Description

Black Stone Minerals was last written up in 2016, however it continues to generate considerable interest among VIC members. It is not only one of the most interesting and easy-to-understand companies in the energy sector, but when compared to all available investment opportunities across all sectors it is also among those that offers one of the best long term risk-reward opportunities.

BSM stock has plummeted 70% since January 1st of this year, first besieged by natural gas prices falling definitively below $2 per mcf, and later by a worldwide slump in demand for crude oil following the Covid-19 outbreak and the start of an oil price war between Russia and Saudi Arabia, which sent both oil and gas to some of their lowest levels in history. Yet, unlike other energy producers which are burdened by large capex budgets and high debt loads, BSM is only slightly leveraged and has almost no capex commitments. The company is a royalty trust which leases mineral rights to oil and gas producers and receives payment in the form of lease bonuses at the time the lease is signed, as well as a cost-free percentage of revenue from production which averages about 20%. Unless the company opts to participate in a particular project, it is not required to contribute any capital expenditures to the exploration or development of the property and is therefore able to cocoon itself financially during difficult times in a way that most energy companies are unable to do. Capital expenditures in 2020 for example, excluding any acquisitions, will probably amount to no more than $2 or $3 million.

If we include the holdings of non-reporting individuals, management and insiders control more than 30% of the company’s outstanding shares, with the Carter family - Thomas Carter being the current CEO - owning more than 10%. The interests of common unit holders are therefore very much aligned with those of management and the board. Although the dividend has been cut twice in the last few months from its 2019 level of $1.48 and will most likely be cut a third time from its current level of $1, the company has derivative hedges in place for the remainder of 2020 which should put a floor on the distribution at about 45 to 50 cents. In a near worst-case scenario in 2021, with gas at $1.50 and oil at $20, and a 40% cut to production, the dividend is still unlikely to be eliminated completely. Furthermore, there are virtually no realistic scenarios in the foreseeable future under which BSM would generate negative distributable cash flow or be forced to file for bankruptcy protection. Should oil and gas prices return to the levels of 2019, investors in the common units could see a rebound of the unit price into the low teens, which would be a return of 300 to 400% from the current price of $4.19. I will address each of these points individually below.

The Distribution in 2020

First let’s examine the hedges for 2020 and analyze a scenario in which oil trades at $20/bbl and gas at $1.50/mcf for the remainder of the year. Let’s also hypothesize that no lease bonus revenue is generated, and that no new capital investments are made by any of Black Stone’s partners, resulting in a 2020 end-of-year production rate which is 25% less than the production rate at the end of 2019. Given the logarithmic nature of decline rates, total production for all of 2020 would therefore be approximately 15% less than the run-rate production at year-end 2019.

2019 End-of-year Production:

              Oil..........4,550,090 bbls    (Q4 2019 annualized run-rate)

              Gas......73,835,485 mcf    (Q4 2019 annualized run-rate)

2020 Total Production:

              Oil..........3,867,577 bbls

              Gas......62,760,162 mcf

*Assumes a 25% decline in run-rate production by the end of 2020, resulting in a 2020 total production decline of 15% from run-rate production levels at EOY 2019

2020 Production revenue:

              Oil...........3,867,577 bbls x $20/bbl = $77.352 mil

              Gas........62,760,162 mcf x $1.50 = $94.140 mil

Production covered under hedging contracts:

              Oil...........3,360,000 bbls

              Gas.......38,648,649 mcf            (1 mcf = 1.036 MMbtu)

Revenue from hedging contracts*:

      Oil Swaps.........$94.046 mil (630,000 bbl/qtr x 4 qtrs x ($57.32/bbl – $20/bbl))

      Oil Collars.........$30.601 mil (210,000 bbl/qtr x 4 qtrs x ($56.43/bbl – $20/bbl))

      Gas Swaps.......$47.648 mil (10,010,000 MMbtu/qtr x 4 qtrs x ($2.69/MMbtu - $1.50/MMbtu)

