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The Relationship Between Time and Money
Though often prudent and far-sighted, even deferred gratification calls for situational analysis. In fact, treating it as a one-size-fits-all financial strategy actually contradicts good financial sense.
October 16, 2008Sponsored by Noble Royalties Inc.
Though often prudent and far-sighted, even deferred gratification calls for situational analysis. In fact, treating it as a one-size-fits-all financial strategy actually contradicts good financial sense. According to the principle behind the time value of money, one dollar today is demonstrably more valuable than two dollars many years in the future, meaning sometimes slow and steady loses the race.
Many of us grasp this concept instinctively. Why, for example, was a recent winning Powerball lottery ticket redeemable for $314 million if the winner was paid over 29 years, but payable for less than half that for a one-time cash lump sum of $145.9 million?
Would a winner who opted for the money up-front be rash and illogical for choosing the instant gratification of a lump prize that paid less than half the annuity option? Or could $145.9 million in hand be worth at least as much as $314 million over three decades? The answer lies in the relationship between time and money.
Mark Wehrle, a registered investment advisor with Austin, Texas-based Davis & Wehrle LLC, explains that while past performance does not guarantee future returns, history bolsters the case for choosing the lump sum. "As far as we are concerned, if a winner in that situation is relatively sophisticated, with an understanding of modern portfolio theory and the importance of diversification, to take an annuity is insane," he says. "A properly invested lump sum could absolutely kill an annuity situation."
Flexibility is another advantage of taking the money up-front, Wehrle continues. "You could flow with the tax code," he says. "If the situation changes with regard to capital gains and income taxes, the portfolio can be adapted. An annuity, on the other hand, is locked in."
Oil and natural gas royalties illustrate the principle of money's relationship to time in a scenario far more common than the one in 146 million chances of hitting the Powerball jackpot. Royalty owners selling their mineral interests at first glance appear to be taking a hit. Even when accounting for inevitable production declines, such royalty transactions generally pay sellers less than what that royalty could pay out for the remainder of its producing life — a concept, economists call discounted cash flow.
Are such sellers simply impatient for accepting a one-time payment equal to, for instance, 84 months of royalty income, when a gradual accumulation of smaller royalty payments may well have paid out more than twice that amount?
Hardly, Wehrle notes. In fact, the reasons behind the decision to sell likely have far more to do with intelligent asset management than impulsive zeal for a big check. And sometimes, he reveals, the reasons for holding a royalty asset tend to be the rationales based on emotion.
After all, while buyers do tend to obtain royalties for a price lower than the asset's possible long-term revenue, they also accept all of the asset's uncertainties. Unpredictable commodities like oil and gas are especially subject to a legion of variables, including risks associated with price, operations, taxes and even geopolitical events. By unloading their production, sellers also unburden themselves of those risks.
Consider the hard numbers reflecting the possibilities with price, to illustrate only one of those many contingencies affecting the value of oil and gas production. Petroleum prices have risen more than sevenfold in the past decade. As recently as 1998, the price for West Texas Intermediate (WTI) crude oil was less than $11 a barrel, but in a decade's time, WTI crude has scaled record-setting peaks, topping $80 billion. Similarly, natural gas at the Henry Hub traded below $2 for 1,000 cubic feet in 1997, but has sold at multiples of three to four times that throughout parts of 2007. While those commodity rates could continue to ascend indefinitely, the cyclical, boom-and-bust history associated with oil and gas prices will lead some sensible investors to take some money off the table and sell.
Furthermore, Wehrle relates that in his experience, the decision not to sell oil and gas royalties is often based on factors other than prudence, explaining that sometimes his clients confuse their loyalty to a loved one with devotion to their mineral interest. "We find that people fall in love with a property and so they question why anything should change," he recounts. "If they are heavily concentrated in a set of inherited royalties, they think their relative would never have wanted them to sell it, and so they fail to diversify. Those people are in real trouble if oil drops back to $15 a barrel."
On the other hand, liquidating a depreciating asset like mineral production allows the seller to redeploy and diversify that freshly freed capital into appreciating assets that will make money in the markets over time. The seller has access to the money immediately and has the opportunity to make more money over the long term instead of holding on to production that will inevitably decline each month.
Wehrle suggests that many shrewd investors tend not to leave most of their eggs in the oil and gas royalty basket. "If you have any type of wherewithal, you can put the money to work in a well diversified portfolio in which you spread the risk and come out miles ahead," he says. "Under normal circumstances, modern portfolio theory says there is no way an investor should have a tremendous proportion of their money in a commodity unless they have a firm understanding of that business."
Mineral acquisition firms like Noble Royalties make it their business to immerse themselves in geology, petroleum engineering, commodity markets and other key disciplines of the oil and gas business. Their grasp of those various aspects, Wehrle suggests, provides such royalty buyers the professional know-how in navigating risks through routes best avoided by laymen.
"Oil is not a mutual fund, stock or bond; it is a commodity and if that is a major part of your income you need to have a lot of geology in your head," Wehrle recommends.
For more information, visit Noble Royalties Inc.