Description

It’s time to go long Viper Energy Partners (NASDAQ: VNOM).  This is a debt-free MLP that owns the mineral rights on some of the best acreage in the Permian Basin and it is the highest quality security in the entire E&P space.  The units are priced at $16.93.  I see downside to $13-14 in a $40/bbl WTI environment and upside to the high $20s at $55/bbl WTI.  It’s yielding 7.6% on the Q1’17 annualized distribution of $0.32/unit with a good organic growth runway in front of it as long as global oil markets don’t experience a prolonged dislocation. There is additional inorganic growth potential from future mineral rights drop downs by its sponsor and general partner, Diamondback Energy (NASDAQ: FANG).  

Viper has a variable distribution policy where they pay out 100% of their distributable cash flows.  There are no incentive distribution rights.  Even though Viper’s quarterly distributions are directly influenced by changes in commodity prices, and even though oil prices are less than half of what they were at the peak, Viper’s most recent quarterly distribution was 28% higher than the last distribution they declared of $0.25/unit before OPEC’s infamous Thanksgiving Day Massacre in 2014 because of the robust organic production growth on their acreage.

The reason why VNOM is so cheap is simply because of technical factors.  Many institutions can’t own MLPs.  For the ones who can, trading volume is too light (130k/d, $2.2mm/d) for them to build meaningful positions.  The market cap is substantial at $1.6 billion but Diamondback owns 74.25%, leaving a public float of just $413 million. The next drop down will likely require a secondary offering of at least $100 million.  This has probably created an overhang, but the additional float will allow more investors to buy the units and perhaps lead to a justified re-rating so that it finally trades in line with lower quality and slower growing royalty peers.

Description & History

Diamondback is an E&P that was formed in 2012 when Gulfport Energy (NASDAQ: GPOR) carved out its Permian acreage in order to create a standalone pure play on the basin.  The cornerstone asset was a block of acreage in Midland County called Spanish Trail, which at that point consisted of only the drilling rights, not the mineral rights.  

My understanding is the mineral rights on the acreage were owned by a guy from Kentucky who made a fortune in tobacco and bought the rights a while back as a diversification tool.  For some reason he wanted to sell out and called Diamondback’s CEO to ask if he did those kinds of deals.  Diamondback was not created to be in the business of owning mineral rights, but opportunities like that don’t come along very often so the correct answer was yes.  They bought the minerals and formed Viper in the spring of 2014 as a separate investment vehicle in order to crystallize the value with investors.  They took Viper public on June 17, 2014 at $26.00.  Pretty good timing.  

Viper has acquired some additional mineral acres over the last few years.  Here’s a snapshot of their current asset portfolio:

Spanish Trail now consists of 16,551 surface acres, of which FANG operates 9,876 acres and RSP Permian (NYSE: RSPP) operates the rest.  VNOM gets a 20.8% royalty on the production that FANG generates.  They get all a 17.2% royalty on the production that RSPP generates.

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Minerals are a thing of beauty.  The E&P company, or operator, is responsible for the costs of making the wells and producing the hydrocarbons.  The mineral rights owner doesn’t have to put up any of the money.  They just start collecting checks after the oil and gas starts flowing. The production stream from wells on the Spanish Trail is approximately 80% crude oil.  Let’s say benchmark oil prices are $50/bbl and benchmark gas prices are $3/mcf. Taking into account basis differentials, the production stream would generate revenue of $40 per barrel of oil equivalent (boe) on the production allocated to paying royalties to Viper, whose only cash costs are production taxes of roughly 7% ($2.80/boe), gathering and transportation costs of $0.25 – 0.50/boe, and cash G&A of $0.50 – 1.50/boe (based on 2017 guidance), for a cash profit of $35.83/boe at the midpoint (~90% cash margin).  That means Viper would still be making money even if WTI fell to $2/bbl.  Think about that.  

Many E&P stocks are worthless if you value them using even $35/bbl WTI because they are further burdened by ongoing lease operating costs (LOE) of $7/boe and development costs of $8/boe for typical oil wells, not to mention higher G&A at $2-4/boe, plus all the other investment costs like infrastructure, land, science, and seismic.  The cash flow profile of E&Ps is further challenged by the fact that much of their costs are front end loaded.  They spend now and get paid later.  

