Viper Energy, Inc. Q2 FY2021 Earnings Call

Good day, and thank you for standing by. Welcome to the Viper Energy Partners Second Quarter 2021 Earnings Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Adam Lawlis, Vice President of Investor Relations. Please go ahead.

Thank you, Peter. Good morning and welcome to Viper Energy Partners second quarter 2021 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 second quarter 2021 conference call. Viper's production during the second quarter was supported by concentrated exposure to Diamondback's Midland Basin development plan as well as an increase in activity from third-party operators. As a result of the strong production and enhanced by our best-in-class cost structure, Viper generated over $75 million in free cash flow during the quarter. This strong free cash flow generation and the resulting continued decrease in net debt has enabled Viper to increase our distribution to common unitholders to 70% of cash available for distribution. This increase in our distribution marks the second consecutive quarter of increasing return of capital to unitholders, and the $0.33 per unit distribution represents a 32% increase from the first quarter distribution. Looking ahead, we increased our production outlook for 2021 and continued to maintain visibility into Diamondback's expected forward development plan that includes several large pads, where Viper will own a significant royalty interest in the second half of the year. Additionally, Viper initiated average production guidance for the second half of 2021 that implies almost 16,000 barrels per day of production at the midpoint. Based on this second half 2021 guidance and assuming production is held flat at the stated midpoint of the range, Viper is expected to generate roughly $320 million of annualized free cash flow in the back half of the year, assuming $65 WTI. Importantly, given these same assumptions, we're expected to generate over $360 million of annualized free cash flow in the first half of 2022, as our hard-earned money hedges roll off. This 2022 free cash flow amount equates to greater than 11% free cash flow yield as a percentage of our enterprise value or almost 13% of our current market cap. In conclusion, the second quarter of 2021 was another strong quarter for Viper that once again highlighted our high-quality asset base, best-in-class cost structure and overall differentiated business model. Given the strength of our balance sheet and our current distribution representing greater than a 7% yield, Viper plans to retain 30% of its cash flow for the foreseeable future to focus on acquiring Diamondback operated minerals as well as to buy back units. Our acquisition strategy is unique, in that we have a clear understanding of our parent company's future development plans and we plan to leverage that knowledge to provide further exposure to the Diamondback development. Operator, please open the line for questions.

And your first question will come from Brian Downey with Citigroup. Your line is open.

Thanks for taking the questions. On cash flow allocation, as you just mentioned, you plan to retain 30% of cash flow for acquiring royalty interest and continuing to do repurchases, which implies about a 70% payout ratio for the coming quarters. Could you give an update on what you're seeing today in the mineral acquisition and divestiture market and how you're thinking about allocating capital between that acquisition bucket and repurchase bucket?

Yes, Brian, good question. I think generally we're moving towards a 70% payout ratio because traditionally this business was funded 100% with equity. I think the world has changed in terms of raising equity to pay for deals; both in the mineral space and also in the energy space in general. So, reserving some of that cash to use in deals feels prudent, particularly since we're not looking to continue to leverage up. Right now, we're still focused on Diamondback operated properties. You can see in the quarter we didn't do much, but there are some deals in the works and a lot of undeveloped Diamondback acreage that has been acquired alongside the QEP and Guidon positions that have potential for Viper mineral purchases. To finish that thought, if we don't have a lot of sites for deals that we're going to use cash for, I think continuing to use cash to buy back units is a prudent use of that capital.

Makes sense. And then on the hedging strategy, you started hedging 2022 with relatively wide collars and deferred premium puts as you hinted at during last quarter's conference call. Should we anticipate that strategy continuing going forward? And it seemed like you were adding, call it, like mid to high 40s per barrel floors. Did you target that level intentionally in terms of how you see distributable cash flow and leverage protection at that level, or has that just happened to be where the collar on deferred premium pricing shook out?

No. I mean, it's really solving for not going above 2 times leverage and also still being able to pay out a good amount of cash flow to the unitholders. In discussions with large shareholders, as well as considering the business model coming out of this down cycle, I think having that insurance for a rainy day is money well spent. You’ll see us continue to build our hedge position a few quarters in advance, so that we're never put in the position that we were in Q2 of 2020 again. So, hedging out-of-the-money puts—this business still generates a lot of free cash, leverage doesn't blow out, and you can still distribute a lot of that cash to unitholders.

