The coronavirus outbreak has created a huge dent in near-term oil demand and triggered a meltdown for commodity prices. The market appears to be extrapolating the current oil environment to infinity, and that doesn’t make any sense: Shale still accounts for over 10% of the global supply stack, and unless prices rebound to encourage drilling, the painful glut will eventually become a shortage. As a result, oil stocks are cheap. Our top upstream pick, Diamondback Energy FANG, hasn’t traded at this level since shortly after its 2012 initial public offering, and its publicly traded mineral rights subsidiary, Viper Energy Partners VNOM, has reached an all-time low.
Both are pure plays on some of the best U.S. shale acreage. Diamondback checks many of the boxes for investors, with a strong balance sheet, an underappreciated narrow economic moat, and an increasingly prominent focus on free cash flow and environmental, social, and governance concerns. Viper presents an attractive way to piggyback on Diamondback’s attractive Permian acreage. Diamondback is the operator on over 50% of Viper’s acreage and offers exposure to a mineral rights market that could double in size with potential for further upside. Viper is the industry leader in consolidating the royalties market, having spent $2.4 billion in acquiring rights in the past few years.
What are the key differences between Diamondback and Viper? Each investment has its own merits, in our view. Diamondback’s operator position means it ultimately has extensive control over its own future, while Viper depends on its operators’ decisions. Diamondback also offers higher levels of hedging, reducing near-term uncertainty. On the other hand, Viper offers a higher dividend yield with the potential for significant increases as we expect it will shift back to paying out near 100% of distributable cash flow once the crisis passes. We think this makes Viper more suitable for investors who value yield and dividends.
Diamondback Cheap for Best-in-Class Narrow-Moat E&P With West Texas Intermediate prices at $25 a barrel, well below our midcycle forecast of $55, Diamondback trades at a more than 50% discount to our fair value estimate. Investor confidence and sentiment with regard to the oil and gas space is miserable, contributing to a decline in the overall energy weighting in the S&P 500 to around 4% at the end of 2019, and likely materially lower today, from 15% a decade earlier. Behind the decline is a lack of investor confidence in the space, given the propensity for write-downs and broken promises regarding free cash flow generation. We think investors are focused on three issues in 2020:
- COVID-19 destroying near-term oil demand, as well as the OPEC+ breakdown, which is raising balance sheet concerns. The spread of COVID-19 has also damped China's oil demand expectations.
- Confidence in capital spending discipline by exploration and production companies, especially with oil prices significantly below our long-term $55 price deck. This speaks to the lack of investors' confidence in the industry being able to generate free cash flow on a sustainable basis, supporting a reasonable level of capital returns to investors.
- ESG concerns, as this is a top focus area for investors, particularly around emissions.
We think these concerns have given investors an opportunity to buy Diamondback at a sharp discount.
In an industry often characterized by large amounts of capital vaporization, Diamondback has generally maintained a strong balance sheet, highlighted by its ability to easily fund its ongoing capital commitments while maintaining a peer-leading recycle ratio, our preferred metric for operating efficiency. Despite Armageddon crude prices thus far in 2020, we think Diamondback can more or less live within cash flows, thanks to its ultralow cost structure and management’s willingness to take action very quickly; Diamondback was one of the first companies to announce big spending cuts after crude prices initially collapsed in March 2019.
With ESG issues gaining traction with the oil and gas industry, numerous asset managers are simply excluding oil and gas investments from their portfolios. Broadly, there have been growing concerns around developing oil and gas in a safe and responsible manner, while minimizing the environment impact and addressing concerns of stakeholders such as indigenous tribes. Unsurprisingly, Diamondback is given an ESG Risk Rating of Severe by Sustainalytics. In turn, Diamondback has announced several corporate initiatives around sustainability, including a focus on energy intensity, water management, diversity, health and safety, and community engagement. The company also, in what we believe is an industry first, explicitly linked management compensation to ESG, with a planned weighting of 10%-15%. ESG metrics include flaring, greenhouse gas emissions, and recycled water.
