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Viper Energy Partners LP (NASDAQ:VNOM)
Q1 2020 Earnings Call
May 5, 2020, 10:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good day, ladies and gentlemen, and welcome to the Viper Energy Partners First Quarter 2020 Earnings Conference Call. [Operator Instructions].

I would now like to introduce your host for today's conference, Adam Lawlis, Vice President, Investor Relations. You may begin.

Adam Lawlis -- Vice President, Investor Relations

Thank you, Lisa. Good morning, and welcome to Viper Energy Partners' first quarter 2020 conference call. During our call today, we will reference an updated investor presentation, which can be found on Viper's website. Representing Viper today are Travis Stice, CEO; and Kaes Van't Hof, President.

During this conference call, participants may make certain forward-looking statements relating to the company's financial condition, results of operations, plans, objectives, future performance, and businesses. We caution you that actual results could differ materially from those that are indicated in these forward-looking statements, due to a variety of factors. Information concerning these factors can be found in the company's filings with the SEC. In addition, we will make reference to certain non-GAAP measures. The reconciliations with the appropriate GAAP measures can be found in our earnings release issued yesterday afternoon.

I'll now turn the call over to Travis Stice.

Travis D. Stice -- Chief Executive Officer and Director

Thank you, Adam. Welcome everyone, and thank you for listening to the Viper Energy Partners first quarter 2020 conference call. Before we get started, I'd like to take a minute to extend our thoughts and prayers to all those affected by the COVID-19 pandemic. The challenges presented so far in 2020 are unprecedented, but our perseverance is evident from the decisive actions we've taken to preserve our strength through this cycle.

Turning to the quarter; Viper grew oil production 6% sequentially and 37% year-over-year. This solid production performance, along with oil realizations of 99% of WTI, unfortunately has been overshadowed by the dramatic decline in commodity prices that began in March and has continued through today. Viper took action and hedged almost 100% of expected 2020 oil production and over 50% of expected 2021 production in the form of WTI collars, putting a floor under future oil price realizations and cash flow.

The advantaged business model of Viper as a royalty company is highlighted during these times of depressed commodity prices, in that, our high cash margins, low capital requirements, and limited operational costs drive continuous free cash flow generation through the cycle. To that end, even at current strip pricing, Viper is expected to generate an over 10% free cash flow yield, assuming today's unit price.

As it relates to the free cash flow from the first quarter of 2020, we have made the decision to retain 75% of that cash flow to fortify the balance sheet. The Board intends to review the distribution policy each quarter. But with the uncertainty in the forward activity outlook and strip pricing, the prudent decision is to retain a majority of the cash flow to reduce leverage and protect the business. Viper remains in strong financial shape with $447 million of liquidity after adjusted for the expected reduction in our borrowing base from $775 million to $580 million this spring.

Looking forward, assuming there's a recovery in commodity prices, Diamondback expects to resume completion of operations in the second half of 2020, with a focus on high interest Viper owned royalty acreage. Viper's relationship with Diamondback also provides the added advantage of Viper benefiting from Diamondback's firm transportation on the Epic and Gray Oak pipelines, with pricing linked to the more liquid Gulf Coast and export markets, and Spanish Trail production linked to MEH pricing.

In conclusion, I want to underscore the fact that mineral ownership remains the safest asset in the oil industry because it's a perpetual, real property interest, that's a high margin business that requires zero capital requirements. Within the mineral sub sector, Viper is further distinguished due to our relationship with Diamondback as our primary operator. Times like these emphasize that relationship with Diamondback focuses its operations on areas where Viper owns minerals due to the lower consolidated breakeven economics.

Operator, please open the line for questions.

Questions and Answers:

Operator

[Operator Instructions]. Your first question comes from the line of Brian Downey with Citigroup.

Brian Downey -- Citigroup -- Analyst

Good morning. Thanks for taking the questions. I guess my first one's on the distribution policy. Could you provide guideposts on how you're thinking about that payout ratio on a go forward basis? Understandably, there may be some leverage ratio implications with the senior notes, but how you're thinking about balance sheet goals, whether that's leverage ratio versus absolute leverage? Just trying to think how we should be dimensioning that payout ratio through the rest of the year?

Kaes Van't Hof -- President

Yes, Brian. That's a good question. We really only have the data that we have in front of us, which is the strip, and we had to make the tough decision based on the first quarter being one of the biggest cash inflows that we're going to have over the next five or six quarters, based on where the strip is today, and that resulted in us cutting the distribution to 25% of available cash. And I think it's going to be a very fluid process. I can only really use the baseline of 25% for now. But we will say, we run sensitivities every quarter with the Board, and the Board is going to have to have a real conversation about that policy going forward. But I think overall, our best indication is where we are at strip, and if we pay our 25% ex-strip today, we're not messing with our secured leverage covenants at the revolver level.

