Horizon Kinetics LLC, a New York-based investment advisory firm founded in 1994, released its Q3 2020 Commentary – a copy of which is available for download here. It has over 70 employees and is led by Murray Stahl. Its investment strategy is long-term and contrarian oriented, and the fund usually holds a concentrated portfolio with original stock picks.
In the said letter, Horizon Kinetics highlighted a few stocks and Texas Pacific Land Trust (NYSE:TPL) is one of them. Texas Pacific Land Trust (NYSE:TPL) is a publicly traded land trust. Year-to-date, Texas Pacific Land Trust (NYSE:TPL) stock lost 26.4% and on November 19th it had a closing price of $574.99. Here is what Horizon Kinetics said:
“There’s not much we haven’t written about TPL in the past, exhaustingly, no doubt, if not exhaustively. Paradoxically, there is far less to say about it than about 99% of the companies in existence, save for other royalty companies, because it is, well, a royalty company. Therefore, other than to briefly frame the business model, which is the essence of its extraordinary value, this portion will be only be comments about recent results and valuation.
Because TPL is a royalty company, other than the portion of its water operations involved in recycling, it is essentially a pass-through vehicle for:
− Royalties on the oil and gas output of other companies that take it upon themselves to commit billions of dollars of capital, take great operating risks, and are operationally intensive.
− Lease revenues on its 900,000 surface acres that are interspersed throughout portions of the Permian Basin, most importantly the Delaware Trend within the Permian. These form a blocking position for operating companies that pay multi-year fees to cross or otherwise use TPL’s land.
− Revenues from the sale of the non-potable water to which TPL’s surface acreage grants it rights.
The company’s royalty and land positions in the Delaware Trend are legitimately described as crown jewel properties in the crown jewel of the U.S. energy reserves.
− TPL requires no capital and has no debt, because it does not need to acquire land or more royalty interests, these having been granted to it over 130 years ago.
− These pass-through activities incur negligible operating expense, since they require perhaps a couple of dozen personnel for the $490 million of revenue they generate.
− Only a very small fraction of the royalty land has ever been drilled on. Plus, within that small fraction, most of it was done with old technology, so probably only a small fraction of those particular reserves has been extracted. It is a resource that should be productive for many, many decades.
In the EIA’s own projections of U.S. oil production over the next 20 and 30 years, it is the Southwest, which primarily means the Permian Basin (the blue line in the graph below), that remains the dominant source.
For all these structural reasons:
− TPL’s free cash flow margins exceed those of the most profitable S&P 500 company.
− It is the single highest quality, highest profitability asset that it is possible to identify in energy –we, at least, have located no other – and therefore a singularly important inflation hedge that can pay off mightily at a contingent moment that might be greatly damaging to most other equity valuations.
− Like any insurance, the cost of not having it, should the need arise, could be extreme. One wants to have some insurance. Yet, the business model does not require an inflationary oil environment in order to provide a superior financial return, as will be reviewed below.
On the business value side, TPL is actually doing remarkably well, which is an expression of its royalty business model and unique mineral rights position. The following are some relevant figures from the June quarter earnings statements. They will be out of date in several days, when TPL announces its third quarter results. Whatever the quarterly results might be, and as all of the preceding discussion to this point should make clear, near-term changes in oil production or prices – the short-term changes that draw short-term attention – are irrelevant or, worse, misleading relative to the long-term case and intrinsic value.
As a basis of comparison, I’ll use ConocoPhillips, which is the 3rd largest U.S. oil company behind ExxonMobil and Chevron. I use Conoco, because roughly one-half of the Exxon and Chevron businesses are chemicals and refining, although their results would look surprisingly similar to Conoco’s.
− West Texas Intermediate oil is down over 25% from its average 2019 price
− Conoco’s 1st Half 2020 revenue was down 48% vs. H1 2019
− Pre-tax loss (excluding gains, impairments and non-operating losses): $(632) million vs. $3,774 million income in the 2019 period.
That is what is going on even among the largest, best-capitalized energy companies. As for TPL’s 1st six months of 2020, excluding land sales:
− Operating revenues were down 12%
− Operating income: $103.6 million vs. $129.2 million
As to TPL’s production-level experience in the 1st half, vs. 2019:
− Oil revenue was down only 11%, because underlying production volume was up 10.9%
− Gas revenue was down only 24% (gas price was down 34%), because production volume rose 30.1%
For TPL’s June quarter, vs Q2 2019:
− Oil revenue down 49.3%. The average realized price was down 54.0%, while production volume rose 10.6%
− TPL’s Q2 pre-tax operating margin: 63% vs. 70%
− Cash: $258 million; total liabilities $80 million
As of June 30th, the Trust’s share of production volumes, in barrels of oil equivalent per day, was 15.7 thousand vs. 13.7 thousand at 12/31/19. Because of the increased drilling volumes on properties where TPL has mineral rights, what would its revenues look like on a run-rate basis?
