It’s rare that a small-cap stock with an unusual business model hits the market and looks good.
But that appears to be the case with an oil-related company built around a new business structure that caught my eye when it went public just under three years ago. Now, with a few years of trading under its belt and an oil price that appears to be moving back in the right direction, this small-cap oil stock could be attractive to risk-tolerant investors seeking a mix of income and capital gains.
A “New” Kind of Small-Cap Oil Stock
The company is a variable distribution MLP (Master Limited Partnership) named Viper Energy Partners (VNOM). It has a market cap of $1.7 billion and pays a 5.7% dividend.
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This is not just another oil explorer and producer, and it’s not just another MLP. Viper is organized more like a royalty company, a business structure that’s worked for a few gold and silver miners, but has yet to roll out in a big way in the oil industry.
Viper generates revenue by owning mineral rights to oil wells operated by other companies. It passes 100% of profits (which works out to roughly 90% of revenue) on to unit holders. This is where the variable part of the business model comes into play. As revenue goes up, investors get more income. As revenue falls, they get paid less.
Viper gives investors exposure to something they can’t easily get elsewhere: mineral rights. If you’ve ever dreamed of striking oil on your property and cashing in on royalty payments for the rest of your life (who hasn’t!), this may be your best shot. You don’t need to own the land—you just need to own shares of Viper, which can be purchased at around 17.5.
Easier than Drilling for Oil on Your Own Land
It’s not all that common for mineral rights to trade, which is why a small-cap oil stock like Viper is a neat idea. Especially since the business structure removes a lot of the risk inherent in the exploration and production process.
The main advantages are that the royalty structure removes all the capital expenditures and operational complexities from the equation. Viper doesn’t need to own and operate drilling rigs —the operator on the leasehold takes care of that. Viper just pays its share of production costs and taxes, and collects its share of the revenue.
As such, Viper’s returns depend on the returns generated by the wells on the underlying property. The key is to have good operators and good property, and to get a fair price on the mineral interests acquired. More on all this in a minute.
There are a few examples of high-quality publicly-traded small-cap oil stocks with this business arrangement, but not many. The only other public pure-play oil and gas royalty company that I’ve researched is PrairieSky Royalty (PSK.TO). PrairieSky is a Canadian company that is also relatively new to the public markets. It went public a few years ago after acquiring royalty interests from Encana (ECA).
Then there’s Franco-Nevada Gold (FNV), which was spun off from Newmont Mining (NEM) in 2007, and is also based in Canada. It’s best known as a gold royalty and streaming company, but has oil and gas assets as well. In Q4 2017, 6.7% of total revenue came from oil and gas, and I’ve seen that number above 20% in the past. In the past six months, Franco-Nevada has acquired $210 million in oil and gas royalties, so it looks like it’s trying to build this business modestly.
The Underlying Assets—What You Get for 17.50
As it stands today, Viper owns 6,401 net royalty acres in the core of the Permian Basin. By all measures, this is good real estate given that the northern Midland is one of the most productive unconventional shale plays in the U.S.
Production has gone up since Viper went public, in part because of $249 million in new acquisitions since it acquired its first assets for $92 million in 2014. In the third quarter of 2014, net production was 2,300 barrels of oil per day (boe/d). In the fourth quarter of 2016, production was 7,919 boe/d. That’s an increase of 244%.
Unfortunately for early investors, the price of oil is down by around 50% since 2014. This hasn’t helped the stock much given that it’s been a challenging time for the company to achieve meaningful revenue growth, despite the nice increase in assets and production. In the fourth quarter of 2016, revenue was $28 million. That’s up just 27% since the fourth quarter of 2014.
Things have begun to look up over the past year, however. Oil is up over 50% since it plunged below the $30 mark in early 2016. Against an improving oil price backdrop, Viper grew revenue by 20%, 18% and 40% over the last three quarters, respectively. With revenues growing, earnings followed suit, rising to $0.19 in the fourth quarter of 2016. That’s up from just $0.03 in the same quarter a year ago.
Better revenue and EPS growth helped the management team grow the quarterly distribution to $0.26 for the February 2017 payout. At that level, the payout is finally above where it was three years ago, and is delivering a 5.7% yield to shareholders.
Analysts expect revenue to jump by 70% in 2017, and for that to drive earnings up by 100%, to $0.89. New acquisitions could increase those estimates even more. But even if there are no new royalties in the near future, the jump in income should pull distributions up. And demand for those fat royalty checks could help the stock move out of its current trading range in the 17 to 18.5 zone and graduate to the 20 to 22 level area where most analysts think shares should be trading today.
Investors should be comfortable with Diamondback Energy (FANG) before getting involved with Viper given how integrated these two companies are. Viper was spun out of Diamondback to house mineral interests that the parent company had acquired. And Diamondback didn’t walk away after that. It still owns roughly 74% of Viper. The same management team runs the two companies.
Diamondback is also the operator on 41% of the acres that Viper owns interests in. These acres generated 65% of revenue in 2016. Diamondback will likely continue to drop assets down into the Viper structure, so investors should keep an eye on any property Diamondback is looking to purchase or has recently bought.
As with most MLP’s, this small cap oil royalty stock isn’t for everyone. If you don’t want to file an annual K-1, steer clear. And if you aren’t comfortable watching your investment rise and fall based largely what the price of oil is doing, move on.
For investors who move swiftly past those potential hurdles, I think Viper could live up to management’s description, which paints Viper as the MLP-equivalent of a high-growth exploration and production company with no capex requirements, low leverage and a minimal cost structure that distributes 100% of available cash to unitholders.
It’s not one I would buy on hopes of the share price doubling over the next two years, but VNOM has the potential to deliver market-beating returns from this level over the next five to 10 years.
For faster growing small-cap stocks, consider taking a subscription to my advisory, Cabot Small-Cap Confidential.
