Friday, May 26, 2023

Dorchester Minerals and Texas Pacific Land

[Previously regarding Dorchester Minerals, L.P. and Texas Pacific Land.]

The big takeaway from the energy producer earnings results from the first quarter is that there were very large increases in capital expenditures which resulted in unimpressive production growth, and even declines. The two possible causes of that adverse trend would be cost inflation (more expensive labor and material inputs for a given result) and resource exhaustion (declining quality of rock requiring more effort to get the same result). 

Another takeaway from the quarter is that the producers' capital expenditure discipline is not as good as we would like. While they are (thankfully) spending less than half of operating cash flow on capital expenditures (which implies that we are still relatively early in the capital cycle), why spend anything to maintain production when Biden is hammering the oil price?

What is bad for producers can be good for royalty owners. We have been saying this for years and this quarter we are asking ourselves why we strayed from the first class assets. Rising costs are bullish for royalty owners. Undisciplined spending on production is very bullish for royalty owners.

The big uncertainty with the non-operating mineral owners is always: how much oil do they actually own and what will their lands produce over time? (As an example, see our past posts, "Is Dorchester Minerals LP Just a Depleting Asset?" and "Dorchester Minerals LP Retrospective".) The quantity that will be produced in the future is unknowable, since the decision whether to produce is no longer in the hands of the landowner once they have leased land to an operator. Also, unlike the royalty trusts which are in a pure runoff mode, the "operating" non-operators (like Dorchester Minerals, Sitio Royalties, and Texas Pacific) can increase reserves, production, and value per share or per unit by making acquisitions. Success or failure at these acquisitions can really only be judged in retrospect.

Let's do a five-year comparison of Dorchester Minerals' production volume per partnership unit, comparing Q1 2018 with Q1 2023

Dorchester uses partnership units (not cash) to make acquisitions of acreage. So the units outstanding have grown 19% total, or 3.5% per year, compounded. Production of oil has doubled, which means that oil per unit increased 71% per unit (11.3% compounded). 

The BOE metric in the table is based on the price equivalence of natural gas (currently a 20:1 ratio) not the energetic (always 6:1) equivalence. Total production of oil and natural gas, in price-equivalent BOEs, has grown 90% total or 60% per unit.

The formula of issuing units to acquire properties seems to be working. Production per unit (BOE) has grown almost 10% per year, compounded, over the past five years. What is great for unitholders is that they did not have to invest in drilling the wells that produced those hydrocarbons.  

By the way, since success or failure at acquisitions is difficult to judge except in retrospect, Dorchester Minerals has something of a barrier to entry against competition. If you were a landowner in an oil and gas basin looking to trade your mineral rights in a tax-free transaction for partnership units that were more diversified, more liquid, and professionally managed by an entity with a long track record of success, how many choices would you have?

The market capitalization of Dorchester is now $1.1 billion (at $28.63 per share) and the enterprise value is $1.04 billion. For the first quarter of 2023, they earned $28 million of net income, generated $39 million of cash from operations, and distributed $34 million to unitholders. The CFO/EV is 15% and the distribution yield is 12.4% (both using Q1 annualized). That was at an average oil price of around $70 and an average natural gas price in the $3 range.

Texas Pacific Land, formerly a trust, is now a C-corp. They are a pure play on the Permian Basin: they own almost 900,000 surface acres, complete with mineral rights, in West Texas. That's about 1,400 square miles; almost as big as Rhode Island. The market capitalization of $10 billion is around $11,000 per acre. When we see Occidental furiously drilling away in the Permian, it is to a large degree on land owned by TPL; Oxy is the single biggest operator on their land. 

Production volumes for TPL (in BOEs) were up 0.6% for Q1 2023 versus the prior year. Importantly, this was achieved with capital expended by Occidental, Chevron, Exxon, and others, and not TPL.

Oil and gas royalties were $80 million vs $104 million, because of lower commodity prices. However, water sales were up, produced water royalties were up, and easement income was up, with the result that total revenue was $146 million vs $147 million the prior year.

Expenses were $41 million versus $23 million the prior year. The biggest issue here is legal and professional fees for the quarter of almost $17 million. There is a battle for control of TPL between the hired help management and shareholders with major share ownership. There will undoubtedly (and unfortunately) be more cash burned fighting over this immense prize. But at the same time we would not expect the legal dispute to continue forever. It is being litigated in Delaware's Court of Chancery in front of the highly astute Vice Chancellor Travis Laster, and he seems sympathetic to the shareholders.

Adding the extra legal expense as well as depreciation back for Q1 would have resulted in after-tax net income of about $100 million. That's a P/E of 25, annualized based on the most recent quarter's lower commodity prices ($75 oil and $3.60 gas). In the higher commodity price environment ($95 oil and $6 natural gas) of 2022, TPL had adjusted EBITDA of $592 million which would be a yield of 5.9% on the current enterprise value.

One thing interesting that has come out in the litigation is that TPL's management wanted to make acquisitions using stock. They thought there were assets (like Brigham Minerals, which is now owned by Sitio) that were undervalued compared to their own shares. In July 2022 when TPL made the offer to Brigham (for $1.9 billion in all-stock consideration), TPL shares were trading for around $1,700 vs $1,300 today. In November 2021, TPL also expressed an interest in buying unspecified assets from Occidental that would have involved the issuance of over $1.5 billion of stock.

It is important to note that one of the shareholders fighting TPL is Horizon Kinetics. The investment in TPL has been a centerpiece of their marketing for years. They were really upset about the idea of issuing stock to make acquisitions. But as we have seen at Dorchester, if management has a good sense of relative valuation, it can create value for shareholders by using its stock as a currency to buy things that are cheaper.

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