion committed to buying mineral and royalty interests.

“The space is so vast—and maybe a bit misunderstood—that I think there’s probably a whole lot more opportunity out there than there is capital in the market today,” said George Solich, CEO of privately held, Denver-based LongPoint Minerals LLC. “There’s enormous potential waiting to be captured and there is a long runway of opportunity ahead.”

This sector of the business is land-driven, so building relationships with landowners, and with E&Ps that will drill your minerals, is the key. The mineral buyer has to discern which acres are most prospective and likely to be drilled—yet not overpay.

“There’s a lot of inventory out there to buy, but the big challenge is buying at a price you can live with and having the acquisition complement your broader mineral portfolio from a growth and yield perspective,” said Holbrook Dorn, senior vice president of business development for Houston-based Black Stone Minerals LP. One of the largest public mineral companies, it has more than 7 million net mineral and royalty acres in more than 60 producing basins.

“I hear people say, ‘Minerals are a low-risk asset class.’ Well they can be, until you overpay for them. All the capital that has come into the space recently has driven costs up materially,” he said.

How does Black Stone handle this dynamic? “For us, the short answer is ‘Work harder and maintain a disciplined approach to bidding on assets.’ And we try to give ourselves an edge by bringing a lot of industry knowledge to the table,” Dorn said. Black Stone has a 14-person technical team that’s involved in underwriting its acquisitions and an 11-person land team to help drive activity on the assets.

Fikes noted that an acre might have had “X” value, but the value of that acre has gone up substantially, given that operators today can drill six wells on a pad, reaching to three benches of pay, recovering more resource. Solich noted that the minerals business used to be a fairly low-tech, dislocated market for many years, mainly composed of mom-and-pops and maybe a few well-capitalized companies that mostly bought cash flow. Today it’s a more competitive marketplace.

Technical edge

In that regard, these mineral companies say technical expertise gives them an edge. Their strategies have to go beyond just buying cash flow thrown off by producing interests. “We think about geology and the midstream capacity in the area; we work with the service companies. We think about these mineral assets as if we already owned them,” Fikes said. “You’ve got to think about near-term development timing and cash flow, how many DUCs there are, drilling permits—all of that. But ultimately our understanding comes from our relationships with operators, not from public data.”

One thing Santa Elena watches over time is how operators outperform their type curves and outperform each other. “We rely on operators using best practices when they drill on our minerals. We don’t worry about a single set of results so much as we look for a continued evolution—one-and-done completion design is wrong. This industry evolves on a well-by-well, week-to-week basis.

“The market provides natural encouragement for E&Ps to adopt best practices and that drives better results.”

Solich said LongPoint has a similar focus on technical analysis before it bids on minerals. “It’s a good time to be in the mineral space if, and I say only if, you have the technical tool box that allows you to understand the resource in each zone and, generally, when it’s going to be developed,” he said.

“Minerals are a huge part of the value chain now,” said Brendon Fikes, co-founder and vice president, Santa Elena Minerals LP.

“Our business model is 50% probabilistic and 50% deterministic, but it’s built on understanding the subsurface wherever we are and assigning reserves up and down the column. LongPoint has no interest in buying a section of land that may be in a good neighborhood, but where we don’t know the subsurface that well or where we have no understanding of when an operator may turn that into cash flow,” Solich said. “We buy a small percentage of minerals with existing cash flow, but a bigger percentage is buying cash flow to come.”

Contrasting strategies

Publicly held Black Stone has about 100 employees managing its interests in 41 states and 64 basins, including in every major unconventional play. “Having such a diversified mineral portfolio exposes you to upside surprises, a more diversified royalty stream with lower volatility and a significant share of Lower 48 exploration and development activity,” Dorn said. A big focus is its 295,000 net royalty acres in the Haynesville/Bossier play in East Texas and 41,000 net in the core of the Midland and Delaware basins.

Black Stone started off as an exploration company, but minerals management and acquisitions have been its core business since the early 1990s. “After living through multiple commodity and play cycles, we’ve found that a diversified portfolio is important for sustained growth and shareholder returns,” Dorn added.

On the other hand, institutionally funded LongPoint, which has acquired more than 50,000 net acres since inception, takes a different approach, generally focusing on being open to multiple U.S. resource plays, but currently targeting minerals in the Anadarko and Permian basins.

“One statistic of interest is that we have nearly 50 rigs drilling on our minerals today, which speaks to our differentiated approach to predicting development timing. Over time, our job becomes more as a portfolio manager of minerals,” Solich said.

LongPoint has no employees. Rather, it is run inside or alongside its “big brother,” FourPoint Energy LLC, an E&P focused on the western Anadarko Basin. When Solich first conceived of FourPoint, its charter included a mineral entity. LongPoint thus emerged in June 2016 when it closed its initial fund of $525 million, including $450 million from the lead investor, the Canadian Pension Plan Investment Board in Toronto. Third parties and a second close added another $275 million, bringing the total to just over $830 million to deploy in the minerals space.

The minerals game is more E&P-like and more high-tech than ever before, said George Solich, CEO of LongPoint Minerals LLC.

“We had the notion we wanted to run the minerals company like we run the E&P company—that is, using the same subsurface mapping and the same rigorous high-tech approach,” Solich said. “We want to shoot with a rifle and not a shotgun—so much so that we told our investors there’s no way LongPoint would be a company unless it was joined at the hip with the E&P company.”

To act like an E&P company, LongPoint takes a granular, high-tech approach. “We want the assets we have to look like the same kind of assets you’d see in an E&P company with reserve reports on all the potential that’s there.”

