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Morningstar | Viper Energy Partners' Capital-Light Business Model Focused on Mineral Rights Is Very Profitable. See Updated Analyst Note from 07 Mar 2019

Viper Energy Partners owns mineral rights in perpetuity to Permian Basin acreage, which generate royalties with no need to invest capital to support drilling activity levels. In short, Viper is paid a percentage of revenue the producer generates from drilling a well and revenue fluctuates with oil prices as Viper does not hedge. The only costs Viper incurs are production-related taxes, general and administrative costs, and depletion expense. Operators, like Viper’s parent Diamondback, own the drilling rights, and Viper avoids taking working interest in wells, avoiding any portion of well operating and capital costs. The result is a capital-light and highly profitable business in the notoriously capital-intensive oil and gas industry. Our fair value estimate is $36 per unit, which implies a 2019 EBITDA multiple of about 20 times, and a distribution yield of 5.2%. In mid-2018, Viper also elected to be treated as a taxable entity, and now issues a 1099. At current prices, we see about 10% upside for Viper.

We award Viper a narrow moat based on a cost advantage moat source. Viper's cost advantage stems from acquiring minerals rights at prices that allow it to consistently earn returns on invested capital above its weighted average cost of capital. For example, Diamondback contributed its original major block of acreage (about 38% of Viper's current total acreage) which Diamondback acquired for $440 million in late 2013, which yielded an estimated $65 million in annual cash flow for a 15% yield. We estimate this acreage is generating around $130 million in cash flows today with no incremental investment by Viper required. We think Viper obtained a great deal on the initial large block from Diamondback, as initial well productivity in the Permian has improved several fold since 2014, more than offsetting the decline in oil prices.

Subsequent acquisitions have also proven smart, as initial well productivity in the Permian has improved about 50% since 2016, when Viper began its latest acquisition efforts. This productivity improvement is mainly due to improved drilling techniques and technology improvements. We think the low-hanging fruit from a technology perspective has largely played out, and the rock quality eventually will decline, so we don't think Viper will benefit this powerful tailwind in the future.

The market for mineral royalties exists to recognize the land value in oil and gas development. We estimate gross royalty payments across the largest U.S. shale plays in 2018 were about $30 billion with the Permian accounting for about half of the market. Roughly 80% of the market is made up of private owners (estimated at 12 million), with the remainder the federal government and state governments.

We estimate Viper controls about 5% of the national market and 10% of the market within the Permian Basin as measured by royalty payments. It has a bright outlook via organic drilling growth at Diamondback, which is currently the operator on 38% of Viper’s acreage, future dropdowns from Diamondback, and further acquisitions of acreage from private owners. The Diamondback relationship is important because it provides Viper with certainty that a large portion of its acreage will be drilled, providing it with greater confidence over its financials versus peers that do not have a similar relationship. In short, acreage that is dropped down to Viper by Diamondback is simultaneously prioritized on the drilling schedule by Diamondback. However, given the level of competition in the space from private equity and other sources of capital, we don't believe Viper extracts better royalty terms (reflecting a premium for customer service, reputation etc.) as its rates hew closely to state rates.