Viper Energy, Inc. Q2 FY2020 Earnings Call

Ladies and gentlemen, thank you for standing by, and welcome to the Viper Energy Partners Second Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. Operator provided instructions. Please be advised that today's conference is being recorded. I now will hand the conference over to Mr. Adam Lawlis, VP, Investor Relations. Please go ahead.

Thank you, Sharon. Good morning, and welcome to Viper Energy Partners' second quarter 2020 conference call. During our call today, we will reference an updated investor presentation, which can be found on our website. Representing Viper today are Travis Stice, CEO; and Kaes Van't Hof, President. During this conference call, the participants may make certain forward-looking statements relating to the company's financial condition, results of operations, plans, objectives, future performance, and businesses. We caution you that actual results could differ materially from those that are indicated in these forward-looking statements, due to a variety of factors. Information concerning these factors can be found in the company's filings with the SEC. In addition, we will make reference to certain non-GAAP measures. The reconciliations with the appropriate GAAP measures can be found in our earnings release issued yesterday afternoon. I'll now turn the call over to Travis Stice.

Thank you, Adam. Welcome, everyone, and thank you for listening to Viper Energy Partners' second quarter 2020 conference call. During the second quarter, Viper had limited completion activity on our acreage, as operators reacted quickly to oil price volatility by cutting capital expenditures, ceasing completions and, in some cases, curtailing existing production. However, Viper’s production during the quarter was supported by 14 of Diamondback's 15 completions having more than an 80% average royalty interest net to Viper. Further, and as it relates to our second half production outlook, nearly all our curtailed production has come back online, as commodity prices have improved in recent months. Importantly, Diamondback has recently bought back three completion crews to work after taking almost three months' break from all completion activity in the second quarter of 2020. Looking toward the second half of 2020, Diamondback expects to focus its completion activity on areas where Viper has significant mineral ownership, primarily in the Midland Basin. This increased completion activity by Diamondback will be supported by Diamondback ending the second quarter with approximately 165 DUCs, roughly 65% of which Viper expects to own a meaningful royalty interest in. This current DUC backlog, along with increasing visibility into third-party operators' anticipated activity levels, will support Viper's production profile for the coming quarters. The advantage of Viper's business model as a royalty company is highlighted during these times of depressed commodity prices in that our high cash margins, no capital requirements and limited operational costs drive continuous free cash flow generation through the cycle. To that end, at $40 oil and production held flat relative to our second half 2020 guidance levels, Viper is expected to generate more than $180 million in free cash flow in 2021, or a greater than 11% free cash flow yield. This is expected to be a roughly 2 percentage point increase from our second half of 2020 annualized free cash flow yield, as some of our hedges roll off. As it relates to the free cash flow from the second quarter of 2020, we made the decision to retain 75% of that cash flow to fortify the balance sheet. The Board reviews the distribution policy each quarter, but with the continued depressed oil prices and uncertainty in the energy industry, the prudent decision is to retain a majority of cash flow to reduce leverage and protect the business. Viper remains in strong financial shape with $436 million of liquidity, and we'll continue to look for avenues to accelerate the de-leveraging process and get back to returning a more meaningful amount of cash flow through our distributions. In conclusion, I want to underscore the fact that mineral ownership remains the safest asset in the oil industry because it is a perpetual, real property interest that is high margin and requires zero capital requirements. Within the mineral subsector, Viper is further distinguished due to our relationship with Diamondback as our primary operator. Times like these emphasize that relationship as Diamondback focuses its operations on areas where Viper owns the minerals due to the lower consolidated breakeven economics. This relationship is evident by the midpoint of our second half 2020 average production guidance, implying greater than 6% growth relative to Q2 2020 average daily oil production, even with the challenging macro backdrop. Operator, please open the line for questions.

Operator will now open the line for questions. Your first question comes from Will Thompson with Barclays.

Hey, good morning. For Travis or Kaes, it seems pretty clear that Diamondback doesn't plan to pursue growth unless we see a much higher forward curve. Given the concentration of activity in Midland, where Viper has high net revenue interest as we saw in Q2, would it be fair to assume Viper could see oil growth in 2021 that could provide upside to the free cash flow sensitivity provided in the slide deck? I'm just curious on your thoughts on the trajectory for Viper next year.

Yeah. I think certainly it's a possibility, particularly from the exit Q4 number. On a year-over-year basis with Q1 being as high as it was, I think it'd be tough to grow year-over-year. We have to see some more activity on the non-op side, but you're exactly right. Even though Diamondback is not pursuing a large growth strategy in 2021, the concentration and focus on Viper minerals, which I think has been accelerated due to the low commodity prices, will benefit Viper and hold Viper up through what is a pretty uncertain time. So I think growth can continue from Q4; right now what we can see is growth into Q3 and certainly growth into Q4 from Q3, all supported by Diamondback. I think 2021 has some optimism, but we've got to finalize the completion schedule at this point.