Santa Elena prefers to buy large, chunky positions because Fikes thinks contiguous acres will more likely accommodate longer laterals and, thus, get drilled. “You’re not important if you own 50 acres in a drilling unit, but you might be if you own 500,” he said. The company does not take any nonoperated interests—only royalties and minerals.

Black Stone focuses on buying minerals where it believes it can spur activity. This may include participating in nonop working interests on its own minerals in future wells once an economic development program has been established. It also may include offering incentives to operators to drill on its mineral acres. About 25% of its cash flow comes from these nonop interests, Dorn said.

“Currently, our nonop interests make up about 40% of our total production with the balance coming from the mineral and royalty interests. On a cash-flow basis, 75% comes from the minerals.”

It is an active acquirer. Through the first half of 2017, the company spent about $100 million, focused on the Delaware Basin and the East Texas Haynesville/Bossier play. It paid roughly half in cash and half in common units.

Black Stone also believes in technology, but it’s a bigger company on a different scale with a strong land component. In first-quarter 2017, it reported record high net income ($61.6 million) and distributable cash flow ($68.5 million) despite low oil prices. It has forecast production growth of 14% this year absent any acquisitions. It typically spends $100- to $200 million in acquisitions annually, occasionally more.

Black Stone’s main nonop working interest is the Haynesville/Bossier play in the Shelby Trough in San Augustine County, East Texas, a legacy asset operated by XTO Energy Inc. The pair bought Encana Corp. out of that area in 2014 and has consistently maintained a two-rig program since mid-2015, pursuing dry gas on about 60,000 net acres.

In February, Black Stone farmed out a portion of this working interest to Canaan Resource Partners LP because it was consuming a lot of capital. “The program succeeded faster than we expected, so we felt it was time to farm-out the most active part of our position and convert that into a royalty asset,” Dorn explained. “The deal will increase production while lowering our future capital requirements.”

Black Stone continues to bulk up its position in East Texas, recently picking up mineral and royalty interests from Angelina County Lumber Co. on approximately 79,000 net acres in exchange for 2.9 million common units and nearly $5 million in cash. Concurrently, it negotiated with another major third-party operator to encourage drilling outside its existing acreage program with XTO.

Black Stone has always worked closely with operators on its mineral acreage. “We’re a mineral owner that understands what operators need to develop a commercial play,” said Dorn.

“We all have a view of EURs and drilling density and the number of benches that will be developed in any given play. At the end of the day, you have to have a view on the pace of development and that will drive valuations,” he said.

Most of its production comes from areas where it initiated the leases, “so, in that sense, ... we help drive activity and we know where a lot of these E&P companies are looking to grow. We can make acreage available to them in return for development commitments.

“Frankly, it’s about active land management, which involves everything under the sun,” Dorn said. “We see pretty impressive growth from our existing minerals and royalties. We believe we can reduce our nonop-working-interest production back to historic levels of about 20% of the total, yet still grow overall production.”

Communicating with mineral owners who might sell to Black Stone is critical. Dorn said, “We’ve always had a very honest dialogue with mineral owners. We’ll even go so far as to walk them through the return model we have on their assets; we prefer having an informed, rational seller. The more tools they have to come to a sell decision, the better—hopefully—it helps facilitate transactions.”

Given that the shales are so productive now, all the surface acres have greatly expanded in terms of what is “developable,” he added. “There’s more potential now, so at the end of the day, is your acreage going to compete for capital and get drilled?”

Black Stone went public to have another arrow in its acquisition quiver. The legacy mineral owners from which it buys assets can take Black Stone common equity. This provides liquidity for them, while also allowing them to defer taxable gains associated with their sale.

Competition, consolidation

All sources contend they’ll see consolidation ahead as competition to acquire minerals intensifies. LongPoint’s Solich said the deal flow he’s seen has been extremely steady, but competition has increased with the influx of new capital.

“If you think about the newness of the minerals market and the vast opportunity set due to the shale revolution, we’ve found ourselves with a lot to do,” he said. “I see a lot of private equity jumping in saying, ‘Let’s go capture resource.’ Everybody knows the resource is there, … but I think the minerals market is different and the exits or end-games are different—and frankly the consolidation is going to be very different.”

Consolidation in minerals—and eventual exits—may not be as frequent or clear-cut as is common for E&P companies. “That’s why we are a different kind of fish in this pond. At LongPoint, we are building a minerals company that we think can provide good returns and good yield year after year. Because we have such a high-tech approach, if there was a long-dated exit or, perhaps, no exit, then the returns we’d provide to shareholders are very solid.

“Buying minerals at a price you can live with—with returns that exceed your cost of capital—is what creates value,” said Holbrook Dorn, senior vice president, business development, Black Stone Minerals LP.

“We think what you need is long-dated capital. This space doesn’t fit every private-equity firm shingle that’s out there. As I look up and down the landscape, this may be the dawn of a new market, but it will not be for everybody and it will not look like the way private equity has monetized in the past 15 years” when it rapidly built, sold or IPOed companies.

E&P company FourPoint operates six rigs, while nearly 50 rigs are drilling on LongPoint’s minerals acreage. (None are its own rigs.) “They are all known operators; we’re not chasing our own rigs,” he said.

“If you buy something for a frothy multiple, you need to get that developed quickly,” Dorn said. “It’s hard to get your acreage back in these hotter plays once you lease it; you may only get a chance to lease it once. So make sure your lease provides for development.”

Because minerals are a yield asset, their true value is time, said Fikes. “There’s a lot of good rock out there, but, if it doesn’t get drilled in a timely way, it’s not worth much. Knowing the pace of drilling is where you can derive value.”

That development pace will pick up if commodity prices hold or improve. “I think we’re in the first couple of pitches in the first inning with a long game ahead,” said Solich.

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