We think flaring is one of the more high-profile issues in the Permian at the moment, especially given the shortage of gas takeaway capacity from the region, which has caused some producers to increase flaring levels. According to the Texas Railroad Commission, the volume-weighted industry benchmark for flaring intensity is 0.10 thousand cubic feet per barre. Texas as a whole does better than the world average, which is 0.14 mcf/bbl, and North Dakota, which is 0.32 mcf/bbl. Diamondback is an average performer on this metric, suggesting that it has room for improvement to be perceived as an ESG leader in the industry. We think the easiest way to improve on this point will be to wait for new infrastructure, namely the Permian Highway (2.1 billion cubic feet per day) to come on line in 2021. Other options include shutting in wells with high flaring intensity (at the cost of reducing oil production as well) and establishing regulatory benchmarks for flaring intensity.
We think a significant point of confusion for investors is Diamondback’s economic moat. Diamondback earns a narrow economic moat based on cost advantage derived from its extremely attractive acreage, where its 2020 combined lifting and drilling costs are about 30% lower than our coverage median, supporting per barrel of oil equivalent margins of just over $4 compared with a loss for our E&P coverage. Diamondback’s forecast 2024 returns on invested capital are about 8.7%, sharply higher than the median 6.3% for our coverage. Further, Diamondback has at least a decade of drilling activity in Tier 1 acreage, ensuring strong returns for the foreseeable future. In an environment where E&Ps are increasingly stressed and declaring bankruptcy, Diamondback’s financial health and outlook allow it to easily cover its obligations over the next few years.
Viper's Differentiated Business Model Has Better Economics Than E&Ps Viper Energy Partners operates a highly differentiated business model that we believe is generally ignored as investors shun the energy space. It owns mineral rights in perpetuity to Permian Basin acreage that generates royalties with no need to invest capital to support drilling activity. Viper is paid a percentage of the revenue the producer generates from drilling a well, and revenue fluctuates with oil prices. Viper typically does not hedge (it has put on hedges in 2020). The only costs Viper incurs are production-related taxes, general and administrative costs, and depletion expense. Operators, like Viper's parent, Diamondback, lease the drilling rights, and Viper avoids taking working interest in wells, avoiding any portion of well operating and capital costs. The result is a capital-light and highly profitable business in the notoriously capital-intensive oil and gas industry.
The bulk of Viper’s interests are mineral interests, which are the most valuable as the rights extend into perpetuity. In contrast, working interests are the least profitable type of ownership, as the owners are responsible for their proportional contribution to the overall well capital and operating costs over the life of a relatively short drilling lease (three to five years).
Mineral rights companies typically generate operating margins of 90% or more, as they are not responsible for capital, operational, environment, and abandonment costs. It is also important to distinguish Viper from a royalty trust. Royalty trusts will typically pay out income over time based on production from a declining asset and eventually cease to exist, whereas Viper can reinvest part of its income in new mineral rights to increase its royalty income over time.
Given Viper’s structurally more profitable and asset-light business model, we think it deserves a premium valuation to the typical midstream company. The company earns 90% cash margins and has no capital spending requirements. Further, much of Viper’s mineral rights last forever. In a scenario where one producer might halt drilling activity on Viper acreage due to lack of capital or better returns elsewhere, Viper would be free to collect royalties four to five years later when the economics improve.
Viper has essentially hedged all of its expected 2020 oil production at prices between $29 and $32 per barrel. It has also hedged the majority of 2021 oil production and will pay out only 25% of distributable cash flows for the time being. The shift was driven to maintain compliance with its credit agreement covenants (specifically the 4 times debt/EBITDA ratio), as a fully unhedged Viper would be more at risk. We would expect Viper to return to paying out nearly 100% of its distributable cash flow as the crisis passes and oil prices recover.