− At 15,700 boe/day and recent $41 average spot pricing for oil (equating, by our estimate, $30/net barrel to TPL based on its mix of oil/gas/natural gas liquids), its royalty revenue is $180 million/year, separate from its other revenue sources. Calendar 2019 oil revenue was $155 million
− For a modest sense of earnings sensitivity, the same June 30th production level, but using $55 avg oil price ($40 net to TPL), revenue would be $230 million of annual royalty revenues ($30/share), which would be 50% higher than last year.
Other Valuation Observations
Among other aspects of TPL’s valuation that are not known in the general public realm (TPL itself being virtually invisible to the public) are drilled-but-uncompleted wells (DUCs) in which the Trust has a royalty interest. These are wells for which substantially most/all of the drilling and expenditure has been done, but for which the operator (say, Chevron or Apache) has temporarily delayed completion. In the past, this might have been in response to limited pipeline takeaway capacity, or perhaps undesirable near-term oil/gas pricing. It’s a timing issue. However, these DUCs require limited expense to complete, and in some cases, the well can be forfeit under lease terms if not completed by a certain expiration date. DUCs numbered 583 at 6/30/20.
o The DUCs, therefore, have a sort of inventory value for TPL. Viewed that way, by very rough estimation, that could be worth $1.8 billion of future ‘inventory’ revenue to the Trust. TPL has a market cap of $3.5 billion. The calculation, for whatever weight one gives it, is as follows, with the assumptions included:
583 DUCs x 1.250 million boe/well x $40 net barrel pricing x 1/16th avg. royalty = $1.8 billion
− Concho Resources Valuation We’ve been asked about the $13 billion enterprise value that ConocoPhillips paid for Concho earlier this month and what that implies for the TPL valuation. A direct comparison cannot be made, at least not with any valid accuracy:
o First, there is the stark difference we’ve been discussing between a royalty business model and a capital-intensive operating company – they are opposite sides of the moon. The return on sales or capital of a developer is a small fraction of that of a royalty company, and the business risk is exceedingly greater. Accordingly, the price paid per equivalent acre for an operating company would be far lower than for TPL’s royalty acres.
o Second, not all acreage is equal. The Concho acreage lacks surface or water rights, which figure very large in TPL’s revenue and business value.
o Also, much of Concho’s Delaware Basin acreage is in New Mexico. That acreage is at risk of federal political policy (federal land) and has higher operating expenses (N.M. permits less infrastructure).
Nevertheless, with that prior proviso, which should dominate the degree of credibility one attaches to these figures, here is a very generalized assessment:
o The $13 billion, for 550,000 net acres (on 800,000 gross acres) comes to $24,000 per net acre.
o In recent years, transaction prices for royalty acreage has been roughly 5x that of ‘operating acres’.
o One still has to differentiate, for each company, between those positions that are in prime locations that are now being operated and producing cash flow today, and those that are less well situated and which might not be operated for many years and which will require large capital investments.
o Not to ignore the obvious, but this pricing occurs during the deepest energy sector crisis on record.
o Making the various detailed and abstruse adjustments that our analyst does, and figured off the Concho acquisition price, we believe the TPL mineral rights alone, separate from the land and water earnings, far exceed the company’s entire market value.
− A Final Word or Two
o All of the TPL discussion takes place in an environment in which the price of oil has declined by 16% in the past 3 years, and 28% in the past 5 years, yet the company’s oil and gas royalties in 2019, 2018, and 2017 were, respectively, $155 million, $124 million, $58 million. And, as calculated above, even at the current severely depressed oil price of $41, the run-rate production level is $180 million. The share price is up 45% in those 3 years and 255% in the 5 years.
One must wonder why you would ever bother with the complexities of a conventional oil company.
One must wonder what the result would be if oil were $100/barrel again, or $200, which it hasn’t been.”
In Q1 2020, the number of bullish hedge fund positions on Texas Pacific Land Trust (NYSE:TPL) stock decreased by about 18% from the previous quarter (see the chart here), so a number of other hedge fund managers don’t believe in TPL’s growth potential. Our calculations showed that Texas Pacific Land Trust (NYSE:TPL) isn’t ranked among the 30 most popular stocks among hedge funds.
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