Powered by hydraulic fracturing and horizontal drilling, the 21st century oil boom is building momentum, offering new opportunities to investors. Oil and Gas Investor talked with executives from three sellers of royalty investments, as well as with one who advises landowners (see sidebar), to gauge strategies for today's market. Here's what we learned.

First, a quick refresher course. Royalties confer the right to receive revenues from the sale of minerals such as oil and gas. The "royalty" owner is like a king or queen who receives value from the mineral without having to contribute to the expense incurred to acquire and sell it.

While drilling for oil and gas is expensive for the operating company, the royalty owner does not participate in those costs. Instead, he or she receives a share of the revenues—off the top, before expenses. The risk is primarily a commodity risk.

"These are the kinds of investments that large endowments and foundations have made for decades. But they've only become available to individual investors during the past 10 years," says Chris Faulkner, chief executive officer of Breitling Royalties Corp. in Dallas. Founded in 2007, Breitling Royalties acquires long-reserve-life portfolios of oil and gas royalties and packages these deeded interests for accredited investors. It is a source for energy-based replacement property for real estate investors seeking to complete a 1031 Exchange and for accredited investors seeking cash flow.

Whether royalties are a good investment alternative for an individual investor or company depends. "You have to understand the modeling of commodities, as well as the oil and gas

"Our investors buy royalties for income...All that matters is Mother Nature and whether or not the oil companies have figured her out." Juan Espinosa, Futura Royalties

production cycle," Faulkner says.

Troy W. Eckard, chief executive officer of Eckard Global LLC, also in Dallas, agrees. "Investors generally hate or avoid the oil and gas industry because they don't understand it. Royalty or mineral acquisitions seem to be the polar opposites of traditional investments in assets such as publicly traded stocks and bonds, which offer easier access to information about the asset."

Royalties are sophisticated investments, suited only for accredited investors. They are attractive because they produce a monthly cash flow without any associated expenses, and 15% of that cash comes tax free due to the depletion allowance. If you purchase a deed to the property involved, it is also 1031-exchange compatible and, of course, transferable to heirs, charity and the like.

Faulkner notes that the price of royalties depends on the commodities markets. "For example, it's difficult right now to buy oil royalties because many people think the price of oil is going up. I, on the other hand, think the price of oil might move down in the second quarter, and natural gas is at a near-term high."

Eckard thinks the prices offered for royalties or minerals definitely are going up. "However, as yet we have no marketplace for mineral owners and royalty owners to market their interest for sale," he says. This limits both sides of the negotiating table, preventing buyers and sellers from determining values in a free-market setting.

"Right now, prices are based upon a small circle of influence or a limited number of prospective buyers," Eckard says. "We need a better mineral and royalty exchange system."

What's hot and what's not

"We follow the money," says Juan Espinosa, chief executive officer of Futura Royalties in Dallas. "For example, almost half of Noble Energy Inc.'s drilling budget is going to the Niobrara shale in Colorado. That's how confident they are in its potential. And they seem to have really cracked the code in that play. The result is that Weld County, in the dead center of the Niobrara, is the only debt-free county in Colorado. The shale is good for Colorado landowners and, therefore, good for our investors."

Futura is bullish about the Niobrara shale and expects to remain heavily involved there. Others focus elsewhere.

"Some investors want to be in the Bakken, in the Eagle Ford, in natural gas—wherever," Faulkner says. "However, we won't buy anything that hasn't matured and reached a flattened decline rate. That's because, during the first 30 to 36 months, these fields lose 75% to 80% of their daily production. It's a hyperbolic decline curve. Year 3 is the buying spot."

Consider, too, the royalty owners' perspective: "In mature basins and geological areas like South Texas, East Texas and the Permian Basin, you'll find wealthier, more experienced, seasoned and maybe more industry-savvy mineral and royalty owners," Eckard says. "They know from experience the long-term value of royalties and mineral ownership and will be less likely to sell unless the price is right."

In the same vein, Espinosa notes, "We anticipate that the not-so-savvy landowners will become much savvier in the years ahead, and brokers are going to start keeping a lot more of the money that's changing hands."

Who's doing the drilling?

Espinosa, Faulkner and Eckard agree that it's crucial to choose properties that are being developed by publicly traded oil companies with deep pockets and a history of success. "The biggest risk in this business is a bad operator," Espinosa says.