Viper’s capital allocation approach is strong, in our view. Viper’s acquisitions of acreage have been supercharged by subsequent increases in well productivity as new and highly productive wells were drilled on Viper acreage by Diamondback. Well productivity has improved severalfold since late 2013, when Viper first began making acquisitions, and more than 50% from 2016-19, a period of heavy Viper acquisition activity. The productivity improvement has essentially meant that greater cash flows have accrued to Viper with no incremental capital spending required, an extremely attractive scenario. For example, we estimate one of Viper’s earliest blocks of acquired acreage was generating about $65 million in cash and purchased for $440 million, a 15% yield. This acreage today has generated about $130 million in cash for nearly a 30% cash yield.
Our $17 fair value estimate implies a 16 times 2020 EBITDA multiple, and our 2020 distribution yield would be 2%. We continue to expect cash margins of around 90%. We do expect production to decline in 2021 alongside parent Diamondback’s production but resume growth in 2022.
Viper unitholders also benefit from Diamondback’s intangible drilling tax credit, as this shields their distribution payment from taxes. This was part of the $300 million agreement to allocate Diamondback priority allocation of Viper’s operating income granted as part of the “check the box” decision to adopt a corporate tax status. This means Viper will issue a 1099, reducing tax complexity for unitholders and allowing for a wider base of investors.
Finally, Viper also benefits when parent Diamondback makes acquisitions, as they typically come with mineral rights that can be dropped down to Viper over time. Looking at several of its past major deals, we can see Diamondback’s ability to deploy capital wisely but also create new opportunities for Viper to acquire additional acreage. We expect more opportunities to arise in the future, as Diamondback can obtain multiples in the 10-20 times range for its interests versus its own stock’s lower multiple.
Why Are Mineral Rights So Valuable? There are six major types of mineral and royalty interests in the United States.
Mineral rights. These are perpetual interests in oil and natural gas ownership for a parcel of land and represent the right to drill and produce hydrocarbons. These rights are leased to an oil and gas company in exchange for a bonus payment and a percentage of revenue (typically 20%-25%) generated from production activity. Mineral rights are considered real property interests and are thus higher in the capital stack than senior secured debt and equity. Once a lease has expired, the mineral rights owner is free to re-lease it in the future. These rights make up 88% of Viper's assets.
Nonparticipating royalty interests. These are claims on mineral rights that also offer a perpetual right to receive a fixed percentage of production revenue without the up-front bonus.
Overriding royalty interests. These are royalty interests attached to a lease of the land, with the percentage of production revenue royalty limited to the life of the lease. Twelve percent of Viper's assets, of which 61% are operated by Diamondback, fall into this category.
Volumetric production payment. This is a structured payment based on a specific volume of production across a specified time frame.
Net profit interest. Royalty payments are made based on the profitability of a defined acreage, which exposes the owner to operating and capital costs, usually over a specified time frame.
Working interest. While an oil and gas operator will lease the drilling rights to acreage, a working interest allows the operator to share its capital costs among multiple parties, each of which are thus responsible for their proportional capital, operating, royalty, environmental, and abandonment costs. This is typically the length of the lease, which can be three to five years.
Estimating the size of the U.S. oil and gas royalty market can be challenging, given the relatively limited data available. Kimbell Royalty Partners puts the national mineral market valuation at an overstated $500 billion-$550 billion, implying about $50 billion in private market royalties being paid annually. However, we think its approach, which uses spot market prices and oil and gas production as of early 2020, a 20% royalty figure, and a 10 times cash flow multiple, is flawed. We don’t think investors are taking the unrealistic estimate seriously, but even using more realistic numbers suggests there is substantial growth available that investors are not pricing into Viper’s valuation.
We think the assumed 20% royalty ignores a more practical reality, as royalty companies very rarely can obtain the full 20% royalty on any given acreage. For example, Viper’s net royalty rate is close to 4%, and Black Stone Minerals’ is 3%. This reduction is because royalty streams are sold off to other owners over time, splitting the full 20% among multiple parties, and the royalties paid can be reduced substantially after taking out producer fees.
Our estimates are built off a more comprehensive industry study. Like Kimbell, we assume current production levels, but we assume a long-term price deck of $55 per barrel for WTI crude. We also agree with Kimbell regarding 20% of the market being federal royalty payments, while noting that private market buyers could whittle federal market share down over time.