Okay. That's helpful color. And in terms of the payout ratio, you guys obviously stressed that that's reviewed on a quarterly basis. I can appreciate there are some restrictions in terms of debt covenants on the payout ratio; I understand it's kind of three times leverage. But correct me if I'm wrong, there is some flexibility in terms of buckets or carve-outs that allow you to exceed that. Help us understand how you're thinking about the payout ratio going forward, as we see a better strip outlook and in terms of loan growth.

Yeah, we have a few buckets in the indenture that allow us to distribute even if we're above three times leverage. We're not above three times leverage today. As the Board went through the conversation on the Q2 distribution, given that total free cash flow is about $0.12 a unit and we're distributing 25% of that, there really isn't a huge delta between paying out 100% and 25% for this quarter. Going forward, we're going to have detailed conversations about what we can do. If we have confidence in the forward outlook and we're not going to get close to four times leverage and we're closer to below three times, then there's a chance to increase that distribution looking into the second half of this year and into 2021.

Okay. Thank you very much.

Next question comes from Chris Baker with Credit Suisse.

Yeah, good morning. Just in terms of on the topic of Diamondback's ownership of Viper, which came up on the call earlier today, it sounds like the Board is comfortable with where things are currently. But just curious what the thinking is longer term as it relates to Viper?

Certainly, Chris, if you look at our prior behavior at the Diamondback level, every opportunity we've had we've increased ownership in Viper. I think we're very comfortable at the Diamondback level with our ownership position in Viper.

Listen, it's certainly a support to the debt at Diamondback. That's kind of the point we were emphasizing. I think there's no intention today to sell down any ownership in Viper. On top of that, look at our actions where we've increased the share count of what we've owned since the IPO.

It's helpful. And then just a follow up, you mentioned looking to accelerate the de-leveraging process. I'm curious how you're thinking about levers you could potentially pull beyond maintaining a lower payout ratio?

Chris, obviously the payout ratio is most visible, but there's a lot going on in the background: doing work on our asset position, making sure we're getting paid for what we deserve to get paid on, working down the accounts receivable balance. Probably more importantly, working to bring some cash in by selling some undeveloped acreage positions. We've had a couple unsolicited bids on completely undeveloped properties where private equity is making a bet on the next two or three years of development and that doesn't provide a lot of value to Viper today. Those are smaller packages here and there that we're looking to sell if it doesn't reduce our cash flow.

Great, thanks.

Thanks, Chris.

Next question comes from Derrick Whitfield with Stifel.

Hey. Good morning, guys.

Hey, Derrick.

With regard to your 2020 guidance, we're backing into an implied Q4 that is materially above the street and on the higher side of your second half range. Does that square with your views based on the expected timing of Diamondback-operated completions?

I think that's fair, Derrick. We tried to come out strong with the forward guidance and also maintain guidance like a lot of our peers who aren't even providing it. Certainly with the high-intensity wells coming on, really starting about now and through the end of the year, we feel really good about the growth profile at Viper into the back half of the year.

Great. And then perhaps for yourself, Travis. Based on your earlier Diamondback call, I know the environment for public or private M&A is challenging for working interest acquisitions. Could you speak to the broader view on M&A for the mineral sector, which is a bit more fragmented and perhaps less mature?

Weirdly enough, Derrick, it's probably harder on the mineral side. There's still a lot of private money that likes this asset class, and therefore the numbers we're seeing on the opportunity set are still too high. There is a large bid-ask spread where people are paying for a recovery in oil prices. That's why we decided to sell some assets that aren't developed; we're getting prices we thought were reasonable and well above our acquisition cost of those particular assets. That spurred the conversation of maybe selling a little bit here and there.

That makes sense. Thanks, all.

Thanks, Derrick.

Next question comes from Brian Singer with Goldman Sachs.

Thank you. Good morning. First question is on the balance sheet and the dividend payout percentage. Can you just talk about how you see that evolving? And where you see on a longer term basis that payout percentage? And the same thing for the balance sheet, do you have a goal now of having a similar leverage at the Diamondback and VNOM level? Or is there comfort with VNOM having higher leverage ratio relative to Diamondback?

Well, it all depends on where the forward outlook goes on commodity price. Given that VNOM is pure free cash flow and doesn't have to spend on capex, we should feel a little more comfortable with a higher leverage ratio at the VNOM level. We still think about leverage on a consolidated and a deconsolidated basis, so we have to be careful there. There's no set target on the VNOM side. We do want to get the payout up from 25% to 50% as a first step, and then have real conversations with the Board on what the future holds. Relying on capital markets for all of your acquisition activity is probably not the most prudent thing to do, but we've had a history of being able to acquire and raise capital. That may be changing a little bit. Overall, we still want this to be a vehicle that pays out the majority of its free cash flow to our shareholders, the largest being Diamondback.

Great. And then a follow up on the divestiture opportunity and then potential acquisitions, would these both be focused or would both divestitures and any potential acquisitions be focused on operators outside of Diamondback? Or is what you're talking about either from a divestiture perspective or acquisition perspective on Diamondback-operated properties?

