Freehold Royalties Ltd
TSX:FRU
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Freehold Royalties Ltd
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Good morning, ladies and gentlemen. Welcome to the Freehold Royalties Ltd. third quarter conference call. Please be advised that certain statements on this call constitutes forward-looking information. These statements relate to future events or are expectations for future performance. All statements, other than those of historical facts, may be forward-looking, and we caution the listener. I will now turn the call -- pass the call over to Tom Mullane, Chief Executive Officer of Freehold. Please go ahead.
Good morning, and thank you for joining us. On the call from Freehold are Darren Gunderson, our CFO; Bob Lamond, our VP of Exploration; and myself. We will summarize our third quarter results, and then we will be happy to answer questions. Similar to Q2 2018, we grew our royalty revenue and funds from operations. Over the quarter, Freehold's royalty interest revenue totaled $37.7 million, up 26% over the same period last year. Funds from operations for the quarter totaled $35.9 million or $0.30 a share, up 29% from $27.9 million or $0.24 a share in the same period in 2017. The increase year-over-year reflected the improvement in revenues, oil prices and reduction in our total cash costs. Cash costs for the quarter totaled $4.46 a BOE, our lowest total in our history. Our basic payout totaled 52% over the quarter, while our adjusted payout was 54%. Our adjusted payout ratio through the first 9 months of 2018 totaled 57%. In the near term, given the outlook for access to capital, we believe the best return to our shareholders is for Freehold to remain active in acquisitions and pay -- and continue to pay down debt with our excess free cash flow. We generated over $16 million of -- in free cash flow over and above our dividend during the quarter, which we allocated to acquisitions. Freehold completed $17.9 million of acquisitions over the quarter. In August, we closed the purchase of 64,000 acres of royalty lands and approximately 90 BOEs a day in production across central Alberta and the Deep Basin for $5.9 million and the assignment of certain minor working interest assets. In September, Freehold closed the purchase of a GORR across 109,000 acres of land with prospectivity for the Clearwater formation in the Jarvie and Nipisi areas of Alberta for $12 million. We saw the acquisitions as providing immediate royalty volumes and funds flow, along with future upside and growth in one of the top emerging plays in Western Canada, the Clearwater. The operator has commenced drilling activity with volumes expected to ramp up as development continues. On the operations side, Q3 2018 royalty production averaged 10,322 BOEs a day, down 5% versus Q2 2018 and 7% when compared to the previous quarter. Volumes were impacted by a combination of lower-than-forecast third-party drilling additions, shut-in volumes reflecting weaker heavy oil and natural gas pricing, which impacted approximately 200 to 300 BOEs a day for the quarter and reduced additions associated with our audit function, which added only 75 BOEs a day over the quarter versus 700 BOEs a day during the same quarter in 2017. Royalties, as a percentage of production, 94%; and operating income, 99%, reinforced the success we've had in adding high netback royalty barrels and disposing of our lower-return working interest production. Reflecting reduced volumes over the quarter, we have revised our 2018 production forecast by 4% to a range of 11,250 to 11,500 BOEs a day. We expect to provide 2019 production guidance as part of our Q4 2018 results in March 2019. On the activity front, drilling totaled 499 gross, 13.9 net wells on our royalty lands during the first 9 months of 2018. This was an increase of 42% on a gross measure, but a decrease of 16% on a net basis versus the same period in 2017.Activity through the first nine months of 2018 was primarily focused on Saskatchewan oil projects. Drilling in the Viking at Dodsland and in Mississippian carbonates in the Southeast Saskatchewan area continue to lead activity in Saskatchewan. In Alberta, Cardium oil drilling continues to drive activity, with a recent uptick in Viking oil development. In Q3 2018, 19 gross Alberta Viking oil wells were drilled on our lands compared with 6 in the first half of 2018. Industry drilled 131 gross wells on our non-unit lands in Q3 2018, 299 year-to-date and 44 gross wells on our unit lands, 200 year-to-date.Approximately 20% of those non-unit drills were on title land with the remainder on our GORR lands. Our top payers continue to represent some of the most well-capitalized E&P companies in Canada. Despite some challenging conditions, our leasing team continues to outpace expectations. Over the quarter, the team issued 19 new lease agreements with 13 companies. This compares to 18 issued in Q2 2018 and 30 leases in Q3 2017. Year-to-date, we have completed 95 new lease agreements on our royalty lands, which is approximately the same level we did all of last year. Since the inception of our leasing team -- since inception, our leasing team has completed 195 new lease agreements. Leasing activity was focused in the East Shale Duvernay, Cardium, Frobisher, Midale and Viking zones. We expect licensing activity to convert into future drilling in our lands through the fourth quarter and into 2019. Now I'll pass the call to Darren to walk us through some of our financials.