Industry and Viper Have a Lot of Room to Grow We see the biggest challenge in achieving Kimbell's projected $500 billion market size is obtaining the full average net royalty rate of 20% nationally, which assumes that all private owners will eventually sell their ownership to professionally run mineral rights companies either public or privately owned. Instead, we assume a net royalty rate of about 8%, implying a rough doubling from the current levels of two of the largest mineral rights owners. This values the market at 40% of Kimbell's expected $500 billion: around $200 billion.
We believe that obtaining higher royalty rates, specifically close to 20% over time, will prove to be extremely difficult. Despite the difficulty, we don’t think Viper needs to reach anywhere close to 20% to be materially undervalued. First, we believe most of the mineral rights transactions in the industry take place after large mailing campaigns on the part of the mineral rights company, either analog (physically mailing the owner) or digital (via email) after building lists acquired from various ownership groups and organizations. We believe only the larger companies like Viper and Black Stone Minerals actually employ landmen to build and source relationships with owners of larger blocks of mineral rights for transactions. Despite the more efficient process for sourcing mineral rights, net royalty rates have remained low, reflecting the deeply fragmented nature of the market where each royalty is split among multiple owners. We think there are challenges here in terms of identifying the owners holding the rights, as well as finding owners willing to sell, as we suspect the acreage is often tied to family legacies and inheritances where there is a substantial emotional component to any sale of rights. As a result, our 8% assumption reflects a higher willingness to sell and improved discovery techniques over time at the professional mineral rights companies, but represents a sharp discount to the full 20% rate, which would assume that all private mineral rights shift ownership to professional companies.
Private Equity Interest Is Increasing For Viper investors, the key takeaway from increased private equity interest is that other investors are seeing the attractive investment opportunity with mineral rights and legitimizing it, as the numbers are still too small to represent material competition to boost rights pricing. We estimate that about $10 billion in capital has been invested in the space since 2012, with major backers that include Blackstone Infrastructure Partners, Quantum Energy Partners, EnCap Investments, and the Canadian Pension Plan Investment Board. Several mineral acquisitions have had private equity backers.
Public mineral interests companies have been ramping up spending as well. While private equity firms and other institutional investors have been investing about $1 billion annually, Viper spent over $1 billion itself in 2019 (excluding the transaction for private-equity-backed Santa Elena Minerals) and has spent $2.4 billion in total since 2014. Black Stone Minerals has spent nearly $1 billion over the same period to acquire mineral interests.
Reviewing major investment activity across the space over the last few years, we believe it is relatively concentrated, with 70% of the $8.2 billion in private investment activity confined to just five groups of players. However, public entities have also been putting sizable amounts of capital into the space as well, with Kimbell, Viper, and Black Stone Minerals investing a combined $4.1 billion in mineral rights since 2014.
PitchBook data also shows increased interest in energy infrastructure assets, in terms of capital invested since 2014, and we expect capital invested in the broader space could reach new highs. We think this data supports a broader interest by private equity players in the mineral rights space more specifically as well. It validates our earlier comments regarding the attractive nature of the space, but it is not enough to represent material competition.
Public Mineral Rights Firms Retain Advantages Over Private Equity Backers While private equity and other institutional capital investment represent viable competition for mineral rights acquisitions, the amount of capital being invested by institutional investors to date ($10 billion) is relatively small. This suggests some challenges in terms of raising funds specifically focused on such a niche market, finding management teams with relevant expertise, and somewhat high search costs in terms of locating viable investments (using landmen or mailing campaigns).
Spending by public mineral rights companies can easily exceed private capital investment, suggesting a potential advantage in terms of access to capital markets (both debt and ease of issuing equity), plus the added advantage of a preference by some mineral rights sellers for taking equity as payment. Public companies do not appear in danger of being crowded out of the market by private buyers. We think equity could be a preferred currency, particularly if the mineral rights are generating income, and the seller can replace the income generated from the mineral rights with a steady stream of dividend income.