We're not focused on any acquisitions right now, but certainly divestitures are acreage positions not operated by Diamondback where we have no line of sight to development. If there's line of sight, or cash flow producing on that asset, then it's not up for sale. The unique nature of the minerals business is that a lot of people like to bet on future development and with no development today, those assets are the ones that we could sell.

Thank you.

Thanks, Brian.

Next question comes from Jeff Grampp with Northland Capital. Jeff, your line is open. Please go ahead. Next question comes from Gail Nicholson with Stephens.

Good morning. On page five with the free cash flow sensitivity analysis, you guys are assuming a 95% WTI realization. Can you just talk about what factors could adjust that expectation on a go-forward basis?

Gail, it really depends on the Brent-WTI spread. If Brent-WTI widens out a little more than it is right now—it's pretty narrow—then you probably realize a slightly higher percentage of WTI. For us, that 95% is a good conservative number for the back half of the year. We're trying to emphasize that while we're a little hamstrung by hedging losses in the back half of the year, the free cash flow really picks up in the first half of 2021 and you get a pretty solid free cash flow yield based on today's strip.

Okay, thank you.

Thanks, Gail.

Next question comes from Leo Mariani with KeyBanc.

Hey, guys. Just wanted to get maybe a little better quantification if possible on second half activity. You mentioned more insight into non-op activity. Are you baking anything on the non-op side into the second half 2020 production guide and roughly how many second half 2020 net well tie-ins are you expecting?

On the non-op side, we're still going to be pretty conservative. We had 1.3 net wells in the second quarter, and we're expecting that number to go down in the third quarter. But the Diamondback side more than doubles on the net wells completed in Q3. That supports the Q3 growth. Into Q4, you're still completing a good amount of Diamondback wells and we're baking in a little bit of non-op—not growth, but a little over one net well coming on the non-op side in Q4. So it's driven primarily, roughly 65% to 70%, by Diamondback activity because we have a lot of confidence in that. If the non-op side surprises to the upside, that's additional benefit for Viper shareholders.

Okay, that's helpful. I understand you don't have a hard leverage target, and agree VNOM supports more leverage than a traditional E&P. But you made the decision to go defensive on distributions and only pay about 25% of free cash flow. Is there some leverage level, say materially below three times—maybe 2.5 times or less—where you feel there's more flexibility at the Viper level to payout more cash flow or to resume M&A activity? I noticed there were no deals in Q2 and you said bid-ask is wide. Just wanted a sense around balance sheet governors to future M&A.

The balance sheet is most important and is holding us back from M&A. If we saw the best deal in the history of minerals we'd still have to think hard about it, but those deals aren't currently out there. On leverage, it depends on the forward outlook. We review this in detail with the Board every quarter. If we see the strip materially improving and we're not getting hit on hedge losses, our path to delevering will naturally happen and then we can bump the distribution back up.

Okay. Thanks, guys.

Thanks, Leo.

Next question comes from Phil Stuart with Scotiabank.

Good morning, guys. I wonder if we could just circle back on the divestiture comments. Is the interest more skewed to the Delaware over the Midland, given it's less developed? Any comments on that?

That's probably fair, Phil. The couple deals we've gotten done are in the Delaware, not to say there aren't Midland opportunities, but our Midland position is in areas that have a lot of active development or visibility, whereas the Delaware is a little less developed and not as clear on the path to forward development.

Okay. And one follow up: you said you're not focused on selling cash-flowing assets, but given the Eagle Ford position is outside of the Permian, would that be under consideration to sell if the bid was there?

Any asset is for sale if the bid is there, but I don't think there's going to be a bid that we'd want to move that asset. We felt we bought into the Eagle Ford at a good price and it's one of the few areas with activity. The job of a capital allocator is to be able to buy and sell; we'll take responsible bids and if someone hits the bid, we'll sell, but I don't think that position is up for sale right now.

Okay, guys. That's it for me. I appreciate the time.

Thanks, Phil.

Next question comes from Welles Fitzpatrick with SunTrust.

Hey. Good morning.

Hey, Welles.

It seems like the work-in-progress wells are perhaps unsurprisingly skewed towards Diamondback. Could you give your thoughts on where you guys see exiting the year in terms of percent Diamondback activity or percent Diamondback production?

It's probably about two-thirds Diamondback production exiting the year. We're a little below that today, probably close to 55% today, and then we'll likely move up another 5% to 10% to Diamondback production. From an activity perspective, we're modeling wells as essentially 75% Diamondback activity in Q3 and somewhere around 55% to 60% in Q4, so you're averaging roughly 65% to 70% Diamondback activity in the back half of the year.

Okay. That makes sense. And if I remember correctly, it's pretty minimal, but can you talk to any federal exposure you might have on third-party acreage, particularly in the Delaware?

I mean, Diamondback has none, but Viper as the mineral owner would be the federal government. We don't have any exposure unless we had a small override, but I don't think we have any of those.

Perfect.

Okay. At this time, I'll turn the call over to Mr. Travis Stice.

Thank you again to everyone participating in today's call. If you have any questions, please contact us using the contact information provided.

That concludes today's conference call. You may now disconnect.