Black Stone Minerals LP

NYSE:BSM

Earnings Call Transcript 2018-Q2

[Operator]

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Second Quarter 2018 Black Stone Minerals L.P. Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded.

I would now like to introduce your host for today's presentation, Mr. Brent Collins. Sir, please begin.

[Brent Collins, executive]

Thank you, Howard. Good morning to everyone, and thank you for joining us, either by phone or online, for Black Stone Minerals Second Quarter 2018 Earnings Conference Call. Today's call is being recorded and will be available on our website, along with the earnings release that was issued yesterday afternoon.

Before we start, I'd like to advise you that we will be making forward-looking statements during this call about our plans, expectations and assumptions regarding our future performance. These statements involve risks that may cause our actual results to differ materially from the results expressed or implied in our forward-looking statements. For discussion of these risks, you should refer to the cautionary information about forward-looking statements in our press release from yesterday and the Risk Factor section of our 10-Q, which will be filed later today.

We may refer to certain non-GAAP financial measures that we believe are useful in evaluating our performance. Reconciliation of those measures to the most directly comparable GAAP measure and other information about these non-GAAP metrics are described in our earnings press release from yesterday, which can be found on our website at blackstoneminerals.com.

Company officials on the call this morning are Tom Carter, Chairman and CEO; Jeff Wood, President and CFO; Holbrook Dorn, Senior Vice President of Business Development; Brock Morris, Senior Vice President of Engineering and Geology; and Steve Putman, Senior Vice President and General Counsel.

I'll now turn the call over to Tom.

[Tom Carter, executive]

Thank you, Brent. Good morning, and thanks for joining the call today. The second quarter was another strong quarter for Black Stone.

Our production during the quarter set a new quarterly record of 44,700 barrels of oil equivalent per day, 5% higher than the first quarter of '18. Oil volumes were essentially flat over the quarter. Gas volumes benefited from a high number of wells completed in our East Texas Haynesville/Bossier program as one of our major operators caught up on some delayed completion activity.

Overall, we saw 11 Haynesville Bossier wells in the Shelby Trough that were turned to sales during the second quarter, which includes 6 wells spud in 2016 that predated our farmout agreements. Those pre-farmout wells have large working interest components to them in addition to their royalty contribution. With the completion of these wells, all the new wells now being drilled and completed by XTO and BP in our program in Shelby Trough -- in the Shelby Trough are farmed out with no further CapEx required by us. Earlier this year, we provided a multiyear production outlook that showed mineral and royalty production volumes growing at a compounded rate in the mid-teens from 2018. We're executing very well on our plan to drop mineral and royalty growth. Royalty volumes set a new quarterly record coming in at 31,100 MBoe per day, which is a 9% increase from last quarter and a strong 47% increase over royalty volumes in the second quarter of 2017.

I mentioned BP's activity in the Haynesville Shelby Trough. BP has been an important partner with us in that area. Given they just committed $10.5 billion to purchase BHP's U.S. onshore assets, it's a fair question to wonder if the development opportunities they're acquiring might siphon capital away from our acreage. We've heard from the top levels of BP's lower 48 business that they remain committed to our joint development area and their full capital spin there as well. We expect ongoing strong performance in the Haynesville/Bossier on our acreage in Angelina and San Augustine counties.

And we're seeing a lot of new drilling activity across a wide spread of our acreage. Gross new wells added on our acreage in the first half of 2018 are significantly outpacing what we saw in the first half of '17. So we are clearly on track for a solid year in terms of well adds.

In addition, lease bonus came in at a healthy $11.6 million for the quarter, driven by activity in the Permian, Bakken and Austin Chalk areas, among others. Record production and improving commodity prices led to new records for both adjusted EBITDA and distributable cash flow of $100.3 million and $87.2 million, respectively. The partnership continues to see successful bolt-on to its positions in the Midland and Delaware basins in East Texas. We acquired approximately $27 million in minerals and royalty assets for cash during the second quarter. Subsequent to quarter-end, we've done roughly $17 million in acquisitions including an $11 million acquisition of mineral and royalty assets that mirror the assets we purchased from Noble last year. Year-to-date, we've done a total of over $75 million in acquisitions.

Regarding the PepperJack project, after drilling and logging what looks to be a very good well in the PepperJack A#1, last year and early this year, we drilled and logged the PepperJack B#1 well in the second quarter. This was a meaningful 13,000-foot step-out from the PepperJack A#1 well. The log of the B#1 is interesting, but the structure was deeper than we had expected for what we're drilling. We have no near-term plans to complete that well. But overall, the 2 wells have done exactly what we'd hoped they would, which is provide us information to use in marketing of this Lower Wilcox project, where we have a significant mineral position. We are currently in negotiations with industry partners for a deal that will drop third-party development of this prospect.

