Editor’s note: This column is part of our Best Stocks for 2019 contest. Neil George’s pick for the contest is Viper Energy Partners (NASDAQ:VNOM).
Petroleum remains a good business to be in. Petrol prices while down from recent highs are still higher than recent lows of 2017. U.S. domestic West Texas Intermediate (WTI) crude has risen from June of last year to date by 23% to over $52 a barrel.
However, the later 2018 downturn for stocks wasn’t a standalone event, as petroleum prices also got whacked. West Texas Intermediate (WTI) and Brent Crude Oil both gave back some of the larger gains over the past three years. WTI has dropped from the recent high of $76.41 to that current $52. And Brent fell from similar highs of $86.29 to a current level of $60.71.
This may not appear to be as good of a market right now. Traders are getting their bear claws out to take a swipe at the bulls, and there aren’t too many running in the thundering herd right now. But there is still plenty of underlying positive news — for particular parts of the petrol market focused on dividends.
WTI (White) and Brent Crude (Orange) Prices. Source: Bloomberg.
It really comes down to what the globe expects from the simplest relationship you learn in economics 101 — how much supply is coming in and how much demand there will be.
The Organization of Petroleum Exporting Countries (OPEC) just had one of their regular meetings and has announced production quota cuts that may take some 1.2 million barrels per day (MBPD) out of supplies to the market.
And we still have the unfolding sanctions on Iran and its oil. Those waivers from the U.S. for a handful of countries are not permanent. This means that the market is set to lose much of the exports of Iran’s 4.4 million BPD, which will erase any of the case that OPEC is trying to make for their supply and demand imbalance.
In addition, Libya remains a war-torn region and its oil exports are down after losing access to its largest oil field.
And U.S. stockpiles of crude are down sharply as reported by the U.S. Department of Energy.
But crude oil is only part of the petroleum market, particularly in the Permian Basin of the US.
The other part of the petroleum market involves natural gas. Natural gas has soared just as crude slipped. The US market for natural gas has spiked from the beginning of October to date from $3.17 per million British Thermal Units (MBTU) to $4.07 — a gain of 28.39%.
U.S. Natural Gas Price Source Bloomberg
The reasons for that include a cold snap around the U.S. and forecasts for the winter months showing lower-than-average temperatures for large swaths of the U.S. that consume a lot of gas for heat.
And the gas story gets better. Inventories have dropped to levels not seen since 2003. And overall storage levels are on average 16% under five-year seasonal levels. So, this isn’t about a quick spike — but rather it should continue in higher prices into the winter months and early spring.
U.S. producers are pumping more and more gas out of the ground, but with rising shipments for industry, including for feedstock in petrochemical companies, there has been less headed for storage.
And then there is the developing story on exports. Already gas is being exported via pipe to Mexico and beyond. And liquified natural gas (LNG) is another major infrastructure build-out for the oil and gas market which will send more gas overseas instead of to U.S. consumers and storage.
Will VNOM Stock Win in the Petrol Patch?
Petroleum is a major component of the U.S. and global economy. This means that the market isn’t going away, and money will continue to be made from the upstream producers through the midstream pipelines and downstream refiners.
The crucial bits are, first, the operating margins for each of the segments and the individual companies. Then, look at the debt coverage for the current capital expenditures, as well as for continuing investments. And then consider the counterparty risks of the companies doing business with each of the segments of the market.
The companies in the U.S. have been in much worse situations than the current market. The look back at for how companies fared, and the risks involved, can be found in the market plunge in oil back in 2014. WTI Crude went from $107.26 in June of 2014 to a low of $26.21 ending in February of 2016.
That period saw a number of companies that learned their hard lessons about margins, debt coverage and counterparty risks. And in the wake of that, companies developed new discipline in how they look at current operations and new projects.
In addition, technology in the fields rapidly improved. Drilling costs dropped, and field development capabilities improved dramatically. The result is that U.S. shale field costs have dropped, and margins have improved.