Your next question will come from Chris Baker with Credit Suisse.

I just want to follow-up on the acquisition program. So, I think a 70% payout ratio would imply maybe a little over $100 million of retained cash for next year. Is the intent to match that sort of pace of acquisitions with that retained cash over time and entirely self-fund it?

Well, there are no guarantees. It really just depends on what size of deals are presented to us. I think we like 70% because our ground game—70% distribution is our ground game—has been a little slow year-to-date, and we've kind of gotten our revolver down to where almost zero, as we set a goal out earlier this year. If there are larger deals, we have to find a different way to fund it than just retained cash flow. But for smaller deals, I think the blocking and tackling deals that we do on a day-to-day basis make sense.

And then just as a follow-up. We've seen some E&P peers introduce or accelerate cash return programs and variable dividends. Could you maybe highlight how you frame up Viper's differentiated value proposition today, thinking about where you might be able to see opportunities to strengthen that profile, given what's a very lean cost structure today and, as you mentioned, a quickly improving leverage profile?

Yes. Viper paid the first variable dividend in the E&P space in Q4 of 2014 and has been a variable dividend payer since then. I think we cut back on the percent distributed. The way I like to think about it, as a mineral company, we distribute 70%, retain 30% without needing to go to the equity markets to fund deals. E&P is kind of the inverse, where they have to spend capital and use 70% of cash flow for sustaining capital, with the rest going to shareholders. I think it's interesting to see the E&P business model evolve closer to what the mineral business model has been for the last four or five years, starting with Viper and some of our peers in Canada. It highlights the value that minerals have. That value has been under-appreciated by the market for the last five or six quarters, but in a rising commodity price environment, having the ability to give almost all your cash flow back to your unitholders is a pretty good business.

Your next question will come from Neal Dingmann with Truist Securities. Your line is open.

My first question, Kaes, probably for you just a bit more on this free cash flow allocation. Can you give me an idea of that 30% of your free cash flow that's not part of the cash distribution? I know you mentioned about not using stock to fund acquisitions. Would most of that then just go to paying down debt, paying the RBL down, and then you can use that again to do deals? I just want to make sure I understand your thinking about that allocation of that 30%.

Yes. You're right, Neal. I think it accrues to the balance sheet; either it pays down the RBL to zero or starts to build the cash position. We want to think about our RBL as temporary funding and not permanent funding. Anything that gets put on that needs to have a path towards reduction in a business like minerals, where you don't have to spend capital to sustain or grow production. That debt balance gets paid down very quickly.

Yes. That makes a lot of sense. And then just secondly, beyond Diamondback, could you talk about your confidence in activity for the remainder of this year and into next, obviously beyond Diamondback, and really how quickly can these plans change? It sounds like you're confident about some stable activity going forward. Maybe just any color around that.

Yes. I feel really good about the Diamondback activity levels, particularly in the fourth quarter. We announced eight wells in Spanish Trail coming on and two wells in the Delaware that have a high mineral interest. I feel really good about that plan. Non-operationally, while still a little murky outside of the next couple of quarters, we are seeing the rig count rise and we're seeing a pickup in net well perspective in the forward outlook for the non-operational side. We'll continue to guide conservatively for the non-op side. I think this is our sixth consecutive quarter of being over 1% above the midpoint of our guidance on the oil front. That’s due to non-op conservatism and realistic assumptions for the Diamondback plan that went into our forecast.

And your next question will come from Gail Nicholson with Stephens. Your line is open.

You guys have an advantaged tax structure, I think 80% of the 2021 dividend is estimated to constitute a non-taxable reduction to taxable barrels. How does this change in 2022 and forward, especially with the higher commodity price environment we're currently in?

Yes, Gail. Looking back, when we converted to a taxable partnership a couple of years ago, we made sure that our unitholders at the time were not differentially affected by that conversion from an MLP to a taxable partnership. What we did was allocate some income from the limited partners to Diamondback to shield their tax structure. That announced special allocation is running—it's not running out, but it’s running lower, especially with the commodity prices rising like they have. Instead of the last couple of years being 100% tax deductible to the mineral owner, it's down to about 80%. If oil prices stay where they are right now, it's going to be around 80% next year. So, still protected, but a little less so than in the past.