We increased the distribution to $0.3375 per unit for the second quarter for both common and subordinated units. That represents an 8% increase for the common over the last quarter. Using Friday's closing unit price, we are trading at a distribution yield of 7.9%. Unlike our peers, we are not currently on a variable distribution model and we don't distribute all of our DCF. So we think the distribution yield can be misleading when comparing us to our peers. For example, this quarter, we had distribution coverage of 1.3x, which means we've retained almost $20 million of cash to fund our acquisitions and development activities. To accurately compare us to peers on a yield basis, we think investors should focus on our distributable cash flow rather than just our distribution.

Distributable cash flow per unit was $0.431 per quarter, which implies a DCF yield of 10% on Friday's closing price and is more than 250 basis points above the average DCF yield of our direct mineral and royalty peers. That doesn't make a lot of sense to us and I think it presents an opportunity for investors wanting exposure to a diverse actively managed mineral and royalty asset.

With that, I'll turn it over to Jeff.

[Jeff Wood, executive]

Okay. Thanks, Tom. And just further to that good point about DCF yield versus just distributions, also point out that now, with the increase in the distribution for the second quarter to $1.35 per unit annualized, we have reached the last stage of our scheduled minimum quarterly distribution levels. So going forward, we and the board will evaluate the appropriate amount to distribute versus retaining coverage based on the performance of the business. That's without the constraints of a pre-programmed MQD other than, of course, the new minimum level established at $1.35. Now, this does not mean we're moving to a variable distribution model at this point but rather the future distribution increases will be based on our financial performance rather than the preset MQD increases that we had in place at our IPO.

Okay. So turning back to the business. We continued our strong momentum in 2018 by building on what was already a terrific first quarter. In the second quarter, we've recorded increases in production, adjusted EBITDA, which crossed over $100 million for the first time since we've been public, distributable cash flow and, most importantly, in distributions paid per unit.

Tom covered our production volumes for the quarter, but I want to talk a little bit more about the mix of that production. We made the decision in 2016 to shift away from our working interest opportunities. We entered into 2 farmout agreements for our Shelby Trough working interest to ensure capital continues to flow to that area or almost completely eliminating our capital requirements there. In fact, the last of our pre-farmout wells in the Shelby Trough came online this quarter.

Our total working interest volumes are down over 15% from their peak in the second quarter of 2017. Since we only report volumes on a total production basis including working interest and royalty if someone masks the tremendous progress we have made in growing our royalty volumes. During that same period in the past year when working interest volumes were coming down by design, our royalty volumes increased by almost 50%. That is a remarkable achievement for a company our size and was driven by greenfield development programs, acquisitions and a lot of traditional landman work. Looking forward, our working interest volume should continue to decline but we believe we'll be able to more than replace those volumes with new royalty volume growth.

In addition, to the production growth in the second quarter, we also benefited from improved commodity prices. Index prices for oil increased in the quarter and differential stayed relatively constant. Remember that as a mineral owner, we typically receive our revenues on a well at least 60 to 90 days after actual production. So we do anticipate seeing the impact of some of the winding Permian differentials in the coming quarters, although we believe that those would be partially offset by improved differentials that we're seeing in the Bakken.

In total, we recorded over $130 million of oil and gas revenues for the quarter and that was the main driver behind the record $100 million in adjusted EBITDA that we posted.

Given the strong production growth we've seen so far this year, last night, we've released updated 2018 guidance. We now expect production to average approximately 45,000 BOE per day. That's up 7% from the midpoint of our original guidance that we released in February. We also expect our production mix to be a little more weighted towards oil and to royalty volumes relative to our original expectations. So all of that is really channeling in the right direction.

Cost expectations for the rest of the year are in line with or below our original guidance, with the exception of exploration expense and that's related to the PepperJack B#1 that Tom mentioned and G&A which may come in above our original guidance because much of our employee bonuses and incentive-based compensation are performance-based and performance has been very good so far this year.

In particular, I'll point out that we are in the final cycle of our IPO awards, which should wrap up by this time next year, and those have caused our noncash G&A to appear elevated relative to normalized levels.

Our debt balance moved down a bit from last quarter both in absolute dollars and at a ratio of EBITDA. We ended the quarter with $421 million drawn on our revolver and with the leverage ratio of just 1.2x. As of last Friday, debt outstanding was down to $395 million. So we have a very solid liquidity relative to our credit facility borrowing base of $600 million. And we remain comfortable with that amount, particularly when viewed against our liquidity needs for the rest of the year. As a result of the farmouts put in place last year, we have almost no working interest participation CapEx going forward. And we've already spent the vast majority of our anticipated evaluation CapEx for our PepperJack development area. This means we can fully focus our liquidity on the acquisition front now.

In closing, 2018 continues to be a banner year for Black Stone. And while we're frustrated that the operating performance has not yet been fully recognized in the unit price, we think the continued execution, clearing up whatever remaining uncertainty exists around the sub-units and moving away from pre-programmed distribution levels should work to close that gap.