Thanks, Tom. Good morning, everyone. Financially, we achieved a number of objectives that continue to position Freehold as a lower-risk oil and gas investment. During the third quarter, Freehold generated free cash flow in excess of our dividends of $16.4 million, which we applied to acquisitions. Freehold closed the quarter with net debt of $79 million, representing 0.6x net debt to funds from operations. Net debt increased versus the same period last year, reflecting our 2018 acquisition activity. Net debt to funds from operations is expected to be 0.8x as of year-end 2018, as we have made some revisions to our Canadian heavy oil differentials and natural gas price assumptions through the remainder of the year. Our debt strategy is to maintain net debt to funds from operations below 1.5x, and we expect to remain comfortably within that range as of year-end. Revenue from oil and NGL production was 90% of total royalty and other revenue in Q3 2018 and is forecast to 87% of full year 2018 revenue. Our operating netback for the quarter totaled $38.74 per BOE. This was a 37% increase year-over-year and an 8% improvement versus the previous quarter, reflecting a modest improvement in oil prices, in addition to an improvement in our operating costs as a result of our working interest dispositions. Now back to Tom for his final remarks.
Thanks, Darren. In closing, we generated strong growth in our royalty revenue and funds from operations during the quarter. We maintained significant flexibility in our balance sheet while maintaining sustainability in our dividend. On the operations side, while volumes came in slightly lower than forecast, we believe our royalty lands will continue to drive development, given their oil weighting and strong economics. In terms of how we expect to allocate free cash flow, our preference is to take advantage of acquisition opportunities as they present themselves. The ability to access capital, both equity and debt, remains challenged for many Canadian E&P producers, and we believe we can service a financing tool through the creation of royalties. And the opportunity for auctioned royalties, both in Canada and the U.S., remains strong. If we're unable to complete acquisitions with our free cash flow, we expect to pay down debt. After increasing our dividend the last 2 years, we expect to revisit our dividend as part of our Q4 results in March 2019. Over the quarter, our adjusted payout was slightly below our targeted range. However, we expect it to increase due to low commodity price environment in Canada. We'd like now to see if there are any questions.
[Operator Instructions] Our first question is from Shailender Randhawa with RBC.
Yes, 2 questions from me. So the first one, just when you look at your 2018 drilling forecast at the 20 net wells, how much of that activity would be in the Southeast Saskatchewan? How would that compare over time and maybe as you think about what drilling in the basin could look like next year? And then the second question, on the Clearwater, can you tell us more about the acreage that you picked up and your evaluation of that acreage?
Okay. Thank you, Shailender. The first question with our 20 net wells, how much we think it's going to be in Southeast Saskatchewan, we believe it's approximately 40% of the drilling would be in Southeast Saskatchewan. What we saw during the year is that we saw more drilling in Saskatchewan and a lot less drilling in Alberta as we move through the year. So we expect that trend to continue. The discounts on oil in Saskatchewan are slightly less than they are in Alberta because there's lighter oil nature of the Southeast Saskatchewan stuff or in the Cromer kind of pricing blend, and it's a lot easier to get it to market. We think that trend -- this trend will continue and we'll have more drilling in Southeast Saskatchewan. As far as our Clearwater acquisition, this was raw land, about 170 sections of Clearwater. Not all of it is prospective, but a majority of it is. It's situated in a very active area, which everybody kind of knows where -- who the players are. It's in the Jarvie and Nipisi area. Lots of prospectivity there. Bob, do you have any comments on...
