Relationship between Lease Bonus and Mineral Rights Value
By John B. Gustavson, Certified Minerals Appraiser #1992-1
Lease Bonus Method for Conventional Oil & Gas Rights
The Lease Bonus method for conventional oil & gas mineral rights has been observed in the market and in literature, ,  since the 1990’s and possibly earlier. In its simplest form it provides an estimate of the Fair Market Value of a landowner’s oil & gas mineral estate under the assumption that the Highest & Best Use is for the leasing and exploration for oil & gas. The Lease Bonus method is therefore applicable during the early stages of an oil & gas play.
The method is reliable when lease terms such as front-end bonus, annual rentals or paid-up bonus, primary term and royalty rate are reasonably uniform in an area. When applied to conventional oil & gas plays with a distinct petroleum system (separate source rock, reservoir rock, etc.), the FMV of unleased oil & gas rights is reliably estimated by multiplying the current lease bonus amount in dollars per acre with a factor of from 2½ to 3.
If the subject property were already under lease, the Appraiser may account for this negative fact by using the present worth of the future bonus.
The Lease Bonus method works similar to a discounted cash flow approach from the landowner’s standpoint. When the Highest & Best Use is for the leasing and exploration of the oil & gas rights, the landowner exercises his executive rights (a defined portion of the oil & gas estate) and receives income in form of bonuses and rentals. Even if no drilling and production were achieved until way out in the future or never, the landowner nevertheless could renew the leases or lease to different oil companies after the primary term and extensions expire. This sequence can be repeated, even allowing a market-observed hiatus between lease cycles to reflect sluggishness in the leasing market.
The similarity with the DCF approach is apparent. A simple cash flow forecast with a reasonable discount rate from the market for calculating the net present value to the landowner will yield an FMV similar to the one seen from this Lease Bonus method. Typically, 3-4 lease cycles over about 20-25 years provide an excellent reality check on the rule of “2½ to 3 times the bonus”.
Lease Bonus Method for Unconventional Oil & Gas Rights
As noted above, the unconventional oil & gas mineral rights include those that are being produced from horizontally drilled wells in shale formations. A change in the relationship between the bonus (now a larger paid-up bonus) and the Fair Market Value of the oil & gas mineral rights has been noted in the market. The multiplier is now 2 times the bonus amount to estimate the Fair Market Value of the mineral estate of early-stage acreage.
The reason is the larger bonus amounts willingly paid by the oil companies. From an oil company’s perspective, the so-called “shale play” start out with the need for a very large land position, because an oil company does not yet know exactly where the “sweet spots” are located. The shale varies greatly in its capability to produce. The oil company must therefore secure plenty of land on which to explore and improve its focus. It must therefore also control the lease rights to move laterally as early results come in.
Such plays are also called “resource plays”. While the shale may be in existence under even county size areas, the shale may not be amenable to horizontal drilling and to frac’ing and other requirements for economic flow. Therefore, petroleum engineers will not name potential oil & gas from such shale as reserves, but only as resources.
In short, the oil companies need the acreage and will pay. Likewise, the landowners also want more money up front. A landowner already knows that just leasing his land to an oil company does not guarantee drilling and royalty income from production, not to mention the numerous development activities, which must precede royalty payments (see Table below). The landowner will therefore insist on more money up front instead of waiting for the uncertain royalty.
1. Land position under control, with possible Shale geological potential
2. Land position under control over Shale with proven potential
3. “Sweet Spots” for oil in lieu of gas anticipated from surveys or sampling
4. Oil shows identified from vertical drilling intersections
5. Delineated Shale prospect for horizontal drill test
6. Permitted prospect for horizontal drill test
7. Unitized land position for horizontal drill test
8. Spudded and surface-cased drill test
9. Drilled horizontal drill test
10. Frac’ed and completed horizontal drill test
11. Producing single leg of horizontal drill test
12. Producing multiple legs of horizontal drill test
The combination of these market factors leads to larger bonus payments for the unconventional oil & gas leases. And with larger bonus payments it follows that the multiplier with which to estimate the FMV of the actual oil & gas mineral estate at these early stages will be smaller. Examples have been observed from the market where the leasing oil company has offered a landowner to choose between one bonus amount for a lease and the double amount for outright sale of his mineral rights. Thus, the FMV for the latter would equal 2 times the offered bonus.
