Impact of Fracking on Real Estate Value, Mineral Rights, and Ad Valorem Taxes

I am a commercial real estate appraiser.   The focus of my experience and practice has been primarily on valuation with respect to urban land economic issues with some agricultural land activities.  I am being called upon more to deal with issues involving mineral rights. 

 

I am searching for information and case studies involving the impact of fracking on real estate values and ad valorem taxation, both positive and negative.  These include major increases in values of hotels, apartment buildings, restaurants, bars, commercial properties in general because of drilling and fracking and pipeline activity.  And conversely major declines in value because of the adverse impacts of drilling in a community, or the stigma associated with the potential for drilling activity nearby, or the negative impact of environmental contamination, or perceived or actual stigma associated with environmental issues.   

 

Also, I am grappling with the following hypothetical case.  (I am just making up some of these numbers thinking they bear some resemblance to reality).

 

For many years land in Farmer Joe’s county had been selling for $4,000 per acre before the fracking boom.  Joe has to retire from farming because of ill health and wants to sell the farm.  There are no buildings on the farm itself as he lives in a house alongside his barn and silos across the street from the acreage.  A landman has given him a signed offer to lease his acreage for 5 years for $5,000 per acre with a 15% royalty.  All he has to do is sign the offer and he will receive a check for $5,000 per acre. 

 

There are successful proven wells all over the place near Joe.  He has done his research and consulted with professionals and believes there is at least a 50% chance that the well will be drilled and produce.  His royalty payments per acre, if the well is drilled and produces, are estimated at:

$3,000 in the first year,

$2,500 in the second year,

$2,000 in years 3, 4, and 5,

$1,000 per year in Years 6, 7, 8, 9 and 10, and

$500 per year for the next 30 years.   

 

At a 13% discount rate the Present Value of this cash flow is $11,324 per acre.  At a 50% probability the expected value of this cash flow is $5,662.  Joe believes this is a conservative estimate of value because he has heard there is a rule of thumb that the value of minerals sold outright is typically 3 times the price being paid for lease bonuses.

 

Joe has had several people interested in the property and he is trying to decide what he should accept as an offer for the property as a whole, surface and minerals.  Joe knows that the buyer will get the $4,000 per acre surface value of the property based on all the sales that occurred in the County before the big fracking boom.  The buyer will also get the immediate lease bonus cash payment of $5,000 per acre.  The buyer will also get the 13% royalty payment if the well is drilled and produces which Joe conservatively estimated at a 50% probability of happening. 

 

Thus, Joe calculated that an offer based on the following calculations would be acceptable to him. 

 

                        $4,000 per acre for the surface

                        $5,000 per acre for the lease bonus

                        $5,662 for the expected value of the present value of the royalties

                        $14,662  for surface and minerals

 

 

When Joe sat down with some of the interested parties he made the argument that the land was worth $14,662 per acre based on these calculations saying that the numbers were actually conservatively low because he had heard that mineral rights sold outright typically fetch 3x the lease bonus payment.  Joe got an offer from one of the interested parties for $14,000 per acre.  The offer was from a wealthy prominent attorney in the County who had just won election as a County Commissioner so he felt pretty confident that he had the money and it was a solid offer.   Joe told her he would need time to think about it.  

 

Anyway, it just so happened that one of the other interested parties was a County Assessor.  While Joe’s asking price was way higher than what he was expecting, this got the Assessor thinking as it was time for Joe’s sexennial re-assessment.  After thinking it through, the  Assessor, agreed with Joe’s calculations and promptly sent him a notice that his property assessment and tax bill were being more than tripled from the $4,000 market value that had been placed on the property by the County.

 

Joe was no dummy and promptly marched down to the County Courthouse and reminded the Assessor that in the States of Ohio and Texas  ad valorem taxes are placed on mineral rights  only when the well is producing.  Joe exclaimed, “I am pointing out that I don’t have a producing well.  I have not even signed a lease!” 

