Minerals Stocks: Tarnished Crown?

[Editor's note: A version of this story appears in the 2020 edition of Oil and Gas Investor’s Minerals Business Supplement. See more stories like this here.] 

For the past couple of years, oil and gas has had few businesses that could court investors like minerals and royalties companies.

The darlings of the sector, public mineral companies traded at a premium to their E&P cousins and even launched successful IPOs as production companies tried and failed to get aloft in the same markets. A relatively small pool of companies—concentrated around Black Stone Minerals LP, Brigham Minerals Inc., Falcon Min­erals Corp., Kimbell Royalty Partners LP and Viper En­ergy Partners LP—has been able to consistently do A&D without alienating investors and access capital through the equity market.

But heavy is the head that wears the crown, and after burning so bright, minerals and royalties companies find themselves more clearly beholden than ever to a vastly weakened oil and gas space.

Producers have not only cut capex but also shut in wells and curtailed guidance for the remainder of 2020. The price war among OPEC+ members, led by Saudi Arabia and Russia, and the ongoing uncertainty due to the COVID-19 pandemic have put oil prices on a volatile path. By the first quarter, publicly traded min­eral companies were seeing drops in market value, and all but one announced plans to slash dividends in the first quarter.

While mineral companies have been built to cover wide swaths of geography and essentially insulate themselves from direct pain in one particular commodity or region, the industrywide suffering has left them more vulnerable than at any time since they first rose to the fore among energy investors.

“The overall sentiment for the minerals market is a bit mixed right now,” Jay Snodgrass, vice president of business development for MineralSoft, said.

A lingering question mark for the space, Snodgrass said, is the magnitude of uncertainly around future development plans by E&P companies.

‘Perfect storm’

Oil and gas producers began cutting spending and dropping rigs in March. However, an additional wave of curtailment announcements began to ac­celerate following April’s historic oil price drop. The cutbacks led to publicly traded mineral companies revising or completely withdrawing their guidance for the year.

Investors made cutbacks of their own, selling off shares.

From the start of trading in March through May 20, minerals companies have seen share prices generally fall. Kimbell Royalty, for instance, saw stock prices fall by 40%, Brigham’s dropped 20% in value and Black Stone by 25%.

“The Achilles’ heel of the mineral companies has always been that they don’t control their own destinies,” said Welles Fitzpatrick, managing director of E&P research at SunTrust Robinson Humphrey Inc.

In early May, Rystad Energy estimated that gross U.S. cuts could reach at least 2 MMbbl/d in June, including liquids. The estimates were based on early communication by the energy consulting firm with 31 U.S. oil producers, meaning actual production cuts could be larger.

“When you look at the mineral companies on an indi­vidual level, they are exposed to different operators and different basins,” Kyle May, senior equity research ana­lyst at Capital One Securities Inc., said. “If you were to carve them out one by one and then talk to each company separately to try to understand what the pro­duction implications are going to be for them over the next one to three months, you’re going to get a different answer from all of them.”

The Permian Basin has suffered the most. Rystad estimates a 42% share of cuts are from E&Ps in the basin—and where most public minerals companies have exposure. The exception is Falcon Minerals, which has a portfolio primarily located in the Eagle Ford Shale.

But, as Fitzpatrick noted, “There’s really nowhere that’s immune, unfortunately.”

Oil producers with portfolios spread across multiple plays followed close behind their Permian-focused peers, contributing a 35% share of the cuts. Still, Rystad noted about half of these diversified companies have assets in the Permian’s Delaware sub-basin as well as the Eagle Ford Shale.

According to Rystad’s analysis, Bakken-focused opera­tors made up 18% of the cuts, with the rest spread among producers in the Powder River Basin Niobrara’s tight oil play and the Eagle Ford.

Once the industry returns to life, after months of shut-ins, will the market be likely to look past the historic and unprecedented drop in oil and gas activity? Fitzpatrick thinks so.

“The stickier and more fundamental value driver,” he added, “is really going to be: If there’s a recovery, where do the rigs come back to?”

The rig count in the U.S., an indicator of future activity unlike curtailments, which have a more immediate impact, began to decrease in mid-March. By May 12, it had reached its lowest point on record at 339 active rigs.

A May 20 report by the U.S. Energy Information Ad­ministration said the U.S. rig count has fallen by about 433 rigs since March 17. About 308, or 71%, of the rigs taken out of service were in the country’s top three crude oil-producing regions: the Permian Basin, Eagle Ford Shale and Bakken.

Looking ahead, Fitzpat­rick said consensus among the industry is that the rigs will come back to the Permian Basin as well as the Denver-Julesburg (D-J) Basin and even the Bakken.

“But some of the other plays might not see the growth that they did in a pre- 2019 world again,” he said.

Capital One’s May said the impact on E&P activity is clearly something that’s changing the landscape and dividend or distribution policy for these companies.

Most companies in the public minerals space announced plans during first-quarter earnings to temporarily reduce distributions. The one exception, Brigham Minerals said it expects to distribute 100% of discretionary cash flow through the second quarter as it has done for the last couple of quarters.

