I have been a staunch proponent and unitholder of Viper Energy Partners (VNOM) since late 2015. I think they have been and currently are the best defensive play in the American Energy space. Many investors are turned off by variable rate distribution schemes. Not me. I am a firm believer in paying out what you can when you can. On the business end, no borrowing to cover an unsustainable dividend. On the investor side, no analysis of fuzzy metrics like payout ratios. VNOM also represents a pure play on rising oil prices since income is derived directly from the wellhead price received for its net revenue interest under any given lease or unit in which it owns a specified royalty interest. VNOM distributes 100% of cash flow to the unitholders on a quarterly basis and has managed to grow its distributions 78% year over year. Although subject to the operating party's capital commitments and drilling schedule, VNOM requires no capital expenditures to participate in current or future production. By my estimation, all of VNOM's royalty ownership is located in plays which are economically viable at today's prices. Better yet, most of the royalty acres are operated under some of highest rate of return (ROR) areas in the tight oil industry and by operators with clean balance sheets and sufficient capitalization. This is very important to the business model. By nature, equity value in a royalty company is deteriorating much like time value on an option contract. Increased drilling activity raises the distributions but depletes the reserves essentially stripping away the future equity value. To counteract this, a royalty company must continue to purchase accretive royalty acres to replace the depletion occurring under the existing holdings. Since VNOM distributes 100% of its proceeds, additional equity must be sold to fund the purchase of new net royalty acres.
When I found out that VNOM entered into the core of the core Eagle Ford by buying 681 Net Royalty Acres (NRA), I jumped for joy. The Eagle Ford Shale (EFS) has recently been neglected by the industry in favor of the trendy, younger sister: The Permian Basin. While the Permian surely has great prospects, mineral and royalty deals have become significantly overvalued in the twin basins based on (in most instances) hype. The core areas of the EFS (Karnes, Gonzalez, DeWitt) have as attractive of economics as anywhere in North America. With a greater production history than that of the horizontal Permian play, the remaining infill locations in the EFS are generally well understood and delineated.
Then I saw the price tag. 681 NRAs for $123 million or about $181 thousand per NRA. As a unitholder, I suddenly felt an overwhelming sensation of sticker shock. The analysis below attempts to dissect this deal by analyzing the known economic variables as well as making some assumptions about the area and operators to qualify if this is, in fact, a "good" deal for unitholders.
Development in the Eagle Ford Shale
VNOM's February investor presentation outlines the area in which the NRAs were purchased. It also lists Devon Energy Corp./BHP Billiton (DVN)/(BHP), Pioneer Natural Resources (PXD), ConocoPhillips (COP), and EOG Resources (EOG) as the primary operators under the acreage.
VNOM EF Acquisition Source: Investor Material
I was able to draw an outline roughly covering the area and pull in all wellbores which correspond to the operators named in the investor material. DVN and BHP have an operating partnership, and as such, the wells classified between the two show up with DVN as operator. COP's operating name in the EFS is Burlington Resources.
VNOM Area of Interest Source: DI Analytics
VNOM indicates in their presentation that approximately 1,070 wells are currently producing on the royalty acreage. I limited the data set to the past 5 years due to data skew from early wells which lacked a proper completion design to indicate a reliable type curve. The end result took in 840 horizontal wells from which to model our type curve as broken out by vintage years below:
VNOM Area Type Curve (All Operators) Source: DI Analytics
Like all horizontal shale wells, these EFS wells have a steep decline rate. By looking at the vintage well count, it is easy to visualize the value of VNOM's purchase in terms of Proved Developed Producing (PDP) reserves. By month 24, the average well has declined between 70-90% from its peak production rate. Below, I plotted production date vs. well type to get an idea of which operators completed which wells in any given year. In conjunction with the type curve, this helps to visualize the PDP value of VNOM's purchase.