And with that, I will turn the call over to questions.

[Operator]

[Operator Instructions] Our first question or comment comes from the line of Philip Stuart from Scotia Howard Weil.

[Philip Stuart, analyst]

As I'm looking out to 2019, on my numbers, even assuming a pretty substantial increase in the dividend, I'm just kind of trying to think about distribution coverage going forward and how you're going to balance that with acquisitions and maybe like where's a comfortable level for distribution coverage if we're trying to kind of come up with an implied dividend increase kind of in the outer years?

[Jeff Wood, executive]

Yes, Phil. This is Jeff. I mean, we've kind of said in -- on past calls that, that kind of 1.1, 1.15 range feels pretty comfortable to us. Look, we're a little frustrated. We're clearly not getting paid for coverage here. We ran 1.3 coverage this quarter. That kind of goes to some of my prepared remarks just about maybe moving us off of the pre-programmed MQD cycle that we had at the IPO. So look, I think with continued performance of the business that we'd be comfortable bringing coverage down and then we probably have the flexibility now that subs are in full pay and we've hit the $1.35 level to think about distribution policy in a little more open way. So like we said, over the long term, I think 1.1, 1.15 is a very comfortable level but we'll continue to think about that is as we move forward because again it's been pretty apparent to us that we're not getting rewarded for these coverage levels.

[Tom Carter, executive]

I would add one thing to that comment. With respect to out years and distributions and coverage, and I totally am in line with what Jeff said around the coverage levels in the 1.1, 1.15. The real variable there is organic production growth on our existing asset base as opposed to acquisitions per se, and we are trying to be as proactive in that sense, and the PepperJack project is one example of that to take assets that we have in our portfolio right now that has basically 0 incremental CapEx involved with them and get those things into industry hands and be able to hopefully bring a lot of that into our production forecast that is not in there now, which would allow us to see production growth and revenue growth in excess of what we've got in our long-term model.

[Philip Stuart, analyst]

Okay. That makes a lot of sense. Any idea on potential timing of third-party development beginning at PepperJack?

[Tom Carter, executive]

Well, I would expect that assuming we get our current -- pending transaction closed, which we expect that we will, we would see production commence on that on or about the end of the year. There will be significant 3D seismic work going on, and after that, we have as much as 5 or 6 wells a year per year if the development continues. So that could turn into a -- given the way the project has developed, there are really 2 meaningful structures out there to be developed and we have quite a bit of minerals underneath it. So that's an example of where we could see volume increases in excess of what we've got in our model.

[Operator]

Our next question or comment comes from the line of Brent Koaches from Raymond James.

[Brent Koaches, analyst]

Just kind of sticking higher level, given your current liquidity position, is there any plans for sort of larger scale acquisitions for the rest of the year? Or should we expect sort of some of the more smaller-scale stuff like that was -- what was announced yesterday?

[Jeff Wood, executive]

Holbrook, do you want to take the first shot at that one?

[Holbrook Dorn, executive]

Certainly. We're looking at a number of sizable acquisitions as well as a myriad of smaller acquisitions. And to date, for this year, we just haven't been successful closing the bid-ask gap on the larger transactions. But they're certainly on our radar and we're going to, hopefully, bring a few of those home.

[Brent Koaches, analyst]

Okay. Great. And then just thinking forward, I know we're a few quarters away from the subordinated conversion. Is there any kind of details or can you just kind of describe the mechanics of the conversion next year and just kind of what investors need to be aware of going forward?

[Jeff Wood, executive]

Yes. Brent, this is Jeff. I mean it's actually very simple. At this point, it's like any traditional subordinated conversion. I mean, as long as we continue -- as long as we pay the $1.35 above common, at least $1.35 above common and subs, over the next 4 quarters, the subs will automatically convert around the time that we paid the first quarter '19 distribution.

[Operator]

[Operator Instructions] Our next question or comment comes from the line of Kashy Harrison from Simmons Piper Jaffray.

[Kashy Harrison, analyst]

So with the conclusion of the MQD phase of the distribution growth, can you give us a sense of how frequently you plan on evaluating increases and distributions moving forward? Will this be a decision that's evaluated quarterly, semi-annually or annually going forward?

[Jeff Wood, executive]

Yes. Kashy, this is Jeff. Look, I [indiscernible] my sense as we know, we've kind of guided over some over the longer terms in that 3% to 5% annualized distribution growth outside of, say, major acquisitions or other big turns in the business. No, I think that was part of my commentary is that the expectation would be that we would discuss with the board every quarter what the correct distribution level would be. So that we're -- we wouldn't be constrained, it may not be the right term, but as we said on the IPO, we had a pretty unique feature in the MQD and then it increased every year by $0.10 up to this current level of $1.35. And so there was a good deal of pre-programmed growth in there for the common buyer. So now I think it'll be an interesting discussion every quarter as to what the appropriate level of distribution should be.