Additional support for the multiplier of 2 toward FMV estimate of unconventional oil & gas rights at early stages of exploration comes from recent literature.
Limitations of Lease Bonus Method
With either conventional or unconventional oil & gas rights the lease bonus method loses reliability as the maturity of the activities (the Highest & Best Use on the Effective Date) increases from early exploration to development drilling and production. One reason is that the availability of unleased acreage will have drastically dwindled. Once production has been established in an area the acreage is rapidly leased up, and it is rare to find unleased acreage.
If ever found, a landowner holding any unleased mineral rights would look to the potential income from near-term royalties as his primary guide to value rather than to a signing bonus. The DCF method may be reliably used by the landowner to estimate the FMV of his future royalty income, because the income is “reasonably likely in the near future”.
It is noted that the FMV of the mineral rights thus estimated is likely arrived at by a much higher multiple of the offered lease bonus than observed for early exploration leases. An offer for Niobrara shale acreage in Colorado gave a choice to the landowner between $500 per net acre as a lease bonus for a 3/16th royalty lease versus $1,900 for outright purchase of the mineral estate. That is a multiplier of 3.8. In this case the local area had already seen Niobrara testing and development and the operator had commenced construction of a horizontal drilling and multiple-well production pad.
It is concluded that the lease bonus approach is reliable for both conventional and for unconventional oil & gas mineral rights as long as the acreage use is in the early exploration stages. At later stages and among producing properties any unleased acreage may be worth 3 to 4 (or more?) times the bonus offered. A more reliable method may be to run a discounted cash flow model, calculate a Net Present Value for the royalty stream and risk it by a probability factor for coming about at the predicted quantity and commodity price in the near future.
John B. Gustavson
Certified Minerals Appraiser #1992-1
 The term “conventional” is used here to denote oil & gas being produced from vertically drilled wells with classical completion technology in contrast to “unconventional” oil & gas including that being produced from horizontally drilled wells in shale formations.
 The term “mineral rights” is herein used interchangeably with the term “mineral estate”.
 Widlund, Douglas S., 1996, Evaluating Minerals In Condemnation Cases, in Land And Permitting II, Chapter 2, Rocky Mountain Mineral Law Foundation, Westminster, Colorado, January 1996.
 Moritz, Edwin C., 1997, Techniques for Valuing Acreage with Unproved Oil and Gas Potential, Society of Petroleum
Engineers, Hydrocarbon and Economics Symposium, Dallas, Texas, March 1997, SPE Preprint 37950.
 Castleton, John, 1990, Determining Fair Market Value of Oil Interests Is an Art, Trusts & Estates, 129, 2. January 1990.
 It is negative from an appraisal standpoint, because the lease bonus has already been paid to the landowner. A bonus cannot be expected again until the lease and any renewal terms have expired, usually a 5 to 10 year waiting period. An Appraiser may discount for that negative factor by using the present worth instead of the current lease bonus, calculated over the years of waiting for the next payment and with a discount rate commensurate with a landowner’s Weighted Average Cost of Capital (usually 3-4 percentage point lower than the extractive industry’s WACC).
 Historically, a large front-end bonus was paid to the landowner to be followed by annual rentals, the latter usually very small and less than five-ten percent the amount of the bonus. Recently, so-called paid-up bonuses have been noticed in the market, which include all future rentals in form of a lump sum added to the front-end bonus.
 Posgate, L., 2013, Methods of Royalty and Leasehold Appraisals, Issues and Comparisons in Several Cases; Soc. Mining Engineers, Annual Convention, Denver, CO, February, 2013 (abstract, slides and audio recording).
 It is noted that the mining in contrast to the petroleum industry frequently uses a compromise by paying the landowner “advance royalty” in lieu of a signing bonus, the former of which is deductible from ultimate production royalties.
 Reference is made to the U.S. Supreme Court decision in Olson vs. United States, 292 US 246, 255 (1934), which stated: “Either some existing use on the date of the transaction, or one which the evidence shows to be so reasonably likely in the near future [emphasis added] that that use would have affected its market price on the date of the transaction and would have been taken into account by a purchaser under fair market conditions.”
 Offer to Ms. Suzanne Nyhus for a 50% undivided mineral interest in 160 acres in Section 18, T8N R60W, Weld County, Colorado, dated February 2013, private communication.