Of course, there is the unavoidable truth that as a mineral rights owner your fate is tethered to the operator on your acreage.  You will only be successful if the operator is successful.  The ideal mineral rights would not only be on acreage where the rock is capable of making great wells, but you would have a competent operator who is well capitalized and therefore capable of funding development without interruption through the ups and downs of the commodity price cycle.  Spanish Trail checks both boxes.  The wells on Spanish Trail rank in the top 3-5% of all the hundreds of liquids-focused North American type curves I track.  In fact, they are so low cost that I estimate the asset is capable of generating production growth within cash flow for Diamondback and RSP (and therefore Viper) for 15 years at $35/bbl WTI and $2.50/mcf Henry Hub (assuming current well costs and LOE, well cycle times, spacing assumptions, expected ultimate recoveries per well, and differentials, etc.).  Outside of OPEC there aren’t many fields that can do that.  

RSP and Diamondback both have strong balance sheets and well-regarded management teams.  Diamondback’s gross debt/EBITDA on 2017 consensus estimates is 1.2x.  They have a B+/Pos rating from S&P.  Their publicly traded debt is well termed out with no maturities until 2024/25 and is trading with a YTW of <5%.  The borrowing base on their revolver is $1.0 billion and no borrowings were outstanding as of Q1’17.  The revolver matures on November 1, 2018 so they obviously need to term that out soon.

RSP is unaffiliated with Diamondback or Viper outside of Spanish Trail.  Gross debt/EBITDA on 2017 consensus estimates is 1.8x.  They have a B+/Sta rating from S&P.  Their publicly traded debt doesn’t come due until 2022/25 and is trading with a YTW of 5.00 – 5.20%.  Their revolver has a borrowing base of $1.1 billion, a committed amount of $900 million and no borrowings outstanding as of Q1’17.  The revolver matures on December 19, 2021.

Valuation

I am going to value the equity in two parts:  Spanish Trail and other Permian.

The asset portfolios of most royalty vehicles are a Noah’s Ark of random stuff so it’s hard to value them with much granularity.  You’re basically stuck with high level valuation techniques such as EV/EBITDA or distribution yield.  Fortunately, there is enough data to value the Spanish Trail mineral rights on a full development basis.  I’m talking about modeling it out from the operator’s perspective on a year by year basis from the bottom up, well by well, and translating those results into the royalty cash flows that Viper’s unitholders will receive on a present value basis.

Spanish Trail is just one of several high-quality assets that Diamondback and RSP can allocate capital to within their portfolios, so how do we estimate what portion of their capital budgets will get earmarked for this specific acreage?  First, as mentioned earlier the wells are in the top several percent of all wells in the industry so it’s highly unlikely either of the operators will ever have another asset deserving of so much capital that any is left over for Spanish Trail.  

Second, the financial incentives of Diamondback and its senior executives are such that they are highly likely to be supportive of Viper in their capital allocation decisions.  Diamondback’s stake is worth $1.2 billion at the current quote, or ~$12 per share of FANG, which is significant relative to FANG’s current stock price of $92.  Plus, the named executive officers from Diamondback’s proxy statment own almost as much stock in VNOM as they own in FANG.

Diamondback’s COO recently bought an additional ~$250k of VNOM in the open market in the $16-18 range.

The bottom line is the lower bound for Diamondback’s capex allocation to Spanish Trail is well above zero.  In terms of sensitizing activity levels for lower commodity price environments, I usually assume in my modeling that operators will only drill if oil & gas prices are sufficient to generate at least a 2.0x recycle ratio at the well level (netbacks per boe divided by F&D costs per boe), which is generally considered the threshold above which E&P valuation creation occurs.  Many management teams are willing to drill almost no matter what because, let’s be honest, who doesn’t like to hunt for buried treasure with other people’s money.  But, I believe the management teams at RSP and Diamondback are more disciplined than that.  Fortunately, these wells are so profitable it’s not an issue under any reasonable commodity price scenario.  They generate a well-level recycle ratio of 4.9x at $50/bbl WTI and $3/mcf Henry Hub, and a recycle ratio of 3.0x at $35/bbl WTI and $2.50/mcf HH.

In terms of the upper bound for capex, Diamondback has consistently talked about running just three rigs on Spanish Trail (two operated by Diamondback and one operated by RSP).  Rather than try to guess under which circumstances they would run more rigs, I assume they run just the three rigs over the modeling horizon and treat the acreage as the conceptual equivalent of baseload generation within their portfolios.