Total gain from hedging contracts:   $172.295 million

*Source: 2019 10-K, p.F-23 and Feb 24, 2020 press release

Total Revenue:

      $77.352 mil + $94.140 mil + $172.295 mil = $344 mil

Operating Expenses:*

           Production expenses & ad valorem taxes..........$27 mil (16% of pre-derivative O&G revenue)

           Lease operating Expense...................................$17 mil

           Cash portion of G&A...........................................$32 mil

*Source: Feb 24, 2020 press release

Interest Expense............................................................$14 mil (avg revolver balance $340m at 4%)

Total Operating and Interest Expense:

            $27 mil + $17 mil + $32 mil + 14 mil = $90 mil

 Distributable CF:

            $344 mil - $90 mil = $254 mil

In this scenario, with oil at $20 and gas at $1.50 for the remainder of 2020, the company would end up with approximately $254 million of distributable cash flow. However, the company is also concerned about a possible cut in its borrowing base by up to $325 million over the next several years and would like to maintain the revolver balance at $100 million below this new level. This would imply a target balance on the revolver of $225 million. Since there are no hedges in place for 2021, it is my belief that management would like to pay down at least $125 million of the revolver balance this year, while hedges are in place and cash flow is more certain, with the remaining $50 million to be paid in 2021. In the hypothetical example above, with oil at $20 and gas at $1.50, this would leave about $129 million in distributable cash flow, of which $21 million would be paid to the Series B convertibles. The common distribution in this case would be about $108 million/206 million common units, or a payout in 2020 of about 52 cents. This is, of course, a 50% cut to the current $1.00 distribution.

Below are two tables which show the maximum distribution that could be made to the common unit holders assuming various average realized prices for oil and gas in 2020. Table 1 assumes a drop in production of 15% during 2020 while Table 2 assumes a drop in production of 25% during 2020. In each case, operating expenses and interest expense are the same as those used in the example above. The distribution to common unit holders also assumes that management uses $125 million to pay down the revolver and that $21 million is used to pay the Series B preferred:

TABLE 1

2020 Distribution to Common Units with a 15% Decline in Production from EOY 2019

for Various Realized Prices of Crude Oil and Natural Gas

Assumes: $125 million payment to revolver; $21 million payment to Series B

TABLE 2

2020 Distribution to Common Units with a 25% Decline in Production from EOY 2019

for Various Realized Prices of Crude Oil and Natural Gas

Assumes: $125 million payment to revolver; $21 million payment to Series B

As can be seen from both Tables 1 and 2, the company will have at a minimum 45 to 50 cents available for distribution to unit holders even after paying down the revolver by $125 million. This is the case regardless of how low prices fall in 2020 and regardless of whether there is a 15% or 25% decrease in production.

Second, If we look at how the distribution changes across all prices for oil in both Table 1 and Table 2, which assumes drops in production of 15% and 25% respectively, one can see that the price of natural gas becomes the only meaningful determinant of distributable cash flow for the remainder of 2020. This is because the company’s oil production, in our hypothetical scenario, will have declined to the point where the contract size of existing hedges is between 81% and 87% of the new, decreased level of production. Changes in the price of oil will therefore have little effect on distributable cash flow in 2020. The oil price will become important again when the hedges expire in 2021, but that is quite a while from now.

The Distribution in 2021

Let’s now examine what happens to the distribution in 2021 assuming oil and gas prices remain at $20 and $1.50 respectively while production decreases by an additional 20% YOY for a total decrease of 40% from EOY 2019 levels.