Okay, great. Thank you. And then just a follow-up regarding M&A. How far in advance are you looking at the same schedule to determine potential asset purchases? Are you saying you want to own something that will be developed in the next 12 to 24 months, or are you looking at a post 24-month development plan?

Well, we certainly have more visibility in the next 12 to 24 months, and that's the benefit of slowing down at the Diamondback level. You have fewer changes to the drill schedule and the completion schedule and the projects on the list are very likely to be completed. Another benefit of generating free cash and having a low breakeven versus commodity price is that if the commodity price goes down $5, $10 tomorrow, the plan at Diamondback isn't going to change. That gives us a lot of confidence in the mineral buying for the next 12 to 24 months. That drives most of our decisions. We really prefer to look at deals and units that don't have permits today because when a permit gets filed, the private mineral buyers get very aggressive in their pricing. That's why we're focused on pads that are probably going to be developed in the second half of next year or into 2023 because we can acquire them for a better price.

And your next question will come from Pearce Hammond with Piper Sandler.

Congrats on a solid quarter, just a couple of questions from me. Number one might seem a little off the wall, but some of the mineral companies are starting to explore solar and wind royalties. I'm just curious if you've looked at that or have any thoughts on that front?

Well, yes. I mean, we've seen it happen in the private markets too, Pearce. It's not something we look at. We don't own a lot of surface at Viper. What we possess is a very small amount, so I don't think it makes a lot of sense for Viper today. But I certainly see it, and I think it's generally positive for the industry, tying to the tradition of the industry doing a good job on ESG metrics. Hopefully, the more this gets attention, the more outsiders will realize that the oil and gas industry in the United States is taking steps to improve environmental practices.

Okay. Thank you, Kaes. My follow-up is: It seems like the thesis over the past couple of years is that there are a lot of minerals in private equity hands that eventually will find their way into the public domain, either by the public mineral companies buying them or potentially some of the private mineral companies going public. I'm just curious if you still see that unfolding or has it happened at a much slower pace than expected? Just curious your thoughts on that.

Yes. I mean, I think generally private equity has done a good job deploying capital into minerals. The issue is going to be monetizing that capital. A couple of years ago, we might have said we wanted to be the biggest mineral company in the Permian, but now we’d rather be the best. That kind of limits the private equity opportunities that work for Viper. We’d need a lot of Diamondback operated minerals to be interested in a position owned by a private equity company, but the conversations we've had with private equity indicate that they are working to solve this. I would bet there will be more public mineral companies in the next couple of years, which will be good for the industry because we still need more liquidity and attention on what I believe is a valuable asset class. Minerals have received a lot of attention in the private markets and not enough in the public markets today.

And your next question will come from Derrick Whitfield with Stifel.

With regard to your second half production outlook, could you provide some insights into the Q3 and Q4 trajectory?

Yes. Good question, Derrick. I think generally, we currently expect Q3 to be a little lighter than Q2, but probably a little better than Q1 on the oil side. We expect to exit the year in Q4 very similar to where we were this last quarter, with a couple of large Diamondback pads coming on at the end of the year—eight Spanish Trail pads and two Delaware wells with a high interest. We plan to exit the year strong. We're trying to under-promise and over-deliver at Viper, and we've done so over the last few quarters. If we get surprised to the upside, that would be great, but the plan is for Diamondback activity in Q4 to give us a solid exit rate for 2021.

Great. As my follow-up, building on Neal's earlier question, I wanted to focus on your high level of visibility. Referencing your forward visibility slides, is the near-term inventory at the 15 net level a good run rate based on Diamondback's 2022 outlook and third-party activity levels?

Yes, I think that's fair. I hope the third-party activity surprises us a little to the upside, given the increase in activity we've seen in the Permian. I'm a bit conflicted on it because I want to keep US production growth as low as possible to maintain this favorable price environment. However, I think it's inevitable that we’ll see non-op and third-party visibility increase as we approach year-end and 2022 budget announcements.

Excuse me, speakers, I'm showing no further questions at this time. I will now hand it back over to Travis Stice, CEO for closing statements.

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

This concludes today's conference call. Thank you for participating. You may now disconnect.