Yes, just a quick comment because, already, since the BOE, we've seen already 9 wells licensed over the land with floor already drilled. So no production shown or anything to report on that yet. But we're encouraged by the activity level around there, and it's largely beating our expectations for this early drilling so far.
Right. Okay. And then like in terms of like your read of the geology, like did you have a look at logs like bypassed pay? Was there seismic? Anything along those lines?
Well, absolutely. Like any of the deals that we have taken, we've definitely done bottoms-up look at this work, both internally mapping ourselves, but also using operator maps and other things around. So yes. I mean, not to go into the recipe, but yes, we've definitely taken a good look at it and are very encouraged by what we see.
And Shailender, another thing is that this is an area that was drilled perhaps for natural gas and maybe targeting some oil sands targets, and it had about one well per section, approximately. So there was lots of logs to key off of to see how extensive the Clearwater was in this area.
Our next question is from Nick Lupick with AltaCorp Capital.
You kind of already hinted to it a little bit already, but I just wanted to touch base and get your take on what the expectations are for Saskatchewan next year, again, given kind of where the differentials are. And I also wanted to talk a little bit about the Alberta Viking as well and see if you guys -- what your thoughts were there, and if you were surprised by the level of activity and if you think that might roll over, given where differentials are.
Okay. I mean, I guess, as far as activity, it's very difficult to predict next year, given the volatility in oil prices. However, we believe that we'll continue to see strong development. We've also seen good licensing in the Viking right now, and some of the operators have early days on budget. Some of those budgets may change with the volatility of oil, but there's hints that we have a large amount of Viking to -- will be drilled, particularly in the Dodsland area. And also, we believe that there'll be continued growth to drilling in the Alberta Viking as well. But given where oil prices are, it's very difficult to predict that. We're going to come out with our guidance here in March. We're going to see what all our producers are going to do as far as budgeting towards -- into 2019. And once we have a handle on our typical producer budgets, we'll have -- we can zero in on what we think is going to be drilled in our lands.
Maybe if I can just add one more comment on that. Yes, again, you did mention the Alberta Viking side. It has been very strong. It's over 19 wells drilled on it and greater than 10 of those on production to date, so -- or at least publicly with production data. And again, strong production that we see on Saskatchewan side, too. So the -- really, the belief there is that this should be a strongly economic place for operators to continue to drill.
[Operator Instructions] Our next question is from Amir Arif with Cormark Securities.
Just a couple of quick questions, Tom. Can you just provide a breakdown of your production in terms of how much is heavy and how much is in Southeast Sask?
Yes. I mean, when you look at our halfway, heavy oil is 12% of our total production, 25% of our liquids, approximately. Darren, do you have a comment on that?
Yes, correct, 25%. It's 25% of our oil production.
Yes. 27% approximately is in Southeast Saskatchewan.
27% of total production?
Oil.
Of your oil volumes? Okay. Oil volumes. Okay. Sounds good. And then I noticed that the lease agreements have a slowdown year-over-year in terms of the new lease agreements that you're doing. Is -- are you changing the structured agreements or anything? Or it's just that people are looking past the short-term dips until they're signing up to new lease agreements?
That's a very good question. Now we are relooking at how we incent people to drill. And so we are being flexible with our royalty terms to get drilling on our lands.
Okay. And can you provide some more color on that in terms of is it like less upfront bonuses or different royalty structures, price-sensitive royalty structure?
One thing that we are doing is we do recognize there's a very large difference between the flat royalties that we charge and the crown royalties. And if we mirror our royalties closer to crown with upfront bonuses and drilling commitments for potentially and maybe shorter terms, which is a little different than some crown, we'll encourage drilling, and it will still be attractive for producers. But these are pretty much custom-made with each producer.
There are no further questions registered at this time. I would like to turn the meeting back over to Mr. Mullane.
Well, thank you for joining us on this conference call. It is a challenging environment in the oil and gas space. We believe we are a lower-risk option if one is to invest in oil and gas. We believe that we will continue to provide a significant dividend to our shareholders throughout this downturn. Thank you very much.
Thank you. The conference has now ended. Please disconnect your lines at this time, and we thank you for your participation.