“Obviously this is all driven by what’s going on with COVID-19, as well as the price war that occurred be­tween Saudi Arabia and Russia, and that’s also led to storage potentially filling,” May said. “You’re getting this perfect storm of basically everything that could go wrong for these mineral companies happening all at once in a short period of time.”

However, looking at the public minerals space from a long-term perspective, he said the business is still there.

“These are assets that are owned into perpetuity,” he said. “The oil, natural gas and NGL under the ground are still there, but the royalty payments will be pushed to the right as E&Ps shut in production and curb activity in the current environment.”

Advantage, minerals

Even in the current state of uncertainty, minerals still have the same advantages over working interests in terms of being noncost bearing, according to Andrew Dittmar, se­nior M&A analyst for market research at Enverus.

“Mineral interests are likely to continue to receive a premium over working interests,” Dittmar said, given that the nature of mineral ownership allows the ability to generate cash flow while maintaining less development/ expenditure risk.

Fitzpatrick added that the ability to not have a capex is “absolutely huge,” because it gives public minerals compa­nies the ability to be free-cash-flow positive. That is, unless a company has debt to deal with.

“They’re safer because you don’t have a lot of the associ­ated costs of being an E&P, but you can offset all of that safety pretty quickly if you lever up,” he said.

min­eral companies is to acquire or buy assets each quarter, which requires capital. Though, the highly volatile market and challenges of work­ing during the shutdown have brought deal­making to a virtual standstill.

“If you consider a world where the mineral companies were not continually acquiring roy­alty acreage, their existing cost structure is sig­nificantly lower,” he said.

With minimal general and administrative expense and a limited number of employees, mineral companies should be able to recognize revenue from production without spending sub­stantial capital on a go-forward basis.

“However, that’s in stark contrast to the E&P compa­nies that have to pay for the lease operating expenses and have capex to drill the wells,” he said.

Still, May described the approach to debt by minerals companies as conservative. In terms of debt maturities, he said the group is generally in a comfortable place as most rely on a revolver or credit facility to cover the cost of A&D instead of secured notes.

As for dealmaking, “How quickly deals return as we come out of the shutdown is an open question at this point,” Dittmar said, adding there will almost certainly be opportunities across the space on both the mineral and working interest side.

During first-quarter earnings season, many public min­erals companies discussed pulling back on A&D. However, management teams said they anticipate deploying mineral acquisition capital later this year depending on whether mineral sellers adjust pricing expectations.

“Opportunities remain for the publicly traded mineral companies to consolidate assets and expand their footprint,” May said.

But unlike E&Ps, he doesn’t see a need for consolida­tion among the publicly traded companies.

“Actually, more often than not, we hear from investors that they want to see more publicly traded mineral companies rather than fewer,” he said.

Broadly speaking, May said mineral ownership is still fragmented.

Further, he sees the opportunity for some “larger, chunkier deals” with private-equity funds potentially in late 2020 as he expects acquisition prices for minerals to begin softening.

“You’re probably not going to see the acquisition price of mineral assets hit bottom until maybe the middle of or later on in this year,” he said. “Because when you think about it from the [perspective of the] individual mineral owner, they’re getting their royalty checks on a delay, so that actu­ally comes a couple of months after that production flows.”

Top picks

May noted that because Brigham Minerals has zero debt, cash on the balance sheet plus a completely undrawn re­volver, the company is in a prime position to take advan­tage of A&D opportunities.

“When you look at Brigham, they’ve got a lot of dry powder where they can go out and acquire new assets,” he said. “They can continue to build up their portfolio and add new transactions.”

May said Capital One considers both Brigham Miner­als and Viper Energy Partners as top picks in the public minerals space.

“These are two very compelling stories and have some unique attributes that set them apart from the rest of the group,” he said.

Viper, in particular, is unique among the publicly traded mineral companies in being linked to a particular E&P, May said, in addition to its position in the Permian Basin.

“Their relationship with Diamondback creates visibility that sets them apart from all the other publicly traded mineral companies,” he said. “Again, when you’re trying to think about visibility and understanding what the po­tential production profile and revenue stream looks like, Viper is definitely in a league of its own.”

Brigham Minerals is also considered a top pick by Sun­Trust, Fitzpatrick said, citing the company’s balance sheet.

Another advantage—the company’s diversified portfolio.

Brigham Minerals has assets located in the Permian Basin, the SCOOP/STACK plays in the Anadarko Basin, the D-J Basin and Williston Basin. The portfolio also in­cludes a diverse group of operators, which May added is helpful in the current environment as some operators may end up potentially financially stressed in addition to imposing production curtailments.

Brigham’s diversification, Fitzpatrick said, protects it from differential blowouts.

“While you’re certainly going to get hit with the rig downturn, it’s a little bit more spread out,” he said. “You have a little bit more surety of what you’re getting.”

Fitzpatrick said SunTrust also has a Buy on Falcon Minerals, which he attributed to the company’s portfo­lio being concentrated under ConocoPhillips Co.’s Eagle Ford position.

“Obviously having that larger balance sheet and active program in the Eagle Ford is really helpful,” he said.