Viper Energy, Inc. Q3 FY2020 Earnings Call

Ladies and gentlemen, thank you for standing by. And welcome to the Viper Energy Partners Third 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 instructions: Please be advised that this call is being recorded today. Operator instructions: I would now like to hand the conference over to Adam Lawlis, Vice President, Investor Relations. Thank you and please go ahead, sir.

Thank you, Bridgette. Good morning, and welcome to Viper Energy Partners' third quarter 2020 conference call. During our call today, we will reference an updated investor presentation, which can be found on Viper’s 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' third quarter 2020 conference call. The third quarter was a strong quarter for Viper as we saw resumption of completion activity on mineral and royalty acreage as commodity prices improved from the historic lows witnessed during the second quarter of this year. Viper's 10% increase in oil production during the third quarter was driven primarily by 38 of Diamondback's 41 completions in the quarter, having roughly 10% average royalty interest net to Viper, as third-party activity remained minimal, again showcasing the differential relationship between Diamondback and Viper. The advantaged nature of the royalty business model with no required capital expenditures and only minimal operating expenditures, further enhanced by Viper’s best-in-class cost structure, has been highlighted during this severe industry downturn as Viper has been able to reduce total debt by 10% in just the past six months. As a direct result of this, and because of our confidence in expected free cash flow to be generated in our forward outlook, the board has elected to increase our distribution payout for the third quarter to 50% of our total cash available for distribution, up from 25% previously. The $0.21 per unit of total cash available for distribution implies a 12% annualized distributable cash flow yield based on our current unit price. On the operations front, we continue to maintain a strong inventory of both work-in-progress and line-of-sight wells. Given that visibility, we have initiated average production guidance for the fourth quarter of 2020 and the first quarter of 2021 of 15,250 to 16,250 barrels of oil per day. While production is already within the high end of our previously guided range, and we remain confident we'll exit 2020 with a strong production rate, Diamondback-operated activity on Viper's acreage is expected to be slightly lower in the fourth quarter this year and into the first quarter of next year before returning to a more elevated level again starting in the second quarter of 2021. This is seen with only 3.5 net Diamondback-operated wells in the work-in-progress bucket, which we define as wells expected to be turned to production within the next six to eight months, but 7.4 net line-of-sight wells which are expected to be turned into production in the roughly six to eight month time period thereafter. Further, we continue to be conservative in our forecast in third-party operated production, despite leading indicators pointing to a return to increased activity levels and timing of operations. Despite this conservatism, at $40 WTI, and production held flat relative to our average fourth quarter 2020 and first quarter 2021 guidance, Viper is expected to generate approximately $200 million of free cash flow on an annualized basis in the first quarter of 2021. This equates to greater than 11% free cash flow yield as a percentage of enterprise value, or roughly 18% based on our current market cap. Viper remains in strong financial shape with $461 million of liquidity and we'll continue to look for avenues to accelerate the deleveraging process so that we can continue to increase our return of this free cash flow to unit holders over the upcoming quarters. Operator, please open the line for questions.

Operator instructions: Our first question comes from the line of Brian Downey with Citigroup. Your line is open.

Good morning, hope everyone's well. And thanks for taking my questions. You increased your implied payout ratio here to 50% in the third quarter. I noted in your deck that you expect to continue to maintain a portion of cash available to reduce debt; any updated thoughts on how we should think about the pace of that payout ratio increasing over time? What guideposts you're watching and what the anticipated ceiling is given those debt reduction goals?

Yes, Brian, good question. I mean, I think we're going to be patient. We did take the step from 25% up to 50% this quarter, and I think we have a lot of confidence in keeping that kind of overall payout ratio going forward. Now, I think the key is going to be Q1 and Q2 as our hedges roll off from 2020 and we start to realize a lot higher oil price on a majority of our production. If prices move higher from here, I think it's logical that the payout percentage rises a little bit. We're focused on getting to kind of two times leverage at the end of 2021, which I think is a pretty logical next step for us from a leverage perspective. But like we've said, the increased payout is not mutually exclusive to further debt reduction.

Great, that's helpful. And then looks like from the deck and the cash flow statement that you sold a small number of third-party operated Delaware Basin acres for a few million dollars. Could you update us on the potential for further third-party operated asset sales? And I guess more theoretically, with the E&P consolidation we've seen within some of Viper's third-party operator cohort, has that changed how you're thinking about your third-party operated acreage footprint at all versus three or six months ago?

I wouldn't say that the E&P consolidation has impacted our thought process on asset sales, but certainly the strength that we're seeing in the private market versus the public market where we're trading has continued to give us confidence that selling some assets at these prices isn't the worst idea. Overall, we're selling assets that are completely undeveloped by their operators with not a ton of visibility and not a lot of active development. We do have some larger packages that we're talking to people about, but we're going to be patient and, like we said last quarter, we're not a forced seller here. But we are recognizing where we trade versus where we can sell some of the stuff in the private markets with zero cash flow.