Brian Downey -- Citigroup -- Analyst

Got it. And then I guess how should we think about leverage reduction as it pertains to revolver pay down versus opportunistically buying back debt, if available?

Kaes Van't Hof -- President

I think that's the key word, is opportunistic. We don't have a lot of experience buying back bonds in the open market. It seems like our bonds trade a little bit, but not much, you know. Certainly -- probably going to be a combination of both parking cash and paying down the revolver, and using the opportunity to buy back debt below par, if the bonds are still trading below par.

Brian Downey -- Citigroup -- Analyst

Got it. Appreciate the color. Thanks, everyone.

Travis D. Stice -- Chief Executive Officer and Director

Thanks Brian.

Operator

Your next question comes from the line of Derrick Whitfield with Stifel.

Derrick Whitfield -- Stifel -- Analyst

Hello, good morning, all.

Travis D. Stice -- Chief Executive Officer and Director

Hey. Good morning, Derrick.

Derrick Whitfield -- Stifel -- Analyst

With regard to your 2020 guidance, we're backing into an implied Q4 guide that's materially above The Street. Is that a reasonable interpretation based on the expected resumption of Diamondback activity in the second half?

Kaes Van't Hof -- President

Yes, Derrick, that's the key, right, is are we getting back to activity, and as we said on the Diamondback call, we need to first bring back our curtailed volumes and then get back to work. Now, the base case is, if that happens, and the way we have it modelled right now, Viper has exposure to about 80% of Diamondback's future completion at about a 7% or more interest. So those are some pretty meaningful numbers when you look at Viper's production. And we hope that that's the case. Now, if things remain weak and Diamondback doesn't get back to work, then that only pushes that out a quarter or two.

Derrick Whitfield -- Stifel -- Analyst

Understood. And as my follow up, could I ask you to comment on your broader views on the M&A market for the balance of 2020? I suspect the Q1 acquisitions were largely a function of work in progress?

Kaes Van't Hof -- President

Yes, that's correct. I mean, we closed everything in the first quarter with -- all those PSAs have been signed in November, December, and January and we certainly weren't going to walk on a PSA that we signed and we honored our commitments. But right now, our acquisition machine is silent for the foreseeable future. Now, mineral owners tend to be stickier with respect to perception of value, and there's often less leverage in the mineral space. So I think it's going to be pretty quiet here for the next couple quarters.

Derrick Whitfield -- Stifel -- Analyst

Helpful color. Thanks for your time, guys.

Travis D. Stice -- Chief Executive Officer and Director

Thank you, Derrick.

Operator

Your next question comes from the line of Will Thompson with Barclays.

William Thompson -- Barclays -- Analyst

Hey, good morning, Travis and Kaes. I wanted to get your thoughts on the push-pull dynamic between E&Ps and mineral owners in terms of shut-ins and continuous driven obligations. FANG had guided to relatively modest curtailment, so I think the shut-in aspect is less of an issue for FANG operated acreage. But maybe for non-op acreage and the amount of override [Phonetic] royalties that VNOM has, how do you expect the leases to -- do you expect the leases to terminate, if E&Ps continue shut-in production, and/or don't activate rigs and crackers in the near term? Would love to hear your thoughts there?

Kaes Van't Hof -- President

Yeah. I think I can really only speak to the Diamondback's portion of that. We've been very focused at Viper in buying [Phonetic] mineral interest versus overrides. And on top of that, most of our overrides are at the at the Diamondback level, and I can assure you that we expect to retain all of our production and leases that have a meaningful life or component to it.

And I think as you think about Viper's production, we certainly modeled in some curtailments. I think Viper will be hit a little less than Diamondback from a percentage basis, just given the nature of the two working together to focus on the higher interest properties staying active.

William Thompson -- Barclays -- Analyst

OK. And then, maybe going back to Brian's question, understanding that covenants restrict VNOM's distributions in the 12-month trailing aspect of debt to EBITDA metric, how do you think about managing the payout ratio if production stabilized and oil prices improve? Are you comfortable going past three times leverage temporarily? I appreciate that three times leverage for VNOM is less cumbersome than three times leverage for an E&P such as Diamondback. So just curious to get your thoughts there.