There is interest and success in terms of private equity firms creating mineral rights companies to take public. Falcon Minerals was recently created via reverse merger to hold Royal Resources’ mineral interests that were acquired by Blackstone Infrastructure Partners over time. Brigham Minerals is a recent IPO backed by initial funding from Pine Brook Partners, Yorktown Partners, and Warburg Pincus. If the stock prices perform well, the private equity backers might have incentive to invest more, but the stock performance to date (more than 50% decline for Falcon and nearly 40% decrease for Brigham) might be a disincentive.
Weighing the Pros and Cons of Mineral Rights The mineral rights model offers substantial advantages over the traditional oil and gas operator model, but there are disadvantages as well.
Mineral rights companies do not have operational control over well drilling activities, which means if the drilling operator has capital issues, or if the acreage is not very economic under current oil and gas prices, it won’t be drilled and thus will not flow royalties. This lack of control extends to midstream assets and parts of the production process. Viper is wholly dependent on other parties to build the assets, address challenges where they occur, and pay royalties.
Mineral rights companies depend on outstanding capital allocation. Nearly all of the value creation in the mineral rights space comes from being able to acquire valuable mineral rights for less than they are worth. Similarly, the companies depend on capital markets access to fund acquisitions, including a reasonably healthy stock price.
Mineral rights companies are exposed to the simple reality of earning royalties on a depleting asset. While they are not responsible for any capital expenditures or operational costs associated with maintaining the asset over its useful life, they need to pursue acquisitions of new mineral rights in order to increase production and shareholder value over time. The position of the mineral rights on the overall U.S. cost curve matters as well, as mineral rights on acreage that is uneconomic to drill are worth less than rights to more economic areas.
Viper's Model Aims to Mitigate Issues With Royalty Model Viper's relationship with Diamondback offers a significant advantage by reducing the uncertainty around the timing of future royalties. Diamondback is the operator on over 50% of the acreage where Viper owns mineral rights. Further, Diamondback owns about 64% of Viper's units. The close ties between the two companies, which also share management teams, mean Diamondback has economic incentive to drill acreage where Viper owns the mineral rights first, as it captures its part ownership of the royalties. As a result, it's no surprise that Viper acreage is prioritized on Diamondback's drilling schedule. The prioritization means that Viper is in a better position versus peers that have to deal with the lack of control over when the wells might be drilled and thus generate royalties.
A large chunk of existing and expected value creation in the mineral rights space, and particularly with Viper and Diamondback, is accrued via strong capital allocation. Both companies have exemplary stewardship. Diamondback has grown very rapidly over the last few years while keeping a clean balance sheet and impressively low per unit costs. Viper’s mineral rights model has focused on increasing production on a per unit basis while maintaining a strong balance sheet. We also look favorably on its recent decision to undergo a “check the box” conversion to a corporate tax status.
Peers own mineral rights across a variety of U.S. basins. In contrast, Viper is focused the Permian, which is the lowest-cost U.S. shale basin on the cost curve with expected costs as low as $30 a barrel. While this does not absolve Viper of the need to replace acreage where production is in decline, it does remove a layer of risk regarding the acreage becoming uneconomic over time.
How Does a Generalist Investor Pick Between Diamondback and Viper? Each investment has its own merits, in our view. Diamondback's operator position means it ultimately has extensive control over its own future, while Viper depends on its operators' decisions. Diamondback also offers higher levels of hedging, reducing near-term uncertainty. On the other hand, Viper offers a greater dividend yield with the potential for significant increases as we expect Viper will shift back to paying out nearly 100% of distributable cash flow once the crisis passes. We think this makes Viper more suitable for investors who value yield and dividends.
On the capital cost side, Diamondback is investing $1.8 billion in 2020 to produce an estimated 299,000 boe/d, while Viper would need to invest nothing to receive royalties from its mineral rights leases linked to Diamondback acreage. This dynamic results in Viper retaining 100% of its midcycle operating cash flow for returning to shareholders if desired, while Diamondback only retains 33% by our estimates. The lower levels of capital intensity allow for free cash flow generation throughout the cycle, as well as the ability to increase profits over time without a corresponding increase in investment.
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