Thank you. Our next question comes from the line of Derrick Whitfield with Stiefel. Your line is open.

Hey, good morning, guys.

Good morning, Derrick.

Thinking about 2021 production, while clearly our lives can still change in the macro conditions, would it be fair to assume that your forward visibility, including work-in-progress and line-of-sight wells, with that visibility you could hold Q3, call it Q4 production relatively flat, assuming a reasonable conversion of that inventory?

Yes, Derrick, I mean I think that's fair. There's obviously going to be some movement. Large pads at the Diamondback level do impact Viper uniquely versus a standard parent-subsidiary dynamic. The kicker is going to be non-op production and non-op volumes, and we're still very conservative on how we're modeling those non-op volumes. But certainly, our leading indicators — permits and rig count and line-of-sight wells — have improved slightly on the non-op side, particularly in the last couple months. So while I won't commit to the exact same flat guidance today, I think it's a potential outcome for the full year.

In case you stand on that point specifically, when you guys look at the permits to assess your third-party activity, does that support the notion that the rig counts largely bottomed from a third-party perspective? And then also, would it support the notion that your completion flow probably bottomed as well?

I think that's fair. You've seen it in the data we put out that Diamondback net wells really held up the company in Q3 and will continue to do so in Q4. Certainly, I hope rig counts have bottomed, but I also hope from an industry perspective we don't go back to a 'grow, grow, grow' mentality and instead focus on maintaining production and hopefully Viper is the beneficiary of some of that non-op production getting turned in over the next few quarters.

Great, very helpful, guys. Thanks.

Thank you, Derrick.

And your next question is from the line of Brian Singer with Goldman Sachs. Your line is open.

Great, thank you. On the Diamondback call, I believe Diamondback said flattish-type production until oil prices move higher and then more longer-term low-single-digit production growth. I just wondered, what's the longevity by which the Viper production profile can outperform Diamondback based on the focus of Diamondback on drilling higher-interest wells from a Viper portfolio perspective? That was obviously a driver of the strong production here this quarter. But what's the longevity of that? Until potentially you start to see Diamondback growth equal Viper growth — what happens on the non-operators?

Yes Brian, I mean, I think certainly in the second half of this year Viper's growth is going to outperform Diamondback. Viper's Diamondback-operated production will outperform Diamondback's overall growth. This does go in waves and we had some really high-interest wells come in in Q3, and that's going to help into Q4. Over the longer term, I would hope that Viper's Diamondback-operated production can slightly outperform Diamondback if Diamondback stays flat or grows a bit — that's our job as a consolidated capital allocator to make sure the drill schedule takes Viper minerals into account. What we see today is a lot of high-interest pads coming on in 2021, continuing the trend of increasing pro forma capital efficiency heading into 2021.

Got it. Thank you. And then my follow-up — you talked about asset sales earlier and understandable focus on deleveraging, part of which you've already shown here over the last six months. But can you just talk philosophically on the acquisition side about the interest level in further growth via M&A and how you expect that market and your interest level to evolve?

I think M&A has been really important to Viper to achieve scale in the mineral space. We're going to echo the comments Travis had on the Diamondback calls: Viper doesn't need to be the biggest mineral owner in Texas or the Permian, we need to be the best. That means we're going to be reshaping our portfolio a little bit by buying minerals under Diamondback and selling non-op minerals. While I'm not going to commit to buy or sell prices here, we do recognize a value disconnect between where we're trading and where these minerals are trading in the private market under operators with no visibility. It's good acreage but there's no control over the drill bit. I'd rather have control over minerals that we operate with a 16% forward yield and pristine visibility.

Great, thank you.

Thank you, Brian.

Our next question comes from the line of Chris Baker with Credit Suisse. Your line is open.

Good morning. I realize it's hard to talk about 2021 without formal guidance from Diamondback, but just looking at slide seven in the deck, it looks like historically you guys have averaged about 70% to 75% of Diamondback activity. What's a reasonable placeholder for Viper's exposure to Diamondback's program next year? Could that be biased above the historical average as we've seen over the past few quarters?

I think it's going to move around. The Q3 number was as high as it's ever been — we had 93% exposure to Diamondback wells — but over a longer period of time two-thirds to three-quarters is a pretty safe assumption. I do think our team will look to increase that number by buying under Diamondback when the balance sheet allows it. But two-thirds to three-quarters exposure to Diamondback completions is probably a safe bet.

Okay, great. And just as a follow-up, realizing the focus today is on the balance sheet, once that peak leverage is in the rearview mirror, is there a specific leverage target that allows you to restart the acquisition program? You talked about two times by the end of next year, but is there a specific target that would give you the green light?

Yes, I think being closer to two times and getting three times in the rearview mirror is more important to us today. If we have confidence that that's going to happen over a couple of quarters, then we can restart the acquisition machine. Part of the acquisition machine can also be funded through asset sales rather than debt or external funding.

And next question comes from the line of Jeff Grampp with Northland. Your line is open.