Kaes Van't Hof -- President

You know, I think we're fortunate to be -- make distribution decisions halfway through the next quarter. And I think if we're seeing significant improvement in production and pricing, that it's a little easier to lean in and make distribution at a higher leverage ratio. So, I think it's all going to be very fluid, but I think overall, we're going to be as flexible as possible and recognize that this business model is meant to distribute cash to shareholders, the largest being Diamondback, and that's still our primary objective here at the Viper level.

Travis D. Stice -- Chief Executive Officer and Director

Yes, Will, I just want to emphasize that. I mean, Viper is a yield Company, with Diamondback being the largest owner of that Company. And you can bet that the Viper level -- we're focused on maximizing return to capital to our unit holders. Taking all these things into consideration, it's still about maximization of that return.

William Thompson -- Barclays -- Analyst

OK, thank you.

Operator

Your next question comes from a line of Brian Singer with Goldman Sachs.

Brian Singer -- Goldman Sachs -- Analyst

Thank you. Good morning. I wanted to follow up on the debt and the covenants piece. Can you -- you mentioned earlier the importance of the secured debt covenant, but can you talk a little bit more about the unsecured covenant and how that will impact -- the three times would impact the timing of and the consideration for the distribution policy?

Kaes Van't Hof -- President

Yes, Brian. The high yield covenant, the unsecured covenant is simply a restricted payment should you be above three times leverage. But there are some baskets that you can distribute out of the biggest being I think trailing net income that we can look [Phonetic] at. On the secured piece, your revolver is looking at four times leverage at that covenant. And I think that goes a little beyond restricting payments. So that's really the impetus for the decision we've made today, is we're not looking to mess with any secured covenants here.

Brian Singer -- Goldman Sachs -- Analyst

Got it. Thank you. And then my follow up is, you talked earlier about some of the assumptions that go in from the FANG operated acreage. What about the -- what you're seeing activity-wise and shut-ins from operators outside FANG? Can you talk about what your base case expectations are for the second and third quarters from a shut-in perspective outside of FANG, and then what activity levels, if anything, you can characterize on expectations as you go through the rest of the year?

Kaes Van't Hof -- President

Yes, I can take activity levels first. We're assuming zero wells get completed on and off acreage in the second quarter, with a small return to work in the third quarter. We haven't modeled shut-ins on non-op acreage as shut-in's, but we've been -- we just take a bigger chop to the PDP decline that we're seeing on non-op acreage. So instead of our normal high single-digit percent we're seeing on PDP, it moves closer to a high-teens or mid-teens percentage we're seeing on the non-op PDP.

Brian Singer -- Goldman Sachs -- Analyst

Great. Thank you.

Kaes Van't Hof -- President

Thank you, Brian.

Operator

Your next question comes from online of Jeff Grampp with Northland Capital Markets.

Jeff Grampp -- Northland Capital Markets -- Analyst

Good morning, guys. Was hoping you could maybe speak to longer term in kind of a more normalized stable commodity price world. Should we think that the payout for Viper moves back to that 100% type of strategy? Or would you guys maybe give some consideration to some sub 100% payout to maybe incrementally pay down more debt or organically fund some acquisitions when that starts ramping back up?

Travis D. Stice -- Chief Executive Officer and Director

Yeah, you know, Jeff, it's hard to predict what the future looks like. But I can tell you, I'll just reemphasize that point that I made, is the reason Viper's set up is because it's a yield Company, with Diamondbacks as its largest shareholder. So you can bet that our singular focus will always be maximizing net return of our capital to the unit holders.

Jeff Grampp -- Northland Capital Markets -- Analyst

Understood. And for my follow up, and I think in the slide deck, you guys kind of emphasized this some too. It's kind of how the lease works. It's the Delaware basin example. Can you guys kind of talk about what that economic opportunity set is this year? Do you see any opportunities for any kind of lease extension, renewal type of payments flowing through to Viper, and any, I guess, kind of high-level characterization of what that economic opportunity could look like for you guys this year?

Travis D. Stice -- Chief Executive Officer and Director

Yes, Jeff. This slide is very important to where we are today because while we're not acquiring acreage, our team is focused on our highest value tracks and what are the lease requirements with respect to continuous development, primary development, or cessation of production. So we're really digging into all these leases and making sure we're communicating with the operators on their plants. And I don't think it's going to be big dollars coming into Viper, but in this market, every dollar matters. And I think that's the benefit of being the mineral owner, is that the acreage reverts back to you if the operator doesn't meet the obligations of the lease.

