Viper Energy Partners LP. (NASDAQ:VNOM) Q3 2020 Earnings Conference Call November 3, 2020 11:00 AM ET

Company Participants

Adam Lawlis - VP, IR
Travis Stice - CEO
Kaes Van't Hof - President

Conference Call Participants

Brian Downey - Citigroup
Derrick Whitfield - Stiefel
Bryan Singer - Goldman Sachs
Chris Baker - Credit Suisse
Jeff Grampp - Northland
Gail Nicholson - Stephens
Neal Dingmann - Truist Securities
Leo Mariani - KeyBanc

Operator

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.

Adam Lawlis

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 our 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.

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 Diamondbacks 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 advantage nature of the royalty business model with no required CapEx 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 and 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 in the first quarter of 2021 of 15.25 to 16.25000 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 Vipers 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 down the back operated wells in the work in progress bucket, which we define as well as 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 its 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 in 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, draw unit holders over the upcoming quarter.

Operator, please open the line for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Brian Downey with Citigroup Your line is open.

Brian Downey

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?

Travis Stice

Yes, Brian, good question. I mean, I think we're going to be patient. We did take the steps from 25%, up to up to 50% this quarter. And I think we’ve 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 and our hedges roll off from 2020. And we start to realize a lot higher oil price on a majority of our production. And if we, I think of where our current prices to higher from here, I think it's logical that payout percentage, rises a little bit. I think, still we're probably focused on getting to kind of two times leverage at the end of 2021, which I think is a pretty, logical first step or next step for us from a leverage perspective. And, but like, like we've said, the increased payout is not going to be mutually exclusive to that further debt reduction.

Brian Downey

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 Vipers, 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?

Travis Stice

I wouldn't say that the E&P consolidation is impacted our thought process on asset sales. But certainly the strength that we're seeing in the private market versus, the public market or where we're trading has continued to give us confidence that, selling some assets at these prices isn't the worst idea. I think overall, we're selling assets that are completely undeveloped on 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 I think 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 public markets with zero cash flow.

Brian Downey

Great. I appreciate…

Travis Stice

Excuse me in the in the private markets with zero cash flow.

Operator

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

Derrick Whitfield

Hey, good morning, guys.

Travis Stice

Good morning, Derrick.

Derrick Whitfield

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

Travis Stice

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 staple planet at the parent Cove. I think the, 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 has improved slightly on the non-ops side, particularly in the last couple months. So, while I won't commit to the same flat as guidance today. I think it's a potential outcome, for the full year.

Derrick Whitfield

In case you stand on that point, specifically, when you guys look at the permits to assess your third party key, so to speak, 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?

Travis Stice

I think that's fair. And I think, you've seen it in the data we put out that the Diamondback, net wells really held up the company in Q2 and, and then well, sorry, mainly in Q3 and will continue to do so in Q4. Certainly, I certainly hope to recount as bottom but I also hope, from an industry perspective, we don't go back to grow, grow, grow, grow, and instead focus on maintaining production and hopefully Viper's the beneficiary of some of that non-op production getting turned in mind here and over the next few quarters.

Derrick Whitfield

Great, very helpful, guys. Thanks.

Travis Stice

Thank you, Derrick.

Operator

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

Brian Singer

Great, thank you. On the Diamondback call, I believe Diamondback said flattish type production until the oil prices move higher and then more longer term, low single digit or just single digit production growth. And 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 on from a Viper portfolio -- from a Viper 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?

Travis Stice

Yes Brian, I mean, I think certainly the second half of this year, Viper’s growth is going to outperform Diamondbacks, Vipers operated production by Diamondback is going to outperform Diamondbacks growth. This does go in waves and we had some really high interest wells come in on in Q3, that's going to help us go on into Q4 but over the longer over the longer term I would hope that Viper’s Diamondback operator production can slightly outperform Diamondback if Diamondback is staying flat or grow a couple of bits higher than a couple hundred bits higher on a percentage basis and then Diamondbacks but, that's our job as a consolidated capital allocator to make sure the drill schedule is encompassing Viper minerals and, and what we see today is that, there's going to be a lot of -- interest pads coming on in 2021, continuing that trend of increasing proform of capital efficiency heading into 2021.

Brian Singer

Got it? Thank you. And then my follow up, but you talked about asset sales earlier and understandable and the understandable focus on de-leveraging, 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 to and your interest level to evolve?

Kaes Van't Hof

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

Brian Singer

Great, thank you. Thank you.

Kaes Van't Hof

Thank you, Brian.

Operator

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

Chris Baker

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

Kaes Van't Hof

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

Chris Baker

Okay, great. And just as a follow up, realizing the focus today is on the balance sheet. But once that sort of peak leverage is in the rearview mirror, is there a specific leverage target? You talked about two times by the end of next year, but is there a specific leverage target that allows you to restart the acquisition program albeit and what it sounds like is a very thoughtful way.

Travis Stice

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

Chris Baker

Okay, great. Thanks.

Travis Stice

Thank you, Chris.