Good morning guys. Travis, maybe just to build on the last thoughts on kind of leverage and payout ratios. What do you guys view, if you formalized any thoughts internally about target leverage and payout ratios in a normalized world, however you guys may want to define 'normalized'?

Yes, I mean in 2020 it's hard to define 'normal.' But I think a mid-cycle oil price of $45 to $55 WTI is a reasonable reference. In that environment, we should be closer to one-and-a-half turns leverage at most. While I won't commit to a long-term payout ratio on this call, one way to think about it is the inverse of an E&P. If an E&P is reinvesting 70% of its cash flow into maintenance capital and returns, maybe a mineral company can be the opposite. A mineral company needs to continue to add inventory — this is a depleting business — but the urgency to add inventory for a mineral company is much different than an E&P.

Got it. Appreciate that. And for my follow-up, how would you say a hedging philosophy integrates into some of those longer-term goals? I know you guys put some on at the beginning of this pandemic, but it seems a bit quieter on that front. Should we expect Viper longer term to return to an unhedged entity, or does hedging have a role going forward?

I think through a down cycle you always have to review the decisions you made and what lessons you learned. One lesson for us is that if you have significant debt you should probably hedge more than less. Viper historically has been largely unhedged because there was not a lot of debt. When we added that bond, we should have hedged, and that's on me for not doing that. Going forward, protecting the downside to guarantee some return of capital on the downside while not limiting upside exposure is likely to become part of the story, along with continued debt reduction or if you use debt to buy something, a clear path to paying back that debt over a short period.

Our next question comes from the line of Gail Nicholson with Stephens. Your line is open.

Good morning, most of my questions have been answered. I'm just curious: if we look at the volatility in the commodity you have experienced in 2020, how are you guys thinking about the need to potentially build cash on the balance sheet going forward just to have as a safety net?

Yes, Gail, it's a good question. I think it's probably less important at Viper than at Diamondback to build cash, because the first step at Viper is to get that revolving credit facility down to almost zero and reduce our reliance on bank funding. The banks have had a tough time with energy companies through this down cycle, and we want to be as low touch as possible with those banks. We're a long way off from getting the revolver to zero, but having the ability to buy back bonds in the open market, pay down debt, and call that debt, since Viper is not investment grade, makes us a little less inclined to hoard cash. But certainly having cash for a rainy day isn't the worst idea in running an energy company.

Our next question comes from the line of Neal Dingmann with Truist Securities. Your line is open.

How many rigs are you operating right now and are you thinking that will be about the same going into next year? How many current rigs? How many rigs are you operating right now?

Neal, we've got 21 rigs running today in the area, including four Diamondback rigs, and I think we've seen something like 60 permits put on our position here in the last three weeks.

Okay, that sounds good. Great details. And then secondly, I know Viper has always benefited from Diamondback's marketing relationships like FTI, EPIC and GRE, and these are long-term arrangements. Are you expecting much change in how we should think about this for Viper going forward, given the length and duration of these contracts?

No, I don't think there will be a change. We set Viper up to receive the same pricing as Diamondback and other E&Ps that have marketing entities which take possession of the barrel in their local market and then sell to broader markets. To have full alignment between the two public entities, we sell at the wellhead and therefore Viper receives the same price as Diamondback. Because Spanish Trail is such a large piece of our production, Viper gets a little more NEH exposure versus Diamondback receiving more Brent exposure, but those are long-term contracts and we are aligned on what they receive.

And our last question comes from the line of Leo Mariani with KeyBanc. Your line is open.

Hey guys, just wanted to follow up on the comment you made around the production guide for 4Q 2020 and 1Q 2021. I know you guys are not assuming much in the way of non-op activity at all in those numbers despite the fact that you're seeing these encouraging Permian trends. Can you elaborate?

Yes, I mean we are assuming some non-op activity, but we're certainly not assuming we get back to the levels seen in late 2019 or early 2020. Non-ops will help a little in Q4 and Q1, but Q4 will probably be mainly driven by the follow-through of these high-interest pads from Diamondback benefiting Q4. Q1 is still a bit far away to make any bold predictions, but I do think Q4 is likely a bit stronger than Q1.

Okay, that's helpful. And regarding the payout ratio, you took it up from 25% to 50%. Basically are you saying you're likely to stay at this 50% for a while until oil prices recover to that sort of $45-plus timeframe?

Well, 'a while' in our industry is a relative definition. We have confidence that in Q1 and Q2 if the strip starts to improve and we receive a much higher price for our commodity, high 30s to low 40s, then it's on the board to look at that forward outlook and see if we're reducing debt to that two-times leverage target. If we can protect that via hedging and maintain the deleveraging path, then we can consider increasing the payout further.

Okay, thanks for your time.

Thank you, Leo.

Thank you. I'm not showing any further questions. So I'll now turn the call back over to Travis Stice, CEO, for closing remarks.

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

Ladies and gentlemen, this does conclude the program. You may now disconnect. Thank you for participating and have a wonderful day.