Description

Executive Summary

Viper Energy (VNOM) is a mineral company majority owned by Diamondback Resources (FANG). We believe VNOM has tremendous upside when the world returns to pre-COVID state with one of the best business models in all of energy through mineral ownership. Unlike other mineral companies, VNOM uniquely benefits from its relationship with FANG by accessing FANG’s drilling schedule providing an asymmetric information advantage when acquiring minerals.

Forecasting commodity prices is nearly impossible, but, if you believe that the long-term price of oil >=$50, continued growth of oil demand and the continual improvement in processes for recovering hydrocarbons, then VNOM should handily reward investors willing to tolerate its temporarily leveraged balance sheet and poorly timed hedge book. 

VNOM’s value is dependent on oil prices, but we believe the current valuation does not adequately value the embedded call option associated with minerals ownership. We believe a good indicator of VNOM’s value is the gross book value of its PP&E less cumulative impairments which currently rests at ~$14 per share. With a $50/$2.75 price deck we believe VNOM could distribute >$1.50 (fully taxed) per share, and this is without any production growth.

Minerals – the Ultimate Passive Business

Mineral ownership is the gift that keeps on giving. For an example, let’s look at Sabine Royalty Trust (SBR). SBR was created at the end of 1982. We went back to 1991 to collect the reserve and production data below (as far back as possible using EDGAR). The mineral interest has not changed since 1995 (the earliest dated annual report on EDGAR) and likely not since inception (but we do not have the original report in hand).

You will note two takeaways from the SBR charts below. 1) Reserves are flat over a ~30 year period 2) the volatility in the trust’s cash flows are driven by commodity prices as reflected in the left side of the second chart in the change in cash flows attributable to the change in price. 

Based off the reserve report, the estimated undiscounted cash flows as of 12/31/1993 were calculated to be $140 million. Revenue from FY 1994 to FY 2019 was $1.1 billion and at the end of FY 2019 estimated undiscounted cash flows were $322 million.  

Total SG&A burden since FY 1991 is $54.4 million or 4.5% of total revenue ($1.2 billion) over the same period.

The mineral business is one of the best businesses in the world -- a mailbox business. You only need to show up to the mailbox once a month, grab a check, cash it and then go home.

Active Management of Royalties

We are not arguing a manager cannot add value to a portfolio of minerals but rather the hurdle to add value is very high and most of the time requires sitting on your hands. 

DMLP is a great example of patience. Since FY 2004 DMLP has made five acquisitions -- or one every three years. Their salaries are not measured in the millions and their acquisitions appear to have added substantial value.

Another example is Black Stone Minerals (BSM). BSM has a large staff dedicated to attracting activity to its legacy acreage outside of core basins. As an example, BSM drilled a well using its own capital on its own acreage to de-risk the property for potential operators. Other public companies are not likely to have similar opportunities because they likely would not have bought BSM’s acreage in the first place. See nola’s write up for how BSM acquired most of its acreage.

Viper’s Strategy

There are three factors an acquirer needs to get comfortable with before committing capital to a mineral purchase: the current level of production, expected changes in production and a commodity price outlook. These three factors are then overlaid with the cost of capital to determine a maximum purchase price. 

Viper is uniquely positioned to have the best knowledge on the expected change in production due to their relationship with Diamondback. This results in information asymmetry between the seller and Viper as the buyer. This is not to say the acquisitions are riskless but rather de-risked compared to another buyer (assuming Diamondback’s reserve analysis is accurate). 

Viper has (and will likely in the future) acquired acreage that is not operated by Diamondback. In these cases, Diamondback will have a view on the acreage but will have not have the same information advantages as Diamondback operated properties. 

Why is it hard to evaluate these companies?

