This article is authored by MOI Global instructor James Davolos, Vice President and Portfolio Manager at Horizon Kinetics, based in New York.
The investment experience of shareholders in commodity based operating companies over the past decade has been dismal, as evidenced by nearly 1500 basis points of annual underperformance of the VankEck Vectors Gold Miners ETF, and nearly 800 basis points of annual underperformance of the Energy Select Sector SPDR Fund relative to the S&P 500 Index. This is in spite of materially higher gold and silver prices compared to a decade ago, and marginally higher oil prices. This has been the result of various factors, namely a lack of industry discipline on capital spending, inevitably oversupplying markets during periods of strong commodity pricing, resulting in low returns on invested capital.
Despite the broader industry malaise, certain businesses within the precious metals industry have returned 14% and 17% respectively over this time period, outperforming both the sector and S&P 500 Index. The companies are gold and silver focused royalty companies, Wheaton Precious Metals Corp (WPM) and Franco-Nevada Corp (FNV). These companies primarily earn royalty streams in the form of discounted purchase agreements for future mine production, in exchange for capital that is used to bring projects into operation.
The unique structure of the transactions is a product of mining operations, whereby an undeveloped mine requires substantial capital investment prior to generating cash flow. However due to capital market hesitation to finance these projects with equity, and burdensome cash interest payments on traditional financing, royalty companies provide a necessary element of mine financing.
In recent years Franco-Nevada has expanded beyond its precious metals core operations, and purchased oil and gas royalties, primarily in the Permian Basin (Texas) and Anadarko Basin (Oklahoma). Unlike precious metals royalties which are primarily used as a financing mechanism, oil and gas royalties are an element of land/mineral ownership, whereby exploration and production companies generally agree to pay a fixed amount of production to land owners in addition to an agreed upon lease payment.
For example, a lease in a prime portion of the Delaware Basin in Texas might command an upfront operating lease payment of $50,000/acre plus 20-25% of oil and gas production paid to the land owner. While gold and silver royalties have been a fixture of the market for decades, and proven to generate excellent risk adjusted returns, energy royalties are currently predominantly owned by private owners.
Historically the only public oil and gas “royalty” companies have been organized as slowing declining trusts, that truly represent minority working interests in an operating lease, with no active management of the assets, hence zero growth potential beyond organic production. These include Permian Basin Trust (PBT), Sandridge Permian Trust (PER), San Juan Basin Royalty Trust (SJT) and BP Prudhoe Bay Royalty Trust (PBT).
These vehicles have largely been valued predicated on a current yield basis, with no value assigned to non-producing acreage or terminal value. This is a function of the nature of these “run-off” structures, which must be distinguished from new market entrants and the precious metals peers.
Viper Energy Partners (VNOM) was taken public in early 2014 by its parent company Diamondback Energy (FANG) in order to monetize a substantial royalty position in the Midland Basin on acreage owned and operated by Diamondback. The transaction facilitated an independent valuation for royalty acreage, which requires minimal working capital, as compared to highly capital intensive operated acreage. The parent company (FANG) benefits through maintaining a sizable stake in Viper Energy.
In contrast to most public energy “royalty” companies at the time, Viper was the first growth oriented company, which has been facilitated by drop down transactions with the parent company. Since this time, the company has expanded beyond sponsored transactions from the parent and acquired assets from 3rd parties.
As a result, total royalty acreage has grown on an order magnitude of 4.4x since the IPO while distributions per unit production growth has exceeded this growth rate. The outsized growth is a function of the accretive acquisition strategy; the market places a far higher multiple of currently producing acreage as compared to non-producing acreage.
Furthermore, Viper and peer companies have been disciplined to limit acquisitions to cash flow accretive. This has resulted in an accretive acquisition mechanism whereby the company can purchase acreage at over a 50% discount to the implied value of its acreage. A critical variable to this compounding mechanism is capital structure; historically the company has only utilized short-term debt in the form of a revolving credit facility to close acquisitions.
Subsequently, the company issues shares to pay down the revolver. To the extent that the company can issue shares at a materials premium to the acquired acreage, the transactions are highly accretive on a cash flow and NAV basis.
Based on trailing distributions, Viper currently trades at a forward distribution yield of approximately 8%. While declines in oil prices will impact this rate in the short-term, we expect organic production growth and hub basis differentials to mitigate the impact over the next year. As an example, indicative operators on Viper acreage suggest over 20% production growth targeted annually over the next five years.
Further, a large portion of current production is subjected to Midland hub differentials, which have been realizing pricing at over a $10 discount to Cushing hub prices recently due to limited pipeline infrastructure. Projects currently under construction are expected to alleviate this congestion by the third quarter of 2019, with most new pipes delivering product to the Gulf coast.
Consequently, gulf pricing is Brent-linked, as opposed to WTI-linked, due to export nature of the product, which currently commands an $8 premium to WTI Cushing. Thus, within 9 months, Viper is likely to experience 20% organic production growth and over a $15 positive shift in differentials as they can realize Gulf pricing.
The market is highly inefficient with regard to oil and gas royalties for a variety of factors. Primarily, the energy sector weighting in the S&P 500 Index has fallen to approximately 6% compared to a peak in 2009 of over 14%. This, combined with increased allocations to passive investment vehicles, has resulted in a dearth of fundamental investment in the sector.
A lack of capital distribution at upstream operators has disenchanted many long-term investors, while negative returns in midstream energy MLPs result in similar valuation applied to royalty yield oriented investments.
We believe that a fundamental, discounted cash flow derived valuation for Viper assets delivers a share price between 50% and 100% higher than current levels depending on spot energy pricing. The market is focused on current yield, while assigned no value to the substantial undeveloped acreage or future accretive growth pipeline.
Finally, Viper Energy chose to convert to a taxable entity effective May 9, 2018. We believe that this will encourage investment in the company and facilitate greater NAV growth, as opposed to simply yield distributions. Viper is in a unique positions to further consolidate the highly fragmented private mineral/royalty market, and multiple private companies seeking public offerings are likely to drive incremental capital into the space.
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