E&P companies almost as a rule will plow every dollar of operating cash flow they generate back into their capital budgets.  In this modeling exercise, I assume Diamondback and RSP follow that practice subject to a budget cap based on the number of wells three rigs can drill.  Assuming well cycle times of 26 days, $5.3 million drilling & completion costs for 7,500’ lateral wells, and an additional 15% for facilities and infrastructure (probably conservative), operator capex is limited to a maximum of ~$265 million.  I also burden the operators with 3% compounded well cost inflation, $25 million of combined G&A to manage the asset, and a full 35% corporate tax rate with no deferred tax benefits.

In terms of drilling inventory, Viper counts 548 remaining locations in their latest investor presentation, but 142 of them are 10,000’ laterals as opposed to the standard 7,500’ laterals with 1 million boe EURs.  I make a simplifying assumption for modeling purposes of 600 locations all with 7,500’ equivalent economics.  It probably evens out in the end because both methods result in approximately the same cumulative feet of horizontal pay when you multiply the number of locations times the lateral lengths and tally it up.

I also rolled into the development model the existing production net to Viper of ~8,500 boe/d.

I took the cash flows generated by this development program and calculated the resulting distributions to Viper’s unitholders.  Spanish Trail alone is capable of supporting double digit organic distribution growth at Viper for six years and positive organic distribution growth for 15 years in total, without any contribution from development on Viper’s other mineral acres.

I calculated the present value of these distributions using a variety of discount rates.  I started with 10.0% since that is the standard discount rate for E&P companies, followed by 7.5% and 6.0%.  Even a 6% discount rate might be too high.  Prairie Sky (TSE: PSK) is the bellwether of the minerals group and it trades with a 4% free cash flow yield even though as I will show later it’s less profitable and is growing much more slowly.

I would also point out that rapidly growing gathering & processing MLPs have a cost of equity below 6% even after adjusting their distribution yields for the IDR burdens, and those businesses have capital intensity.  Antero Midstream (NYSE: AM) is yielding 3.6%.  If you gross it up for the IDR burden which is currently ~18%, they have a 4.4% cost of equity.  Rice Midstream (NYSE: RMP) is yielding 4.2%.  If you gross it up for the IDR burden which is currently 4.4%, they have a 4.4% cost of equity (coincidentally).  Both those entities have excess distribution coverage so the total distributable cash yield is >6% for both companies, but “distributable cash flow” is only burdened with maintenance capex, not total capex which includes growth capex.  Take into account total capex and both entities are FCF negative.  Viper on the other hand is and always will FCF positive, and requires no capex in order to grow.

Data tables showing the present value of Spanish Trail’s cash flows are laid out below for the three discount rates I chose, so the reader can see the valuation sensitivity under a variety of oil & gas price combinations.   

• Base Case:  I use $50/bbl WTI as a base case because U.S. shale producers are now the world’s source of swing production and $50-55/bbl is roughly the level they need in order to grow production within cash flow.  I use a 7.5% discount rate.

• Low Case:  I use $40/bbl WTI as a downside case because that’s approximately the level at which Tier 1 operators like RSP have said they would need to dial back activity.  I use a 7.5% discount rate.

• High Case:  I use $55/bbl WTI as an upside case that’s the threshold above which a lot of drilling inventory at Tier 2 and Tier 3 E&P companies starts to come alive.  I use a 6.0% discount rate.

I generally won’t use benchmark gas prices above $3/mcf because there is an ocean of gas supply that is economic at those levels.  (Page 29 of Cheniere’s investor day presentation from Apr-19-2017 shows we have 30 years of gas supply that works at $3/mcf, and that figure reconciles with my bottom up analysis of the bellwether shale gas producers.)

• Other Permian:  Viper holds the mineral rights on another 67,695 gross acres/2,966 net mineral acres in the Permian Basin.  We don’t have as much granularity about that acreage as we do at Spanish Trail so we have to back up and use high level valuation techniques.  Looking back at operator acreage transactions since the spring of 2016 across the Midland and Delaware sides, drilling rights have been going for >$30k/acre adjusted for existing production at $40k per flowing boe.  Mineral rights are far more valuable than drilling rights.  Viper recently bought 887 net mineral acres for $68 million, or $76k/acre.  If you value the rest of Viper’s Permian acreage at $76k per net mineral acre, you get another $225 million of value, or $2.30/unit.  

I don’t think it’s a stretch to see that stuff getting valued at $125k/net mineral acre, especially when you have great operators developing the acreage and an ongoing rate of change story.  After all, some of the best operated acreage in the Permian is worth >$100k/acre.  The wells on both sides of the Permian continue to get better, and additional zones are still being delineated.  Three years ago well-level F&D costs on Spanish Trail were $13.80/boe and there were only a couple of horizons.  Now F&D costs are down to $6.60/boe and three horizons are being targeted.  My valuation gives them no credit for further gains.  A $125k/acre marker would get you another $3.87/unit on top of Spanish Trail.  