 

The Assessor countered, “Well that is exactly the point.  The minerals have not been severed from this property, but you did have a solid offer of $14,000 per acre for your real estate including the un-severed minerals.  What better indication of at least a minimum value of your property is that $14,000 per acre offer?  It could be worth more, because it wasn’t high enough to get you to sell?  Plus I have half a dozen other sales of unleased acreage at around $14,000 per acre.  That is pretty good evidence of value.  And mineral rights are real estate.  Just because there isn’t a separate assessment for the minerals doesn’t mean they don’t have value!  It’s just that the value of the minerals is not assessed separately yet!

 

 

So that brings up the crux of my question.  Has anyone dealt with this issue with an Assessor jacking up the assessment because of the discovery of minerals in the area?  If not how are Assessors dealing with the issue of comparable sales of properties that include un-leased, un-severed mineral rights.  Or even sales of properties that have wells that are non-producing.  I’m trying to get at the problem of separating mineral rights value and surface rights value when looking at comparable sales.  When I see these vast acreages of land being bought and sold by Chesapeake or another oil and gas company for such and such a price are they typically selling the surface and minerals or are they almost always talking about just the minerals?

 

Thank you for bearing with me through this long read.  Any information, insights, corrections, or noting of any misconceptions or blatant errors in the scenario above would be greatly appreciated. 

 

And also any cases where fracking has had a negative impact on value such as in the case where a surface owner does not own the minerals and ends up having a drilling rig showing up in his backyard one day would be very helpful. 

 

Thanks

 Ted

 

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Replies to This Discussion

Permalink Reply by bo boboski on September 20, 2014 at 11:29pm

I hope you're not right on the possibility of county assessors jacking up peoples land taxes because of their mineral values. Has this happened elsewhere? With the IRS taking 35% to 45% of this "found $$$ " ,and now the counties trying to get their fingers in it, it may cause folks to just sell out and move away.

Permalink Reply by Barry D on September 21, 2014 at 12:45am

bo,

I believe that has already begun.

I am not sure which county but there is one that receives  statements from the oil and gas companies of royalties paid to landowners. They tax based upon that. The IRS receives a copy of your 1099 so it wouldn't surprise me that companies also send this info to the counties.

There are companies who deduct back taxes from bonus payments and send the money to the county.

As far as the IRS is concerned; you are obligated by law to report all income, "found" or not.

It's a sad situation, the average person finds a way to get a little ahead and the politicians find a way to take it away.

Again, if it hasn't begun it's only a matter of time.

Permalink Reply by bo boboski on September 21, 2014 at 1:22am

I can see if a parcel is in a production unit,receiving royalties, that they could get a good idea,with the decline curve,past  & present well results from the same area,  of what the well will produce as income for the property over the years, and use that to adjust the value of the property. But to make that adjustment before the property is even leased woul be ludicrous. Should be opening themselves for lawsuits!

Permalink Reply by Barry D on September 21, 2014 at 1:40am

bo,

I am sure that county Auditors and Treasurers would love to come with a formula to tax undeveloped oil and gas; I think you are correct that it would open a legal; can of worms.

As far as taxing royalties, they don't need to guess. The company just sends a copy of the 1099.

Permalink Reply by pg guy on September 24, 2014 at 1:28am

In my experience, a 1099 is issued to the payee, and a report of same is sent to the IRS.  Any further disemination of a 1099 is up to the recipient.  I have issued tens of thousands of O&G 1099s over a period of many years, for income generated in multiple states and paid to recipients in every state, and never once provided the information to anyone else, unless directed by the recipient, in writing, to do so.

My guess is that any back taxes deducted from bonus payments are the result of liens on the property.

Additional question I have:  If property valuations for tax purposes can be partially based on mineral values, would not the taxes be reduced after a few years of production, when the minerals are largely depleted?