There are no hedges in place for 2021 so revenues would be:

2019 End-of-year Production:

              Oil..............4,550,090 bbls    (Q4 2019 annualized run-rate)

              Gas..........73,835,485 mcf    (Q4 2019 annualized run-rate)

2020 End-of-year Production:     (assumes a 25% decline during 2020)

              Oil...............3,412,568 bbls

              Gas...........55,376,614 mcf

2021 Total Production:         (assumes a 25% decline in 2020 and a further 20% decline in 2021)

              Oil................3,003,060 bbls

              Gas............48,731,420 mcf

2021 Production revenue:

              Oil.................3,003,060 bbls x $20/bbl = $60.061 mil

              Gas.............48,731,420 mcf x $1.50 = $73.097 mil

Total revenue:   $133.158 mil

Operating Expenses:

      Production expenses & ad valorem taxes..........$21 mil (16% of pre-derivative O&G revenue)

      Lease operating Expense...................................$16 mil

      Cash portion of G&A...........................................$30 mil

Interest Expense.......................................................$10 mil (avg revolver balance $250 mil at 4%)

Total Operating and Interest Expense:

            $21 mil + $16 mil + $30 mil + 10 mil = $77 mil

Distributable CF:

            $133 mil - $77 mil = approximately $56 mil

In this scenario, where production declines 40% from the end-of-year levels of 2019, where the company has no derivative hedges in place, and where gas and oil prices remain at $1.50 and $20 respectively for two years, the company would still be able to pay down the revolver as well as make distributions to common unit holders up to a combined total of $35 million, in addition to making the $21 million payment to the Series B. It is important to note that this is an extreme scenario designed to show just how resilient the company’s distributable cash flow would be in a truly depressed environment extending several years into the future.

Bankruptcy Risk is Negligible

Table 3 extends this calculation of the company’s distributable cash flow assuming various realized prices for oil and gas in 2021 and assuming a 40% drop in production below the end-of-year levels of 2019 (a 25% decline in 2020 followed by a 20% decline in 2021). Operating expenses and interest expense are the same as those used in the example above and the company is still assumed to have no hedges in place. Entries in RED are those combinations of oil and gas prices that lead to negative distributable income in 2021, or for which there is insufficient distributable income to cover the $21 million payment to the Series B preferred.  Entries in BLACK are those combinations of oil and gas prices that provide sufficient distributable cash flow to pay down the revolver, pay distributions to common unit holders, or both. As can be seen from the small red section in Table 3, the world would have to witness unimaginably low prices in oil and gas before Black Stone would be unable to pay, at minimum, the Series B preferred. An average oil price of $10/bbl in 2021 combined with an average gas price of $1.25/mcf is not an outcome with a high degree of probability.

TABLE 3

2021 Distributable Cash Flow (in millions) with a 40% Decline in Production

for Various Realized Prices of Crude Oil and Natural Gas

Assumes: no commodity hedges in place

Future Upside Potential

Table 4 shows the upside potential to common unit holders should production return to the pre-Corona virus levels of 2019. Operating expenses and interest expense are the same as for Table 3, however it is also assumed that the company pays down the revolver by an additional $50 million and receives lease bonus revenue of $30 million. The table shows the maximum distribution possible to common units under this set of circumstances for a variety of realized prices for oil and gas in 2021.

TABLE 4

2021 Distribution to Common Units with Production Returning to 2019 Levels for Various Realized Prices of Crude Oil and Natural Gas

Assumes: $50 million payment to revolver; $30 million lease bonus revenue; no commodity hedges in place

As can be seen from Table 4 above, a return to the pre-Corona virus prices and production levels of 2019, which averaged $2.50/mcf for gas and $55/bbl for oil, would allow the company to pay a dividend of about $1.30 per unit, even after paying down the revolver by an additional $50 million. In such a situation, unit holders should see the value of their units increase dramatically into the mid to high teens.

Conclusion

Black Stone Minerals will most likely pay a dividend of at least 45 cents in 2020. Over the next two years, even considering the most dire set of circumstances, there is little risk that the dividend is eliminated completely, and there is virtually no risk of bankruptcy. Should prices of oil and gas recover to the levels of 2019, which saw gas at $2.50 and oil at $55, investors in the common units could see a rebound of the unit price into the low teens from its current level of $4.19 per share, for a return of 300 to 400%.          

Risks:

Oil and gas prices remain at distressed levels for many years and production gradually tapers off to a level at which the company can no longer pay a distribution to common shareholders

Catalyst

A recovery in oil and gas prices