The current WTI market even with the big price plunge is still well above the lows from the last bear market. And WTI is also well above lows over the past two years and is actually near the two-year average price.
But what you also have to recognize is that much of the U.S. oil market has been successfully dealing with is the discounts in localized oil prices for crude particularly coming from the Permian Basin in West Texas as well as other shale fields around the nation.
So, the margins that we’ve seen from the companies in the heart of North American oil production this year prove out that profitability is very much still possible at lower local prices.
Now, I’d like to introduce to you a domestic petrol company that is set up differently from a traditional exploration and production company and one that will be profitable even with lower crude prices and buoyant natural gas prices.
Viper Energy Partners (NASDAQ:VNOM) was set up as a passthrough limited partnership that went to the public market in 2014. It was set up by Diamondback Energy (NASDAQ:FANG) to hold petroleum properties in the U.S., primarily in the West Texas Permian Basin.
The transaction is known as a drop-down, as Diamondback contributed some initial field assets and the IPO raised addition capital to acquire further oil field assets. And in turn, Diamondback holds shares in Viper and also is the contracted operator of some of the properties of Viper. Diamondback simplifies its asset mix and allows the market to better value the rich and easily recoverable petrol reserves in the Permian Basin and receives dividends just like shareholders in Viper.
What sets VNOM apart is that it does not largely operate or develop its field assets. It mainly collects the royalties from companies and operators in working interest contracts. This means that Viper has less need for heavy capital investment in equipment and services. This frees it from having to constantly budget for development and maintenance.
And in turn, it focuses on keeping an eye on its working interest owners while looking to expand those interests from existing assets or by acquiring additional assets.
This simplifies it for investors, who get the benefit of revenue from oil and gas production as well as the rising future value of the underlying field asset reserves.
In May of 2018, VNOM changed its form of incorporation from a passthrough to a regular corporation. This is like many other passthroughs that want to be able to attract more institutional and fund investors. Those groups have limits on how much that they can have invested in passthroughs. It also provides the opportunity to increase its investments in further field assets over time providing growth opportunities for investors.
And for investors, this means an end to K-1 tax reporting forms which will be replaced with 1099-DIV forms like any other traditional corporate stock company.
Oil production continues to advance, with projected oil and gas equivalent seeing gains by 34% for 2018 over 2017. This increase in production from its fields continues with gains of over 311% since coming to the market in 2014 through the end of the first quarter of this year.
The company has some 14,000 acres, with a fraction of that in current production. This means more potential for even higher growth rates in production, resulting in even higher royalty cash payments. And even though it is converting to a corporation, it has ample trailing tax deductions that will continue to shield regular, qualified divided payments with return of capital distributions.
Revenues over the trailing year with higher petrol prices are up 117%. But even with prior years’ lower petrol prices, the three-year average shows gains running at 30.3%.
The other key thing about VNOM is that it does not hedge against oil and gas price fluctuations. Because it doesn’t have to worry about capital expenditures on equipment, it doesn’t need to be as worried about prices. This means that it is a very pure play on petroleum prices.
Given the structure of the company, margins are very fat, with operating margins running at 66.2% and the return on assets is at 14.8%.
It has piles of cash with a current ratio (cash against near term liabilities) of 9.9 times. And its debts are low at only 9.2% of assets, primarily to fund its operations more smoothly as needed in between new acquisitions and further development of working interest operators.
The dividend yield is at 7.4% and the dividends come quarterly. They have also been rising over the past three years by an average 35.1%. And this was during lower crude oil prices.
Viper Energy Provides a Great Bite
VNOM stock is also cheap based on its stock’s current price-to-book ratio at 2.58 times. And, with much of its field assets yet to be developed there is a lot more value to the underlying company.
I see that the current market for petroleum stocks makes for bargain buys with the right company. And armed with low-to-no capital costs, lots of cash and potential for more leasehold development — Viper Energy looks like one of those companies.
Neil George is the editor of Profitable Investing and does not have any holdings in the securities mentioned above.