Viper has another 232 net mineral acres outside the Permian.  I think it’s in the Eagle Ford but it’s so small I’m not going to ascribe any value to it.  

Note that I have burdened Spanish Trail with 100% of Viper’s cash and non-cash G&A so the NAV figures are net of all central costs.

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There are some things Diamondback is doing to drive further value creation beyond Viper’s current asset base.  First, Diamondback acquired a bunch of acreage in the southern Delaware Basin last December that came with 1,149 net royalty acres.  That is a material amount relative to Viper’s existing 6,169 net mineral acres in the Permian.  It’s hard to know with precision what that is worth but there is almost no doubt it will be dropped into Viper and the drop will be accretive.  Viper will eventually do a secondary to fund at least part of the transaction.  

The additional float will help unlock the value here because it will open up the units to more investors who haven’t been able to buy it.  VNOM’s daily liquidity in the 36 days prior to the last secondary in January 2017 was $2.0 million.  In the 36 days following the offering (excluding the first day of trading immediately after) the daily liquidity rose to $4.5 million.  Additional float can clearly make a difference to liquidity and I think we saw the equity start to get traction with new investors as the market absorbed the stock.  And, there is a possibility that the additional liquidity could make VNOM eligible for inclusion in the Alerian index.  It needs to have $2.5 million of daily trading volume for 6 months.  Daily liquidity has been just over $2 million so it’s well on the way.

Diamondback also has 445 net royalty acres in Martin and Upton Counties that can be dropped.

Second, Viper is becoming more aggressive about trying to acquire the mineral rights on other acreage that Diamondback operates.  For example, they sent out 500 letters earlier this year to royalty owners on the southern Delaware acreage looking for sellers.  Right now 41% of VNOM’s acreage is operated by Diamondback.  They want to get that ratio over 50%.

For mineral acreage they may acquire outside Diamondback’s operatorship they want leases with lots of permits or continuous drilling clauses.  They want operators who are motivated to drill – not the Chevrons of the world.

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Comps

What you are about to see is a massively discounted valuation relative to its peers, which is especially noteworthy in light of the differences surrounding quality and growth potential.  

Viper is trading at a material discount in terms of distribution yield and as a multiple of EBITDA even though it is growing much faster and has the highest oil cut from its production stream.  The only reasonable explanation I can come up with is the technical market factors I discussed at the beginning.  I mean, Viper is at 13x 2017 EBITDA and even Permian E&Ps are trading at 10x 2017 EBITDA.  Diamondback and RSP are just above 10x.  The idea that the minerals are only worth a 2-3x premium to the operators drilling on the same acreage doesn’t make sense.  It’s the same rocks, the same wells, and the same differentials, but one party has all the capital costs and the other doesn’t.  (I am oversimplifying to make a point).   

Viper significantly outgrew its royalty comps through the downturn, demonstrating the superior

economics of its acreage.

 

It’s the only one in the group whose most recent distribution is above the prior peak from right before the OPEC Thanksgiving Day Massacre.

In terms of how Viper stacks up directly against individual peers, I am going to focus on the comparison to Prairie Sky since that one is the bellwether.  Note that PSK trades ~10 turns higher than VNOM on 2017 EBITDA and it yields ~500 bps less.  However, Viper is trading pretty close to them in terms of EV/boe of resource.  This analysis is not quite apples to apples because Prairie Sky’s resource estimate is based on trailing five-year average type curves, and type curves have obviously improved a lot in the last few years, whereas the resource estimate for Viper is based on more recent EURs.  Nevertheless, the two valuations are in the same ballpark.  Let’s talk about whether that makes any sense.  In preview, it doesn’t.  Viper should be higher.  

Prairie Sky is disadvantaged by virtue of its production being from Canada where it is further away from benchmark pricing hubs than Viper’s acreage, resulting in much wider negative basis differentials on its realizations.  

Moreover, 50% of Prairie Sky’s production is natural gas whereas Viper’s is only 10-11% gas.  Rolling it all up, Viper’s production stream is roughly twice as valuable as Prairie Sky’s.