• Mineral companies are black boxes that throw off cash
  
  • It is hard to build a bottom-up model given the tens to hundreds of thousands of interests owned by any one mineral company. The quantity of information is voluminous, and frankly, the quality (potential title issues) can be poor which makes it nearly impossible to determine a precise valuation. Most private mineral buyers enjoy a higher quality of information when they purchase an interest. In the public markets, this level of information is unobtainable.
• Net Royalties Acres are not fungible
  
  • In our opinion, it is not a worthwhile exercise to look at net royalty acres across companies because each NRA can have massive variations in value. The most glaring example of quality difference in NRA’s is evidenced by BSM. BSM owns millions of net royalty acres that are worthless in today’s commodity price environment. Further, NRA’s with a basin can vary wildly in value. So, an investor cannot heavily weight NRA’s when determining the value of a mineral portfolio.
• Reliant on operator activity
  • Production drives cashflow and mineral companies are not in control of their production levels. This creates uncertainty as to how much production a mineral company will record from quarter to quarter. Mineral companies tend to have a dividend focused shareholder base, thus creating issues around the uncertainty associated with production. 

How can one evaluate the industry?

We propose some good old’ fashioned ratio analysis with the base line assumption that management will compensate for the quality of acreage by what they are willing to pay for it. 

We focus on Gross PP&E rather than Net PP&E. Most mineral interests are PERPETURAL claims. GAAP does not depreciate land because it is perpetual (it is subject to an impairment analysis). Yes, there are only so many hydrocarbons in the ground, but look at the reserves of high-quality acreage and/or well-managed mineral interests over time. Reserves are relatively flat due to upward revisions from previous estimates which typically compensate for most of the production (and sometimes more than). 

The true value of minerals will be tied to commodity prices, but when prices are at cycle lows, this approach provides another anchor to reasonably value these companies when cashflow is depressed.

Given our view, we use gross PP&E as the capital denominator to evaluate management’s ability to deploy capital. We compare production to PP&E, benchmark strategies by looking at the mix of PP&E subject to depletion and PP&E not subject to depletion, and cumulative impairment to PP&E. This exercise is an attempt to avoid empire builders and find out the quality of underlying properties.

Production to Gross PP&E

A higher production to gross PP&E is indicative of high reserve mineral interests acquired cheaply. Second takeaway is the volatility of a given production stream. VNOM and MNRL have higher volatility which is likely a result of their higher exposure to newer wells.

One can dive further down and look at BOE production per Depletable Gross PP&E (i.e., acreage that has begun to produce). Unsurprisingly, all mineral companies are seeing declines in production for 2020. VNOM saw a major decline in production in 2020 as a result of Diamondback pulling back on new wells. Shale wells have a high initial production with steep decline curves before maturing (i.e., lower declines at lower production levels). Diamondback is prioritizing VNOM acreage in 2H 2020 and should see production growth in 2H compared to 1H.

Below is a look at royalty revenue as % of Depletable Gross PP&E. This chart considers the economic difference between natural gas and oil. It is directly impacted by commodity prices. Note these figures are not annualized.

Strategy 

To overly generalize there are two basic schools of thought when buying minerals. One, buy ahead of the drill bit which attempts to buy mineral interest before the owner realizes there is about to be an increase in production. This strategy requires a fair amount of work to find permits and then track down who owns the permitted interest and attempt to buy it from them. The second strategy is to buy cash flow from existing production which typically comes with less risk and can trade at healthier multiples.

To highlight the difference in acquisition strategies we look at PP&E broken down by subject to depletion/evaluated (i.e. producing) and NOT subject to depletion/unevaluated (i.e., not producing).

VNOM has the most property NOT subject to depletion which goes hand in hand with their unique competitive advantage in knowing FANG’s drilling schedule. This advantage, along with a historically inflated currency, led VNOM to take increased risk and acquire unproven properties.

Cumulative Impairment to PP&E

Impairment typically comes when there is a change in the level of commodity prices. Reading the filings for disclosure on the drivers of an impairment charge is vital. Specifically, we search for any discussion of operational performance in impairment explanations and impairments when commodity prices are strong or flat. Operationally, issues or revised production should cause one to question the quality of the acreage. It is worth noting that a few of the public mineral companies are only now going through their first commodity cycle.

