Description

Summary:  We are long Blackstone Minerals (BSM) and believe it is a misunderstood, defensive investment with unusually asymmetric upside given the business quality (it is a royalty company, not an E&P).  We view this as a low risk +50-140% over the next 18-24 months (30-80% IRR) and believe it represents one of the best risk/reward skews we have come across in the market (high quality business, unlevered, aligned management, unique structure that protects downside, inexplicably discounted valuation vs. peers who have lower quality assets, clear explanation for why the mispricing exists).  BSM is largely unlevered and pays a 7.5% dividend yield that is 2x covered at current depressed/trough commodity prices.  The common dividend is contracted to grow a minimum of 9% per year through Q1 2019 and is insulated by the company’s unique subordinated unit structure (which is underappreciated by the market and adds a significant layer of downside protection, see discussion below).  A further recovery in commodity prices offers upside optionality (especially for you gas bulls – production is 2/3 gas) but is not necessary to achieve our targeted return (in fact, given the protection of the subordinated unit structure, the return profile outlined here works down to oil at $30/bbl and gas at $2.00/mcf – so any improvement in commodities represents incremental upside).  BSM is run by an owner-operator management team (who has been there since the company was founded in the early 1980s).  Management collectively owns more than 20% of the company and has a long history of value creation through the cycles (note the share buybacks they executed in Q1 2016 at the market bottom along with the various acquisitions they were able to execute over the last year as the energy cycle troughed).  Lastly, we also believe the company’s outsized exposure to the Haynesville Shale could be an underappreciated source of upside due to the increasing competitiveness of the play (we think now one of the most economic gas play behind the Marcellus/Utica) and its proximity to the growing gas demand in the Gulf Coast region (i.e. no differentials which have plagued economics for Marcellus/Utica producers).  

What this opportunity exists:  BSM was structured as a Master Limited Partnership and IPO’d in mid-2015 into the MLP bloodbath last year (however, it should be noted there are no general partner promote/splits at BSM, unlike most other MLPs).  Given the losses sustained by investors in MLPs over  the last year and the heavy retail/high net worth concentration of the MLP investor base, there has been apathy/disinterest around anything MLP-oriented and this dynamic has contributed to the mispricing of BSM.  BSM is the largest U.S. holder of mineral interests and represents a very unique and high quality asset base that is virtually impossible to replicate.  Mineral royalties are arguably the highest quality natural resource assets you can buy given they represent perpetuity call options and bear no capex or opex (in sharp contrast to the E&Ps that drill on their lands who bear all these costs as well as geological risk – which over time has rendered them very mediocre businesses).  Despite this differentiated asset base, the company is covered by E&P analysts (and even worse E&P MLP analysts who cover business models that should never have existed like Linn Energy) who comp BSM against their E&P coverage universe despite the radically different business models.  Despite being the largest and most diversified royalty portfolio with the highest quality asset base and most established management track record, BSM trades at a 50% discount to the 4 public royalty comparables (see below) on both yield and EV/EBITDA.  A multiple in line with the group would imply +140% to the stock price. 

Company Background:  Black Stone Minerals is the largest U.S. owner of oil and gas perpetuity mineral interests.  The company’s royalty portfolio spans 17 million gross acres in 41 states covering every major U.S. resource basin.  The Company owns the mineral rights that oil and gas E&Ps lease in order to drill and produce hydrocarbons.  When mineral rights are leased (usually for a three-year term), BSM receives an upfront cash payment (known as a lease bonus) and retains a royalty interest in all future production from the well.   The royalty interest is free and clear of any capex or opex and typically entitles BSM to 20-25% of well production.  Upon termination of lease, all future development rights revert to BSM to explore or lease again.

In addition to its royalty interest production, BSM has the option under its lease agreements to participate directly in the wells its lessors drill on a well by well basis (and bears its proportionate share of both opex and capex).  This working interest business represents ~1/3 of total production but produces minimal current free cash flow given the upfront capex spend.  As we will discuss below, we think this portion of the business is a key piece of the misunderstanding.

