Viper Energy: Massive Income Potential And 9% FCF Yield At $80 Oil Prices (NASDAQ:VNOM)

Introduction

It’s time to discuss Viper Energy (NASDAQ:VNOM), a company I consider one of the best ways to buy elevated income and capital gains.

On May 19, I wrote an article titled Paradigm Shift! 4 Of My Favorite Dividend Stocks To Buy Right Now,” which was based on a follower request and included some of my favorite dividend stocks with favorable valuations – including VNOM.

That said, I have never written an in-depth article on Viper Energy, which means it’s time to change that. After all, I consider VNOM a superior stock for energy income and a fantastic stock to potentially outperform the market by a wide margin for many years to come.

In this article, I’ll walk you through my thoughts and explain what makes VNOM such a fantastic stock for long-term (dividend) investors.

So, let’s get to it!

Top-Tier Permian Exposure

I’m all over oil and gas. By now, I doubt that comes as a big surprise to anyone.

This has many reasons:

• I believe demand is here to stay. As I wrote in a recent article, the demand picture for fossil fuels remains strong, which bodes well for global production – for many decades to come.

• Supply growth has rapidly weakened. The U.S. shale revolution has run out of steam after the pandemic, which gives OPEC+ more pricing power and provides a stable basis for prolonged elevated oil and gas prices. As we can see in the chart below, after explosive growth since the Great Financial Crisis, output growth of unconventional oil production in the United States has been rather flat since the pandemic. The Permian Basin is the only basin capable of lasting growth, but more on that later.

• On a market with an overall lofty valuation, with a high probability of higher-for-longer interest rates and inflation, I believe energy is the place to be. It trades below its ten-year valuation range and is cheaper than any other sector, including “value,” which isn’t an S&P 500 sector.

When it comes to investing in energy, there are many ways to put money to work. This includes buying companies producing oil and gas, pipeline operators, companies providing essential services, and royalty companies.

Especially the last category has caught my interest, as I made Texas Pacific Land (TPL), one of Viper’s closest peers, my largest investment, with roughly 12% of my entire account value.

The “problem” is that TPL yields less than 1%.

That’s where Viper Energy comes in.

Viper Energy focuses on owning and acquiring mineral and royalty interest in oil and natural gas assets – mainly in the Permian Basin.

Unlike Texas Pacific Land, it does not have surface and water rights, which isn’t a dealbreaker, as I’ll explain in this article.

Viper Energy has mineral and royalty interests – often in perpetuity. This means it benefits from oil and gas production without incurring production costs, as it’s not an oil and gas producer.

This makes it a great stock for periods of elevated inflation.

As of the first quarter, the company has roughly 32,000 net royalty acres. Half of these are operated by Diamondback Energy (FANG).

Diamondback is one of the fastest-growing oil producers in the United States and owns 56% of Viper’s common stock (including 100% of its Class B stock).

This relationship allows VNOM to buy additional mineral and other interests in oil and gas assets, while Diamondback also provides management, operating, and administrative services to VNOM.

In general, VNOM has a number of significant tailwinds.

• The business model does not come with elevated capital requirements and drilling/completion costs.
• Its assets are located in the Permian Basin, the most important basin in the United States – and one of the most important basins in the entire world.

Due to massive consolidation in this area, including Diamondback Energy buying Endeavor Energy, the Financial Times believes it will be a major driver of higher prices.

“There is no way the US rig count grows after the recent wave of consolidation by Exxon, Chevron, Diamondback and Occidental,” said Conrad Gibbins, co-head of the upstream Americas business at Jefferies. “That points to one thing, which is we’re headed towards higher oil prices. It’s not a question of if, it’s a question of when.”

That adherence to strict exploration plans suggests the US shale energy industry will shift further away from its role as a swing supplier, able to quickly turn up the production dial to douse price rises as it did early in the boom. – Financial Times (February 14)

While the Permian has room for output growth – especially for (associated) natural gas – these deals further improve breakeven prices. The Financial Times estimates that most producers are breakeven in the $30-$35 WTI range, protecting shareholders/operations even against very subdued oil prices.

On a side note, can you spot the start of the shale revolution in the chart below?

As a result of the attractive Permian, Viper Energy is consistently using cash to expand its footprint in this basin.

In 2023, for example, it executed two major acquisitions (among others):

• It bought 4,600 net royalty acres in the Permian and 2,700 net royalty acres in other basins from GRP in November. It spent roughly $760 million on this deal.
• Earlier in 2023, it bought 660 net royalty acres from Diamondback Energy for $75 million in the Southern Delaware Basin (part of the Permian). This acquisition averaged 7.2% net royalty interest and a current production of 300 barrels of oil per day.

With regard to production, in 1Q24, the company noted that operational trends are positive, with increased activity and productivity on its land.

For the second quarter, it expects 3% production growth despite divestitures of non-Permian assets, which contributed roughly 450 barrels of oil per day before the sale.