Permalink Reply by Werner Kostendt on September 24, 2014 at 10:06am

The ad valorem tax on gas and oil reserves are taxed only for the year in which, during any part of the preceding  year, the well was in production.  My understanding it is a formula based on the most recent year's production.  It assumes a standardized rate of decline and is a factor which distills the results of a discounted cash flow analysis into a single number.  The discount rate currently applied in Ohio is currently 13% plus a safe rate.  The safe rate is something like the return on a Treasury Bond.  If the well production declines in one particular year then the ad valorem tax will decline in a way modeling the decline in the reserve.  Eventually once production gets so low the ad valorem tax will disappear.  This is distinguished from federal, state, local, county income taxes which are applied to the net income generated from the well.  It is also to be distinguished from the severance tax which is based on the number of barrels extracted from the ground. 

Permalink Reply by Werner Kostendt on September 24, 2014 at 10:19am

It seems that some counties that don't have a strong recent history of oil and gas production don't bother with a separate minerals ad valorem tax. At any rate the ad valorem tax is not supposed to be charged until the well is put into production. So somewhat paradoxically the property that has never been drilled and has the highest mineral content and presumably the highest value, would not be taxed at all for minerals. 

I have heard that there is one county Auditor who wants to tax these reserves, regardless of what the state law says and says he will go all the way to the Supreme Court to say that those reserves have taxable value. 

Here is the State's formula for the county's to use in calculating ad valorem value of minerals.

http://codes.ohio.gov/orc/5713.051

Permalink Reply by Werner Kostendt on September 21, 2014 at 5:21am

No I have not seen that.. just posing that as a hypothetical.  According to Guernsey County Auditor Tony Brown as quoted by Judie Perkowski in Dix Communications on line posting July 2, 2012:

"...no value may be added to the surface (land) because of income generated by a lease or purchase of the oil and gas mineral rights" 

I don't know if that is a statutory law that minerals are not taxed on an ad valorem basis until producing or if that is a policy or tradition adopted by assessors.

Permalink Reply by jason irvine on September 21, 2014 at 2:07am
I think the value below has gone up and the surface has gone down. The majority of people seem to move here for rest quite clean air very rural areas etc.... most of which has changes and some impacts have yet to be discovered or determined. I think a lot of buyers will be reluctant because of the unknowns.

Especially here in wwv. The big selling points have a lot of question marks beside them. I know a lot of that crap is from anti frackers. I know it crap but buyers dont. I wish there could be a large survey asking people how they view these areas now compared to what theyou used to think. I bet people would not take a chance to purchase land around here until after they see what happens.....this takes years. I know my hunting camp isn't quite the same. Noises are the most notable. It doesn't feel as remote as it felt before.
Permalink Reply by Werner Kostendt on September 21, 2014 at 5:46am

A large survey or actual before and after selling prices... before and after fracking. 

Permalink Reply by Werner Kostendt on September 21, 2014 at 5:31am

Jesse,

Yes, the O & G is severable hence the debate over severance taxes were paid as a percentage of the amount pumped and it is relatively small in Ohio compared to some other state and I think some states charge it based on the revenue pumped, So if prices go up the tax goes up.  Then there is the state, income, and local taxes to the royalty recipient and the driller and then finally the ad valorem tax which kicks in based on the estimate value of the mineral remaining in the ground once production starts.  So a lot of taxes generated from a well, but the ad valorem on the minerals is not a factor until production kicks in. 

Permalink Reply by Werner Kostendt on September 21, 2014 at 5:57am

I am in Ohio.

I thought of the possible impact of this after I sent my post.  However, land has been bought and sold and financed for decades where the minerals have already been sold off.  I bought my own house in a subdivision in Hudson and there was one page out of a hundred or so that stated that the purchase of my lot did not include minerals.  It also noted that there was a pipeline easement running along my rear property line.  The minerals caveat was in everyone's deed in my subdivision of over 200 lots, and it did not seem to bother anyone, back when the subdivision was developed pre-fracking.  It doesn't seem to bother the buyers now or their lenders now.  It doesn't seem like anyone gives a second thought about it.  Of course, that could change if drilling rigs started showing up in people's back yards. 

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