The company went public in Q2 2015 into the worst energy and MLP market since 2009 and has sold off meaningfully below its $19.00 IPO price (now $15.25).  BSM has a minimally levered balance sheet and aims to be consolidator of royalty interests in a period of forced selling among E&Ps and other royalty interest holders.    The company currently has rights to 30boe/d (net to them) of production, 2/3 of which is gas.

Thesis:
Misunderstood Business Model:  At a cursory level, BSM could resemble a more traditional E&P MLP and is often grouped with those companies and is covered by E&P analysts.  However there are important differences that make BSM and royalty trusts more generally a vastly higher quality business model than a traditional E&P / E&P MLP.  There is no opex or capex associated with royalty revenue.  In contrast to E&Ps, BSM simply collects a fee from third-party production on its land and effectively outsources all of the geological risk, technical expenses, capital outlays, and operating costs to others.   And while BSM does plan to expand via land acquisitions (several announced already this year), drilling and new discoveries on its existing minerals provide a cost-free growth mechanism, which is in stark contrast to both midstream and E&P MLPs which grow only at significant capital cost.  Royalties are a very high quality business and are in effect a “perpetuity call option” on future growth in production and in commodity prices. 

Despite these differences with traditional E&P companies, BSM has been lumped in with E&P MLPs which the market (correctly) views as impaired business models.  Part of this may be due to the ~1/3 of BSM’s production is from working interest production (and not royalty interests), and which does require opex and capex. It should be emphasized that BSM has the option but not an obligation to participate alongside operators (meaning the working interest program is entirely discretionary).  The working interest program allows BSM to “cherry pick” plays and participate in these wells on a “half-cycle economics” basis (i.e. the exploration and delineation risk is borne by the E&P company and BSM can choose to participate once the play has been de-risked).  It is also worth noting that BSM’s working interest program represents <10% of its cash flow, implying that > 90% of the distributable cash underlying the dividend is from the pure royalty portfolio. 

We believe that this option to invest in wells at BSM’s discretion is valuable for at least two reasons.  First, it is simply an attractive use of capital given the information that BSM has when it makes drilling decisions (again they can simply cherry pick the best acreage in which to participate). Second, it lets the company control its own destiny to a degree, which is contrast to its royalty peers.  It is difficult for royalty companies (much less analysts) to estimate their production growth because ultimately drilling budgets are out of their hands.  BSM has said that over their history, production on their acreage has organically grown on average at a 5-6% annualized “same-store sales” level under their ownership, we acknowledge that there could be some lumpiness in their production results.  This drilling program helps to smooth that lumpiness and provides a growth backstop.  Evidence of this is their execution through this most recent downturn:  BSM has managed to grow production despite the weak industry conditions (deepest and most elongated sector downturn in the last 50 years). 

Significant discount to comps:  While there are a few other royalty trust business models in the market both in the US and Canada, BSM differentiates itself in both size and scale.  BSM is by far the biggest player and has far more geographic diversity.  With the exception of Dorchester Minerals, the other royalty trusts are confined to a single region. 

Despite offering geographic diversity, scale, hedge protection (BSM is the only one to use hedges), and a growing/protected dividend (more on that later) BSM trades at a significant discount (~50% below) vs. its peers.  We think that this may be due to the capex associated with its working interest program, although bear in mind again that this is completely discretionary and this owner operator management team only engages when it sees attractive returns on that capital.  In addition, Freehold Royalties has similar working interests as a mix of its production yet trades at a significantly higher multiple.   

Dividend Structure Provides Growing Support:  Like all MLPs, BSM pays out the nearly all of its cash flow in a given quarter as a distribution.  BSM however has structured its dividend to protect the common units (50% of total units outstanding) over the subordinated units (also 50% of total units).  The subordinated units, which are owned by the Company’s legacy shareholders and management, only get paid after all common units have received the Minimum Quarterly Distribution (MQD).  There are no arrearages for Subordinated Units.  For example, while BSMs cash flow covered 1.1x their Q1 2016 dividend paid to all units (common + subordinated), cash flow covered 1.9x the dividend paid to just common units.  Said another way, in that period, cash flow would have had to decline 47% before the common dividend would be as risk.  As noted above, this would require oil < $30/bbl and gas < $2.00/mcf. 