VNOM did call out in their Q that impairment is tested using TTM commodity prices and could record an impairment going forward. Q2 2020 TTM WTI average was ~$47. Q3 will be around $43, and if oil stays at $40 for the rest of the year, then Q4 will likely be around $39.

Return on Capital

We use funds from Operations (ex-SBC) [Cash flow from operations less SBC less WC changes] over gross property values. It’s worth noting that even in Q2 2020 -- the worst environment for oil in history (negative oil prices) -- these companies generated cash flow.

You will notice these companies returns on capital are highly correlated to commodity prices.

Commodity Prices

Any conversations about commodity prices get muddle quickly because there are second, third, fourth and fifth derivates to any change. Commodity markets are extremely complex. So, without prognosticating the path of prices, we are comfortable that in 2-3 years the price of oil will be >$50 with the potential to spike, for a period, to >$70.

Now, ignore our forecast, and look at the Dallas Federal Reserve Energy Survey where they ask energy executives what price is needed for rigs to return to drilling. 

We would also note that we find far too few oil field service companies earn an economic profit or even their cost of capital. Medium- to longer-term well cost inflation will come into play, and higher commodity prices will be needed to offset increased capital costs. Well cost inflation benefits the mineral owner as it supports commodity prices.

Valuations

The issue that always comes up whenever we talk with a private mineral buyer about the public companies is, “How do you value them with any confidence?” 

Historically, and we believe currently, the market values these equities on a cash-flow yield. This led to some lofty valuations when commodity prices were higher and production growth was the name of the game. As a result, the market assigned a massive premium to mineral interests creating a private-to-public arbitrage. For a period, the market was paying $3.50 of EV for every $1 dollar that VNOM deployed. This created an incentive for many public companies to “consolidate” and participate in M&A.

Ultimately, we believe these equities will trade with a distribution yield, but we are comfortable using our Adjusted Gross PP&E per share to guide valuation as we pass through the lows in the commodity price cycle.

Pushback

• Shale is a broken business model
  • Like all commodities, there is a price at which extraction and recovery of natural resources works or doesn’t. US Shale represents high single digit share of global oil supply. It’s hard to remove that much supply and not see a response in prices.
  • We gain further comfort in VNOM’s acreage. The quality of reserves in the Delaware is not as high as the Midland Basin, but it is superior to anything in Oklahoma and many other shale plays. This should enable VNOM to see continued drilling on their non-Diamondback operated properties in the future.
  • If/when consolidations occur at the operator level it should result in more disciplined capital spending. This will lead to lower production levels/growth but higher commodity prices. The net effect will be negligible to PV of cash flows as lower production is offset by higher prices. Should Diamondback look to be a consolidator, then it opens up mineral opportunities for VNOM.
• Isn’t this just a play on higher oil prices?
  • Yes - $40 oil is not sustainable long-term. Minerals are perpetual interests and well suited for a play on any recovery.
• Electric vehicles and peak oil demand
  • If you believe we have hit peak oil, then we are shocked you made it this far into the write up. Kudos. Take a look at this table https://www.worldometers.info/oil/oil-consumption-by-country/. We have a hard time seeing how China and India do not see increased demand for oil as these populations increasingly seek lifestyles closer to North American or European countries.
  • We wrote up our thoughts on the constraints to EV penetration in our ORLY write up. Our thoughts have not materially changed.
• Energy just goes down every day. Why would you want to own it?
  • Hope

Noteworthy Items

Hedge book – VNOM hedged commodity prices at the lows. Below is the hedge book as of 6/30/2020

SG&A – VNOM maintains the lowest cost SG&A of the peer group on a BOE basis. Ideally SG&A would be a single digit % of royalty revenue but that isn’t the case for most in the space. 

Debt – 

Bank Debt - $153.5 million with total borrowing base of $580 million (down from $775 million in Q1). Q2 weighted average interest rate on bank debt was 2.41%

5.375% Senior Notes Due 2027 - $479.9 outstanding at 6/30/2020. VNOM repurchased some of these notes in Q2 at a slight discount to par. The bonds currently trade above par. 

Catalyst

Oil