These dynamics not only hurt the profitability of Prairie Sky’s existing production, but they constrain the ability of producers on their lands to prosecute a more aggressive organic growth agenda.  I have analyzed the well-level economics of many producers on their lands and punitive differentials mean the recycle ratios are simply not high enough for many of those type curves to support rapid growth without higher commodity prices or external capital, even though the rock can be good.  In other words, they need a helping hand. Viper doesn’t need any of that.  The wells work NOW.  The internal capital is available NOW.  

So, Viper’s production is growing significantly faster, is twice as profitable, and yet it trades 10 turns cheaper on EBITDA and 500 bps wider on yield.  I should also point out that as an MLP it doesn’t have to pay corporate income taxes, whereas Prairie Sky’s corporate tax rate is in the mid-teens and will eventually rise to 25%.  If Viper got the same EBITDA multiple as PSK it would trade at $31/unit for 86% upside.  If it got the same yield as PSK it would trade at $50/unit, for 200% upside.  I struggle to think of another situation where the best company in an industry group traded at such a material discount to the next peer in a normal environment.   The only fundamental explanation I can see is the terminal value at Prairie Sky could be a bigger portion of the share price given they own the rights on millions of acres, but if their land position were capable of delivering on those terminal value expectations I would think we would be seeing greater signs of growth.  Also, Spanish Trail’s drilling inventory is not exactly shallow at 15 years, and that’s on just the 3 horizons.  You can probably count on one hand the number of E&P companies with 15 years of inventory that is as high quality as Spanish Trail’s.   The inventory will probably expand with the delineation of additional benches.  Even if they don’t, 15 years is plenty of time to add mineral acres and grow the terminal value potential.

To be fair, there are a few ways in which Prairie Sky is more favorable.  One is the diversity of operators on its lands.  They have 340 of them and only one accounts for >10% of revenue.  If one of them goes bankrupt it’s not going to be a mortal blow, whereas if something goes wrong with Diamondback then Viper be significantly impacted.  

Prairie Sky has additional levers they can pull to drive earnings that Viper doesn’t have, such as compliance activities.  Their lands are so vast and have been around for so long it’s almost certain there are operators who have been flying under the radar and not paying their royalty obligations.  Identifying non-compliant wells and establishing collections is like finding money in their couch cushions.  They have a big couch.

Finally, Prairie Sky has been very disciplined about limiting dilution from stock-based comp.  Their dilutive securities would increase the share count by 60 bps, while Viper’s potential dilution is 250 bps.  

Macro

I think the main way you really can get hurt by investing in Viper in the short to medium term is if Chinese oil demand cracks as a result of that economy finally being overwhelmed by the unsustainable imbalances that have been accumulating.  China accounts for 12-13% of total demand and it has accounted for 40% of cumulative demand growth since 2009.  I don’t have an edge on China.

A recession would also be bad as it relates to global demand in general.  It seems like we’re probably due for one.  That’s not a risk unique to Viper though.  

In the very long run oil demand is going to roll because motor gasoline accounts for ~45% of consumption in the U.S. and electric vehicles are going to take over.  I don’t think this will happen soon enough to affect Viper’s near-term cash flows, although it will impact the terminal value.  For what it’s worth ~25% of Spanish Trail’s present value is generated in the first 5 years and ~50% is generated in the first 10 years.

I read some analysis from Raymond James the other day that anticipates EVs will only have displaced >200 kbl/d of oil demand by 2020. Battery costs are coming down rapidly but EVs are generally still a luxury here in the U.S., and they are certainly not affordable for anybody but the wealthiest in most parts of the world.  Even if EVs were affordable for the masses today it would take years for the car fleet to fully turn over.  The infrastructure required to support this transition will also take decades to develop.  

While the exact shape of oil’s long-term future is uncertain, it will probably remain an important commodity for decades to come because of the attributes that have made it the king since World War II – high heat content, immediate combustion, portability, versatility, and accessibility.  Almost no matter what path its demand follows and what it gets priced at, Viper will be able to earn a profit and pay distributions because of its highly variable cost structure and lack of capital intensity. 

I haven’t focused much on the global supply picture because Viper and its operators are on the sharp end of the cost curve ex-OPEC.  It’s unnecessary to make a case for materially higher oil prices as a result of stress in the global upstream industry to make money on Viper, but the case is there to be made on a cyclical basis if you want to do so.  I would say I am agnostic to mildly bullish on the potential for higher oil prices.  We’ll see.  The one theme I am certain of is that production from the best shale producers will take market share and Viper is a direct beneficiary of that theme.  Significantly higher oil prices would be gravy.

Catalyst

• Another drop down followed by a secondary offering
• Addition to the Alerian