Completion Date Vs. Well Type Sized by Lateral Length Source: DI Analytics
The majority of the wells that have come online did so more than 24 months ago. Furthermore, the above graph shows that all of Pioneer's production comes from the down dip gas window in the Dewitt County EFS as their wells are classified as "Gas" by the Texas Railroad Commission (TXRRC). The current rates at which most of these wells produce are low but steady. The decline curve for existing production now follows an exponential decay as opposed to the hyperbolic nature of "first production". While this supports long-term cash flow for VNOM, it is quite clear that the PDP value will not support the sticker price of this purchase.
The DeWitt, Karnes, Gonzalez corridor was identified early on as the "sweet spot" of the EFS. It is oily but sufficiently geo-pressured so that the reservoir provides a strong gas drive to force the hydrocarbons up through the fractures and into the wellbore. It has also seen significant development. While I would not classify this area as suffering from exhaustion, one can see from the AOI map above just how densely drilled this area already is. Operators have mostly figured out an efficient down spacing model and have added significant reserves by proving up other targets such as the Upper EFS and the Austin Chalk. I believe that significant drilling locations remain on VNOM's acreage but just how many could surely be debated.
If we look at the key wells given to us by VNOM in their investor material, we can demonstrate the economics of the remaining locations using Decline Curve Analysis (DCA) and Discounted Cash Flow Modeling (DCF). While the NPV and EBITA numbers stated herein are for VNOMs approximate net revenue interest (stated as .6% across the spectrum) in each future well, I would like to point out that these wells should have operator IRRs exceeding 100% (with the exception of some of Pioneer's acreage which is too far down-dip) at today's strip.
Key Well Economics
The following key well type curve economics are used to demonstrate an approximate NPV for remaining locations under VNOM's royalty acreage. I used the stated .6% net revenue interest with a fairly high discount rate (PV15) because late year cash flow is not as important to the distributions as near-term cash flow. The high discount rate also helps to eliminate forecasting uncertainty. The well forecast has been truncated to 200 months. Although a royalty is technically cost free, all wells experience terminal decline whereby the working interest owners are faced with paying lease operating expenses in excess of the monthly cash flow generated by the well. Oil prices are fixed at $60 minus a $2 basin differential. Gas prices include a 12% premium to $3 Henry Hub to account for NGL value. NPV numbers also include State severance tax calculated at 7.5% for gas and 4.6% for oil. At the time of this writing, VNOM (has proposed changes to the structure) is still a Master Limited Partnership (MLP) and as such no federal income tax burden is applied to the economics.
Gwosdz A 13H Type Curve and Economics
The Gwosdz A 13H is an Upper EFS well operated by DVN.
Gwosdz A 13H Oil EUR Type Curve Source: DI Analytics
Gwosdz A 13H Gas EUR Type Curve Source: DI Analytics
Gwosdz A 13H Type Curve Economics Source: DI Analytics
Cantu A 13H Type Curve and Economics
The Cantu A 13H is a Lower EFS well operated by DVN.
Cantu A 13H Oil EUR Type Curve Source: DI Analytics
Cantu A 13H Gas EUR Type Curve Source: DI Analytics
Cantu A 13H Type Curve Economics Source: DI Analytics
Wagner A 12H Type Curve and Economics
The Wagner A 12H is a Lower EFS well operated by DVN.
Wagner A 12H Oil EUR Type Curve Source: DI Analytics
Wagner A 12H Gas EUR Type Curve Source: DI Analytics
Wagner A 12H Type Curve Economics Source: DI Analytics
Oliver A 9H Type Curve and Economics
The Oliver A 9H is a Lower EFS well operated by COP.
Oliver A 9H Oil EUR Type Curve Source: DI Analytics
Oliver A 9H Gas EUR Type Curve Source: DI Analytics
Oliver A 9H Type Curve Economics Source: DI Analytics
EOG Denali Unit
Based on the map provided in the investor material, The EOG Denali unit would appear to play a small part in the VNOM purchase. The plat of the unit provided below shows how little room should be left in the unit for additional upside.