This divestiture also explains why the company’s newest full-year guidance shows a 250 barrels of oil per day decline at the midpoint.

On a full-year basis, the company expects 46,000-48,000 barrels of oil in net royalty production per day. More than half of this is expected to come from high-margin oil (natural gas prices are subdued in the Permian).

It also has a healthy balance sheet with a sub-2x EBITDA leverage ratio and roughly $600 million in liquidity.

Moreover, the company is upbeat about future growth as Diamondback continues to execute effective tests.

This includes operations in the Wolfcamp D and Spanish Trail formations by putting two wells to work. One of these was under an existing Wolfcamp B well.

The company managed to produce oil with enough separation to avoid the “parent-child” effect, where one production lowers the output of another production (like drinking from one can of Coke with two straws).

Viper Energy is very upbeat about Diamondback’s operating efficiencies and expects this to lead to prolonged growth tailwinds.

So Much Shareholder Value!

Because of its asset-light business model, the company is highly efficient.

At $80 WTI and flat production, the company is expected to generate $3.50 in per-share distributable cash flow per Class A share.

As VNOM is currently trading at $38, this implies a 9.2% FCF yield!

Because of these tailwinds, the company has a highly favorable capital framework.

This includes a commitment to returning at least 75% of distributable cash to Class A shareholders.

• In 1Q24, the company paid a $0.27 per share base dividend. This translates to a base yield of 2.8%. This dividend is even sustainable at $30 WTI!
• Beyond that, it uses variable dividends and buybacks to meet its 75% payout target. In 1Q24, it paid $0.32 in variable dividends (no buybacks). This brought the payout ratio to 75% and the total annualized yield to 6.2%.

On a longer-term basis, I expect the company to pay a double-digit yield (based on its current stock price), as I anticipate triple-digital dollar oil prices once we get a synchronized global growth upswing.

For now, we have prices close to $80 in an environment where both China and Europe are struggling. This bodes very well for longer-term prices.

I also expect the per-share value of VNOM to improve.

See, there’s a huge benefit that comes with the company’s focus on buybacks on top of special dividends.

The company aims to increase the per-share value of its business through organic growth, acquisitions, and buybacks. That way, it enhances its overall business and the per-share value.

On a long-term basis, this improves the dividend payments per share as well.

After all, when fewer shares are available, cash flow per share increases (all else being equal).

Since 2022, the company has increased the per-share oil production by 40%, with cash margins in the 80-90% range.

In general, as I already briefly mentioned, because of the company’s low-cost business, it is well-protected against inflation!

It benefits from potentially rising oil and gas production and prices (inflation) without having to deal with inflation-related headwinds on production.

Hence, as much as I love oil and gas producers (I’m not changing my mind about them), I have fallen in love with royalty plays like Viper Energy.

With regard to its valuation, I’m keeping it simple.

Valuation

The company has a 9% annualized distributable cash flow yield at $80 WTI. At $90 WTI that number rises to 11%.

As I expect oil prices to rise much further with support from potentially outperforming natural gas prices, I’m very upbeat about its income prospects and believe buying a company with these free cash flow numbers is a steal.

Hence, I am applying a Strong Buy rating.

Having said all of this, I have not yet bought the company. That’s mainly based on my decision to keep a highly concentrated portfolio. I discussed this in a recent article.

After investing much more cash than expected in TPL, I’m now figuring out which energy stocks to add.

VNOM is definitely on my list, as it perfectly fits my long-term vision. It also wouldn’t hurt to add a high-yield royalty stock to my low-yield TPL investment.

On a side note, I have more similar plays in store that I will discuss in the weeks ahead. So, please stay tuned for that!

Takeaway

To me, Viper Energy stands out as an exceptional investment for long-term income and growth.

With significant exposure to the Permian Basin and a unique business model focused on mineral and royalty interests, VNOM benefits from oil and gas production without the costs, making it a fantastic inflation-proof investment.

Meanwhile, its strong relationship with Diamondback Energy, efficient capital framework, and elevated free cash flow yield make it a compelling choice for a wide variety of dividend investors.

Pros & Cons

Pros:

• High Yield Potential: VNOM offers an elevated yield with its commitment to returning 75% of distributable cash to shareholders.
• Permian Basin Exposure: With assets in the Permian Basin, the most important oil field in the U.S., VNOM benefits from stable and growing production.
• Asset-Light Business Model: By owning mineral and royalty interests rather than producing oil, VNOM avoids high production costs and inflation-related headwinds.
• Strong Partnership with Diamondback Energy: This relationship provides operational efficiencies and growth opportunities.
• Future Growth Prospects: With continued acquisitions and a favorable outlook for oil prices, VNOM is well-positioned for long-term capital gains.

Cons:

• Market/Commodity Volatility: Energy stocks can be highly volatile, and VNOM is no exception. While it has a low-cost business model, it is still prone to oil and gas prices.
• Limited Diversification: Unlike Texas Pacific, the company has no surface and water rights, which limits diversification.