Operator

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

Jeff Grampp

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

Travis Stice

Yes, I mean, in 2020 I don't know what normal is anymore, Jeff. But, I do think it's kind of a mid-cycle oil price, 45 to 55 WTI, which is a long way from where we are today. We should be closer to the turn a turn and a half levered at most. And while I won't commit to a long term payout ratio on this call, I do think it's something like the inverse of an E&P. So if an E&P is reinvesting 70% of its cash flow into, maintenance capital and returns, maybe the mineral company can be the opposite. I think, we've heard a lot talk about variable dividends this in the E&P space and I asked investors to go look back at what we've done and Vipers been a variable investment vehicle, variable payout vehicle, for five or six years now and it's returned a lot of cash back to shareholders.

So I think, I think a rule of thumb could be that it's the inverse of an E&P. I mean, a mineral company certainly needs to continue to add inventory. This is a depleting business. But the urge that inventory for a mineral company is much different than an E&P.

Jeff Grampp

Got it. Appreciate that. And for my follow up, how would you say a hedging philosophy integrates into some of those kind of longer term goals. I know you guys put some on at the beginning of this pandemic, but it seems like been a little 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?

Travis Stice

I think through down cycle, you always have to look at the decisions you made and figure out, what were you doing before the down cycle that was good, bad or indifferent? And one of the lessons learned, I think, for us at Viper is that, if you have debt, you should probably hedge more than less. And, Viper was always an unhedged vehicle because there was not a lot of debt. When we added that bond, we should have hedged and, that's a shame on me for not doing that. But I do think lessons learned is that, well I don't want to trap Viper into a specific cashflow number. I do think protecting the downside from some sort of wide range of colors that guarantees our investors some form of return of capital, on the downside and doesn't limit their exposure to oil prices on the upside, is probably going 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, over a short period of time.

Jeff Grampp

All right, that sounds good. Thanks for the time, guys.

Travis Stice

Thank you, Jeff.

Operator

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

Gail Nicholson

Good morning, most of my questions have been answered. Just kind of curious, if we look at the volatility, in the commodity you have experienced in 20. How are you guys thinking about, that maybe not hoarding cash, but the need to potentially build cash on the balance go-forward basis, just to have as a safety net?

Kaes Van't Hof

Yes, Gail, I mean, it's a good comment. I think it's probably less important at Vipers than Diamondback to build cash, just because the first step at Viper is to get that revolving credit facility down to almost zero, and, and reduce our reliance on bank funding. I mean, you've seen obviously, the banks have, 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. So I think we're a long way off from getting the revolver to zero, but, but certainly having, the ability to buyback bonds in the open market, pay down debt, and also call that because Viper is not investment grade, has a little less of a need to hoard cash, but I do recognize that, having cash for a rainy day isn’t the worst thing in running an energy company.

Gail Nicholson

Great, thank you.

Operator

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

Neal Dingmann

[Indiscernible] acreage and are you thinking that will be about the same year assuming sort of going into next year?

Travis Stice

Neal, can you repeat that question?

Neal Dingmann

How many current rigs? How many rigs are you operating right now?

Travis Stice

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

Neal Dingmann

Wow. Okay, that sounds good. The great, great details. And then secondly, I know Viper as you know has always benefited from Diamondback FTI, Epic and Grey. And, I know the price and its length there. So I'm just wondering, are you expecting much change? I think what these are long term contracts, so would there be much change in how we think about this for Viper going forward or not really given sort of the length and duration of these contracts?

Travis Stice

No, I don't think there'd be a change and we set this Viper up to receive the same pricing as Diamondback and other companies have, other E&P have marketing entities that take possession of the barrel in their local market and then sell it to the international market or wherever they end up selling the barrel to and in order to have full alignment between the two public entities, we sell at wellhead and therefore Viper receives the same price as Diamondback. I think, Viper because of Spanish trail being 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 you want to make sure -- are aligned on what they receive.

Neal Dingmann

Very good. Thank you.

Travis Stice

Thanks, Neal.

Operator

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

Leo Mariani

Hey guys, just wanted to follow up on comment you made around the production guide for 4Q, 2020 and 1Q 2021. I know you guys were right, that you're really 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 transfer?

Travis Stice

Yes, I mean, we were assuming some non-op activity, we're certainly not assuming, we get back to level seen and the end of 2019 or early 2020. I think non-ops going to help a little bit in Q4 and Q1, but Q4 will probably be mainly driven by the follow through of these high in our iPads from Diamondback, benefiting Q4. And then Q1 is still a little bit far away from us right now to make any bold predictions. But, I do think Q4 is likely, a bit stronger than Q1.

Leo Mariani

Okay, that's helpful. And I guess, just from a perspective of the payout ratio, just kind of wanted to make sure I understood you guys correctly here. You obviously took it up from 25% to 50%, which is nice to see. I guess, basically just saying that, we're likely to kind of stay at this 50% for a while until we really see oil prices kind of recover to that sort of 45 plus type timeframe.

Travis Stice

Well, yes, I mean, I think a while in our industry is a relative definition. So, we have confidence that Q1 and Q2, strip starts to improve, and that we're going to receive a much higher price for our commodity, high 30s, low 40s. And then I think it's on the board to look at that forward outlook and see if we're reducing debt to that two times, leverage, kind of target, with extra pricing, and can we protect that a little bit via hedging? And if we can do that, then then let's, increase the payout even further.

Leo Mariani

Okay, thanks for your time.

Travis Stice

Thank you, Leo.

Operator

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.

Travis Stice

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

Operator

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