Description

Summary:

We own a fair number of MLPs (despite the K-1 hassles) and have been following/invested in BSM on-and-off since its IPO in 2015.  The three VIC BSM writeups between 2016-2020 provide very useful history and significant detail on some of the key plays, etc. and were relevant to my continued interest in this name.  The 2020 pandemic-crisis writeups were especially timely.  The point of this writeup is to put the idea back on the front burner for those who know the name, introduce the name to the many new members who have joined since the prior writeups and-- for both audiences-- to describe in particular the current setup as I think now is again a very good entry point with a very positive risk/reward over the next 6 quarters.  In essence, I think there is another leg that should play out in the short-to-medium-term, given the combination of an imminent turnaround in production growth + locked-in significant increase in cash flow from the hedging program.  

Short Background/Description for those new to BSM:

1. What does a mineral royalty company do or how is it different than a garden variety E&P?

Mineral royalty companies like BSM own the minerals below the surface of a tract of land and have the right to extract the minerals (in this case oil/natural gas) from below the surface.  Mineral royalty companies like Blackstone then lease the mineral rights to a 3rd party who is responsible for the capex and ongoing costs.  In Blackstone’s case, they still have a small “working interest” business in which they share in the costs associated with drilling and operating the wells in that business, but this is only approximately 10% of their production volumes currently; the ~90% of their business (that is, the royalty business) has little to no capex and operating costs.  The lease terms essentially provide for the mineral rights owner, BSM, to receive a royalty on production revenues. 

2. Where is BSM’s acreage?

Black Stone Minerals (BSM) is a natural-gas weighted mineral royalty MLP (as an aside, because of the K-1s, you don’t want to own this in your IRA).  It owns a vast acreage position of over 20 million acres primarily in the Permian, Haynesville & Bakken.  

Here’s a helpful snapshot of the company’s acreage that gives you a sense for the breadth of the holdings as well as some of the concentrations (though note that this is from a presentation from March of this year, so some of the data in red below the map is out-of-date):

One significant advantage in the current environment is that a significant chunk of BSM’s acreage (in particular the Haynesville/Bossier) is located within easy transport distance to gulf coast LNG facilities.  This is a relative advantage because other operators are having some trouble accessing pipeline transport and because of the significant uptick in demand for LNG globally, esp. Europe.

Recent Financial metrics

1. Recent production history:

BSM’s production hit 50,000 BOE/d in 2019, but is now around 34,000 BOE/d.  This occurred for several reasons: 1) curtailment of non-operating wells; 2) sale of some assets (Permian) to reduce debt in 2020; 3) pandemic-related industry-wide reduction in capex.

2. Significant Balance Sheet improvement over the last 3 years:

DEBT 4q19 1q20 2q20 3q20 4q20 1q21 2q21 3q21 4q21 1q22 2q22

($$MM) 394 388 323 147 121 111 96 99 89 69 86

There was a big downtick in 2020 related to a substantial asset sale; otherwise, there has been some further debt paydown from  FCF generation that has come from paying out less than 100 percent of its distributable cash flow.  (Last quarter coverage was 1.2x, for example)

Current setup: downside versus the upside case: 

1. Downside risk seems low with a current distribution yield of ~11.5%.  BSM has an aggressive hedging plan in place, so the current distribution is being generated even though  ~70 percent of its production was hedged in at around $66 oil and $3 gas approximately one year ago.  If oil prices fall dramatically over the next 6 quarters such that BSM’s 2024 commodity realizations retrace to $66/$3 (a substantial portion of 2023 production is already hedged at nearly $5 for gas and $85-ish for oil) in 2023, there should not be much diminution in the distribution given that the current distribution is being generated with such a large percentage of production hedged so far below the strip.

Put another way, even if commodity prices fall dramatically such that BSM is forced to return to 30 cent/quarter dividends (or thereabouts) for 2024/2025, maybe the unit price goes to $12 (10% yield).  But in the meantime (the next six quarters), you collect distributions of approximately $2.98.  So, from today’s level, a downside case results in a wash. 

2. Upside case:

a. Unit pricing is off ~16% over the last six weeks likely caused by the oil price retreat from $122 to $92 (-24 percent) & temporary dip in natural gas price (now mostly retraced).

b. Production growth temporarily lower than planned due to 3rd party delays.  Slope of growth should pick up as delays resolved.  15-20% production growth expected over the next 6 quarters, much of this contracted.  