EOG Denali Unit Depicting 101-104H Austin Chalk Wellbores and underlying EFS Development Source: DI Analytics
The Denali unit is interesting because it points to the viability of the Austin Chalk (AC) across the acreage spectrum. Initially, the lower EFS was targeted under this acreage with great results. However, the economics of the AC in isolated areas far exceed those of the EFS. A mapping technique called SoPhiH (in conjunction with other factors) can be used to determine the most productive intervals across a given leasehold position. Whereas, So refers to hydrocarbon saturation, Phi to porosity, and H to interval thickness. Multiplied together, these attributes produce a number that is usually scaled on a 0 to 15 basis. The recipe for the recent success in the AC can be attributed to a high SoPhiH number combined with a lack of a natural fracturing within the pay zone. This allows a modern completion technique to exploit the reservoir in a way in which the past AC programs did not. The end result is some of the highest ROR percentages in North America. Production history is still adolescent in these areas, and as such, no determinations about EURs are made in this analysis. Given the higher porosity within the AC (compared to EFS), it is likely that these wells will drain much larger areas. With 4 wellbores currently situated in the Denali unit - I see little room for continued drilling success. However, if this interval can be proved up across VNOM's acquisition acreage, then significant upside may be present.
The PXD acreage is a true wildcard in this deal. PXD's 49% operated working interest in their EFS position is currently up for sale. The economics vary across their DeWitt County position because the EFS is sliding off into a thermally mature (dry gas) window across the southern portion of their acreage. That said, the northern acreage has economics comparable to the key wells listed above. If a small operator were to purchase PXD's position - it is entirely possible that it may become a cornerstone of that company's portfolio resulting in a high capital allocation to future development. This could accelerate payout on VNOM's purchase.
Given the public information surrounding this deal, it is impossible to properly value VNOM's purchase. I will defer to management and assume that the metrics used to evaluate this acquisition make sense. Notwithstanding, it is demonstrable that the PDP value is not an overwhelming factor in the purchase price. VNOM guides that they are exposed to 225 active permits. Pulling permits for the named operators, I show the following breakdown:
Active Permit Map by Operator Source: DI Analytics
Permit Count by Operator: DI Analytics
If we take our NPV numbers from the key wells and apply it to the permit exposure, we can draw some reasonable conclusions about this transaction.
VNOM is exposed to 158 active permits from COP - we can make a rough translation based on NPV value from the Oliver A 9H that this represents $29.822 million or approx. 25% of the purchase price. The average NPV value of the DVN type curve equals $179 thousand. With exposure to 53 permits, the NPV value for DVN/VNOM equals $9.487 million or 7.71% of the purchase price. PXD's permits contribute another 1% roughly leaving us with a total of 33.7% in permit value. It is believable that this deal contains 17.3% in PDP value. All up, for this deal to work - VNOM needs 50% NPV value from the remaining locations to breakeven.
Maintaining and growing the distributions is the highest priority for VNOM. Buying royalty under an area with competent operators and great economics will certainly help accomplish that goal. However, any time new equity is issued to fund an acquisition - existing shareholders are faced with a degree of dilution. It is important that these acquisitions have visibility to favorable returns. After all, equity in a company is nothing more than a discounting measure of future value. Even with 50% of the value of this deal in the pipeline (or on the way there), significant future drilling locations are needed to achieve payout and provide a measure of profitability. If management cannot achieve this, what does this say about the equity value? While large and stable distributions can certainly prop up the stock price, inability to acquire future royalty at a price which makes sense will certainly not help equity value - especially when new stock is issued to do so. Royalty deals are risky in nature because they inherently involve a lot of moving parts. Because of the risk, a high return is usually expected by the investor. The monthly payments can serve as a bond proxy while one waits for future development, but the future development needs to have upside on the order of 2:1 or 3:1. It seems unlikely that we can get to those numbers based on the realistic remaining locations. This is a small piece of the VNOM portfolio and may not have much of a material effect on the company. Still, as a shareholder, I am paying attention to these deals. For now, VNOM is a hold.
Disclosure: I am/we are long VNOM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.