[Tom Carter, executive]

Yes. And I would just go back to the comment I made earlier that the growth in those distributions is very much driven by growth in production, and our pivot away from working interest and seeing those volumes decline, which they will when you quit putting capital into them, masks the tremendous growth that we're seeing in our royalty production. And I think once that phenomenon works its way through the system, which it will, and we continue to work really hard on our organic existing asset base, we hope to be able to beat those numbers in the future.

[Kashy Harrison, analyst]

Got it. That's super helpful color there, guys. And then I wanted to say congratulations on the PepperJack exploration project. I was wondering if you could help us think through how you conceptually think about the ultimate returns on the investments, assuming you're able to successfully get third-party operators to drill on the acreage and you're able to receive the benefits of the mineral royalty ownership.

[Tom Carter, executive]

Well, I'll take a stab at that. With what we've found in the PepperJack A, which is still untested but we have a very good solid suite of logs on it and it looks like some very nearby analogies and we expect that, that well may be something in the 20 Bcf range and that's been corroborated by an independent outside engineering evaluation and we own 100% of the minerals under that. And so we think that we are, if you will, playing on house money at this point in time with that well behind us and we have proven up an area -- we have gone a long way -- let me restate that, gone a long way with one well to proving up an area that covers maybe as much as 4,000 or 5,000 acres, where some of it we own full interest minerals in that we acquired as long ago as 1992 and we've gotten 8 or 9x our money back on that mineral acquisition since we did it. So I would say the returns are infinite.

[Jeff Wood, executive]

Kashy. This is Jeff. Let me just add one point to that. And we talk a lot about this but I think it's a point that's missed by a lot of investors and this idea of these embedded dropdowns in the asset base because we've included all of the undeveloped acreage in the company at the time that we IPO-ed. So the PepperJack is just another example of that, right? If you look back at the time of the IPO, the Shelby Trough area that we talk about all the time, it really wasn't producing -- it was hardly producing anything. And it's now our largest production area and all of that has come into the benefit of Black Stone without us having to kind of "drop it down" from the sponsor entity that could have retained that. And PepperJack is just another example of this, and it's frankly one of the key things that we try to do here is put some of that undeveloped acreage into development and those are cost-free drop-downs. For our shareholders, I think it's a real point of differentiation between us and some of the peers out there.

[Operator]

Our next question or comment comes from the line of Tim Howard from Stifel.

[Tim Howard, analyst]

And apologies if you already clarified this, but does Black Stone have the option to kind of move to a more variable distribution policy before 2Q '19 when the subordinated units can convert? Or is the policy set until that conversion?

[Jeff Wood, executive]

Now it's kind of the best of all worlds for common shareholders and that we can really do whatever we want with the distribution as long as we pay a minimum of $1.35 annualized to the common.

[Tim Howard, analyst]

Okay. So we could potentially see the policy shift in 3Q '18 given there's no more kind of working interest funding going forward. Is that fair?

[Jeff Wood, executive]

Sure. I mean, yes -- I mean, it's not really a policy shift. You could see a distribution increase but you couldn't see a policy shift that would say, "hey, we're going to take both common and subs down to about 20, for example yet".

[Tom Carter, executive]

It could go up, not down.

[Jeff Wood, executive]

Yes. It can go up and not down.

[Tim Howard, analyst]

All right. That makes sense. That's what we want to hear. And then just a little bit on the hedging strategy. We saw that cost was [indiscernible] in 2020. Did you anticipate that being a -- kind of playing a larger role in your hedging strategy going forward?

[Jeff Wood, executive]

Look, I think we're going to stay relatively vanilla in our hedging strategy. That is just one more aspect to provide a little more stability to the distribution. We thought that with the way that oil was moving especially with some of the backwardation in the curve to leave a little upside, while still maintaining, I think, 55 is the bottom end of that color just made some sense. So that's not a fundamental shift away from our hedging strategy of only using swaps, but it's just one more tool in the toolkit. But I would not -- we're not -- I wouldn't expect us to start moving in anything exotic. It was just we thought those are a little more attractive terms than a straight swap price.

[Tim Howard, analyst]

Got it. And then just on long-term production guidance, would you anticipate updating that once per year?

[Jeff Wood, executive]

I think we'll -- we haven't made a firm decision on that, Tim, how often we're going to update that 5-year guidance. I think we'll just do that as it's appropriate but there's not a set policy today on how often we'll provide updates.

[Operator]

[Operator Instructions]

[Tom Carter, executive]

Okay. Thanks, everyone, for joining the call today and we look forward to speaking with you in the future.

[Operator]

Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may now disconnect. Everyone have a wonderful day.