1. One of the core reasons for the positive growth outlook is the partnership with Aethon Energy.  Aethon will increase its rate from 15 wells drilled in the 2022 year (ending September) to 25 wells drilled for 9/2023 and then to 27 wells drilled for 9/ 2024.  Renewing or expanding this partnership has a strong chance of occurring.  Recent chatter about Aethon going public (see: https://www.bloomberg.com/news/articles/2022-06-17/gas-producer-aethon-said-to-mull-ipo-at-10-billion-plus-value#:~:text=Aethon%20Energy%20Management%2C%20a%20closely,people%20familiar%20with%20the%20matter) would be a boost as well, since it would give Aethon additional access to capital.

2. XTO (Part of Exxon Mobil) is also resuming drilling.  Management gave a little color on this in the recent conf call: “lo and behold XTO is back out there in San Augustine, as well on our acreage for three wells this year and possibly more going forward”.

3. In the Permian, the qualitative information is also positive: “We've recently seen new deals in some of our highest interest lands in the Pecos and Reeves County area and expect increasing drilling activity and production growth there as well.” 

4. Lastly, the Austin Chalk has the potential to boost the growth curve even further.  Here is what management said about this basin, including reporting on a very large well recently drilled there:  “the Austin Chalk play was summarized via a very positive report by Enverus on June 29. And the exciting part of that is that, the report didn't include the last well out there, that's flowing at 2,200 barrels of oil per day and almost 12 million cubic feet of gas per day. That is a monster well by any standard and is part of the reason we're excited about our prospects out there.

Some additional quotes from the short (25 minute) 2Q call that support the imminent inflection in the production growth profile (emphasis added):

“So, we feel great about our volumes as we move from this last cycle forward. The plays are there, the operators are there, the economics are there, and we will grow production.”

“we see that [the production decline from 2019-early 2022] as in the rearview mirror with new and old operators spooling back up strongly and revival plays [Austin Chalk] looking very promising”

“Assuming the macro environment stays constructive and our key operators in the Shelby Trough and Austin Chalk deliver on their stated and mostly contractual plans, we expect to grow production through 2023 and exit next year at close to 40,000 BOE per day”

“So even, if production levels stayed flat from 2022 to 2023, which of course is not our expectation, that would imply over $50 million of incremental distributable cash flow next year” [this is approximately 6c/unit/quarter]

“we anticipate that the area [Shelby Trough] will spool back up quickly. We've also seen volumes trend up in the Louisiana side of the Haynesville play, driven by our efforts to strike accelerated development deals, with operators like Comstock…”

“we are working towards contractual well commitments on our acreage [in the Austin chalk] delivering a strong line of sight to 25 to 30 wells per year spud over the next 12 months.”

So, in short, I like the setup here as-- aside from a truly draconian commodity scenario-- the downside is maybe breakeven-ish, given the bult in DCF from the hedging program over the next 6 quarters, whereas the upside, given probability of core production growth + further upside from Austin Chalk, could provide 10-20% return on top of a ~11.5% (and increasing) distribution yield.  Needless to say, there is also the potential for significant upside should the “higher-for-longer” thesis on natural gas prices come to pass.  Put another way, I think you get the upside case of production growth and/or “higher for longer” commodity price deck for free.

Note: For those concerned about hydrocarbons getting phased out, even the most ardent believers in renewables seem to indicate that domestic demand for natural gas will not begin to decline until around 2035.  And, most seem to indicate that export of natural gas (LNG) will continue to rise, even beyond 2035.  See, among other resources:

https://www.mckinsey.com/industries/electric-power-and-natural-gas/our-insights/the-future-of-natural-gas-in-north-america

https://www.csis.org/analysis/how-will-natural-gas-fare-energy-transition

Catalysts:

1.  Production increases; increasing slope of production growth

2.  Distribution increases

3.  Debt paydown

4.  New Partnerships added/existing partnerships expanded/renewed

5.  Austin Chalk proven up/extended/delineated further

6.  New plays identified on currently non-leased BSM acreage

Catalyst

Catalysts:

1.  Production increases; increasing slope of production growth

2.  Distribution increases

3.  Debt paydown

4.  New Partnerships added/existing partnerships expanded/renewed

5.  Austin Chalk proven up/extended/delineated further

6.  New plays identified on currently non-leased BSM acreage