The second nuance to the structure is dividend growth.  BSM’s Minimum Quarterly Distribution (i.e. the amount that the common must get paid before the subordinated can get paid) is contracted to grow 9% per year through Q1 2019, after which the subordinated units will convert to common units at a ratio that guarantees the free cash flow of the company is adequate to maintain the Q1 2019 dividend run-rate.  This structure is unprecedented in the world of MLPs and underappreciated by investors and sell-side analysts. 

Haynesville Concentration is Positive for Gas Bulls:  In 2015, ~25% of total production was from the Haynesville shale in North Louisiana and East Texas, and nearly all of the 2016 drilling capital budget will be spent in the Haynesville/Bossier.  The Haynesville was an early beneficiary of the shale revolution, but has been little more than an after-thought over the past cycle due the rise of the Marcellus/Utica.  However given the decline in liquids pricing (making dry gas more economic in comparison) and the onerous basis differentials seen in the northeast (in Dom South hub producers right now are getting ~$1.40/mcf less than they would in the Haynesville), interest in the area has picked up and the drilling and completion techniques that were perfected in the Marcellus/Utica are starting to be applied in the Haynesville.

If you are a gas bull, the exposure to the Haynesville is pretty attractive.  As a refresher for those who haven’t been following, U.S. gas supply and demand are heading in different directions.  Supply has been declining outside of the northeast for several years, and due to the poor realized economics in the northeast new drilling has slowed dramatically and production there has been started to roll over as well. The backlog of pipelines projects that will eventually alleviate the basis differentials in the northeast appear to be slowly moving to the right.  Meanwhile, demand has been strong with record demand from power burn and looming LNG and Petchem projects in the Gulf Coast.  This dynamic is potentially setting up the gas market to be undersupplied in the 2017-2018 timeframe, requiring a price signal to incentivize drilling.  Given its geographic proximity to gas demand growth (i.e. no basis differentials in contrast to the Northeast) and encouraging well results (reflecting significant cost reductions and well productivity advancements over the last 1-2 years), we think the Haynesville should be a beneficiary of the gas bull thesis – along with the Marcellus/Utica, it will be next in line to dispatch on the cost curve.  BSM’s largest partner in the Haynesville is XTO (ExxonMobil subsidiary), and our research indicates they have been seeing impressive well results there and are increasing rig counts.  A bit of history on the Haynesville:  it’s a pure dry gas shale play that was discovered in 2008 and was a focus for the industry from 2008-2011.  However, the Haynesville was thereafter de-emphasized when drilling capex shifted to oil shale wells (which bring associated gas as a by-product) given the more attractive economics those plays were yielding at $110/bbl oil.  The fall in oil combined with the application of recent technology advances from the oil shale plays to the basin has rekindled interest as the basin has rapidly moved back down the cost curve. 

Guidance Revision:  Q1 results were strong, and the company indicated that they may be revising guidance with its Q2 results.

Owner Operator Management Team: Board of Directors, affiliates, and management own >20% of company. CEO Tommy Carter owns ~10% of units (split 50/50 between common and subordinated) creating a strong incentive to preserve and grow the distribution and allocate capital prudently.  Importantly, because of his split ownership of both share classes, he has no incentive to game the subordinated share conversion mechanism. 

Valuation: Valuing a perpetuity call-option that a royalty interest represents is a difficult exercise.  The reality is that these royalty trusts (and MLPs more generally) typically trade on a yield basis.  Using that short hand, we see substantial upside if this were to even approach the yields that its comps trade at (average of 3.5% yield), using the guaranteed $1.35/unit dividend in 2018.

Catalyst

Q2 earnings (raise production guidance)

Investor re-engagement on yield-oriented investments that is occuring across the market as yields have fallen