"These investments are for 'patient money,'" he says. "If the operator begins drilling today, it will probably take 90 days to drill and complete the well—and six months before you see a check. You sometimes have to wait nine to 12 months for your first check. So you have to consider your opportunity cost, too."

Investment opportunities likely will increase as new shale plays evolve and as new reservoirs in mature basins are tested and proven commercially productive. Meanwhile, technology continues to unlock value in areas that were written off as noncommercial in years past.

Currently, drillers are focused on liquids-rich basins rather than natural gas finds, Eckard notes—as is he. "When it comes to prices, I see an artificial basement and an artificial ceiling for natural gas. Crude oil, on the other hand, is a global product that's subject to global economic influences. In either case, though, it's all about the economics. If the price is right, natural gas can be as financially solid as liquids. And natural gas is an added-value component of many oil plays."

"Drilling is a game of billions, not millions," says Espinosa. "We tell people, 'If you have a net worth of at least $1 million, and you're a sophisticated investor and you're concerned about your nonperforming assets, consider royalties. They're not for everyone. It's an affordable way to play in the big leagues, doing it with thousands of dollars instead of billions. But it's an alternative investment all the way through, and there are lots of charlatans out there, so be careful."

Futura Royalties purchases mineral interests with its own capital. It then offers sophisticated accredited investors the opportunity to become mineral owners by purchasing direct, deeded mineral ownership in "the best shales around," according to Espinosa. "Our investors buy royalties for income...All that matters is Mother Nature and whether or not the oil companies have figured her out," he says.

Breitling Royalties sells direct, deeded ownership in royalties in the form of securities. Eckard Global sells partnerships in pre-structured programs, assignable royalty interests and

individual ventures. Royalties also are available through publicly traded royalty trusts.

"These are not trading vehicles," cautions Espinosa. "Everyone knows how to get in. You get out by selling them in the secondary market."

What does the future hold?

"As commodity prices have increased over time, the demand for royalty investments has increased, narrowing the economics and reducing the potential returns," says Eckard.

In the last five to 10 years, the American energy industry has developed in ways that no one would have imagined, and that is increasing the opportunity to buy royalties.

"Previously, we were a nation of proven geological reservoirs with long-established production trends based upon conventional exploration techniques," Eckard says. "Now, the shale plays have opened vast new areas of virgin territories of new minerals available for buyers. These new evolving trends, basins and shale plays are beginning to set clear parameters for newly developed areas for opportunities for royalty investments.

"Now we are a country discovering millions of new acres of hydrocarbon-rich minerals due to the 'shalevolution.' Our defined mineral inventory of known productive mineral interests is growing by almost immeasurable quantities. However, the royalty and mineral opportunities are still in their infancy for buyers."

He notes that as E&Ps spend the next decade or two developing new ideas, royalty and mineral players who are watchful and well positioned can follow these players like alligators following a wounded bird in a pond. He advises being patient so as to strike when the opportunity meets your need.

"If you put a hundred millionaires in a room and described the nuances of investing in mineral and royalty ownership and the associated risks and rewards, maybe five of those wealthy investors would still be interested in investing," he says.

"Why? Energy investing is not a fad, not a trend, not a solution to a problem when other investments appear less favorable. Investing in energy should be a core investment and should be one in which the investors, regardless of their sophistication, should have a defined action plan working with reputable companies."

Eckard also notes there are some who consider the energy industry to be the greatest shell game in the history of investing. There are so many variables, so many moving parts, and so much of the investment is out of the control of the investor.

On the other hand, he says, some of the greatest wealth in the history of modern investing is due to energy holdings. "This country is seeing its finest hour when it comes to petroleum investing, and those investors who are not timid, not afraid to investigate, and who are not buying into alternative energy will stand to make substantial gains in energy investments going forward.

"The last time I looked, I could not put wind into my gas tank, make plastics out of solar energy, or asphalt our roads from nuclear energy and so on," he says. "Royalties and minerals are the foundation blocks of investments in the petroleum industry—for those who think in decades, not minutes."

And, he notes that in today's investment world, where a long-term hold seems to be buying a stock at 8:30 in the morning and holding the position until 2:30 that same day, "Investors who still hold true to hard assets as the core of a successful portfolio will see royalties and minerals as a logical choice."