And that's the strongest form of security in the oilfield. And if the operator wants to let go that acreage, we can release it at some point. But most of the discussions we're having right now are about extensions on obligations and extensions on a continuous development.

Jeff Grampp -- Northland Capital Markets -- Analyst

All right. Understood. I appreciate the time, guys.

Travis D. Stice -- Chief Executive Officer and Director

Thanks, Jeff.

Operator

Your next question comes from the line of Gail Nicholson with Stephens.

Gail Nicholson -- Stephens -- Analyst

Good morning. Just any thoughts on how we should think about oil price realization for the remainder of the year?

Kaes Van't Hof -- President

Yes, Gail. On the Diamondback operating side, Viper and Spanish Trail gets the Diamondback deal, which is kind of an NEH less $3. That's about a third of Viper's oil production. Most of the rest of Viper's oil production on the Diamondback operator piece will get a Brent less pricing, and there's just so much moving around on that front that, in a normal world, there would be Brent less $6 or so. But it's probably a little higher today. And then on the rest of the acreage, we get midland pricing, and that's why we've hedged that exposure and hedged all of our WTI exposure.

Gail Nicholson -- Stephens -- Analyst

OK, great. Thank you. And then just a higher-level question. Viper has a durable free cash flow profile and really does provide security in this tumultuous world that we find ourselves in right now. So when you look at today's environment and going forward, what do you think is the biggest challenge for the business?

Kaes Van't Hof -- President

I think the biggest challenge is making sure we're getting paid for what we deserve to get paid, and making sure our operators are honoring these leases. The leasing boom in the Permian of the last ten years has put some pretty onerous terms into some of these leases, and Viper needs to spend a lot of its time making sure those obligations are honored.

Gail Nicholson -- Stephens -- Analyst

OK, great. Thank you.

Kaes Van't Hof -- President

Thank you, Gail.

Operator

Your next question comes from the line of Jason Wangler with Imperial Capital.

Jason Wangler -- Imperial Capital -- Analyst

Hey, good morning. Kaes, you just had a couple of questions about it, but curious, Slide 7 talks about kind of 2021 being where the theoretical lease expires. Is that mostly kind of where we start to see that happen? Is 2020, kind of more of a year where you're going to see extensions and things, but 2021 is where you may well see more of that opportunity come up for you and for Diamondback?

Kaes Van't Hof -- President

I would say so, since we're already so far into 2020. But this was a -- just an illustrative example. I mean, I think a lot of leases in the Delaware were taken in the '14, '15, and '16 timeframe, and they've either been extended by now or development has already occurred. And the question is how much continuous development is going to continue to occur on those properties.

Jason Wangler -- Imperial Capital -- Analyst

OK, so something to kind of watch for going forward. OK. I appreciate it. Thank you.

Kaes Van't Hof -- President

Yes, definitely something to watch for and where our business development meetings used to be about what minerals are we looking to acquire, it's now about, what are we hearing from our operators and what are the offers on the table for extensions or new leases.

Jason Wangler -- Imperial Capital -- Analyst

Thanks so much.

Kaes Van't Hof -- President

Thank you.

Operator

Your next question comes from the line of Leo Mariani with KeyBanc.

Leo Mariani -- KeyBanc -- Analyst

On the leverage side here, just wanted to get a sense of whether or not you guys have kind of a leverage target for VNOM? Fully get that it might have grown a little bit more than expected in this unprecedented downturn here. So just kind of wanted to get a sense of, where do you guys kind of want to see that kind of debt-to-EBITDA going here maybe in the medium to long term?

Kaes Van't Hof -- President

I mean, I think overall, we've tried to be pretty conservative at both the Diamondback, Viper, and Rattler levels, on a consolidated basis, I think given the weakness in commodity prices, our leverage is going to look higher than we've traditionally been comfortable with. So I think overall, Leo, the business is probably going to have to look at, are we at two times levered at $40 oil, are we turn and a half of leverage at $40 oil, because you can enter a year at $60 and be at $20 within three months. So I think the volatility of this business is continuing to point toward lower leverage, even with a business like Viper, that has pure free cash flow.

Leo Mariani -- KeyBanc -- Analyst

Well, that certainly makes a lot of sense for sure. And I guess just to that end, I know that the distribution policy is clearly an ongoing event. But from a high level, is it kind of fair to maybe think about some of this as, when you think you kind of get the leverage a little bit more comfortable, that's when you can kind of play a little bit more offense on the distributions? Is that how investors should think about it?

Kaes Van't Hof -- President

Yes, I think that's fair. I mean, just as Travis said, this vehicle is set up to return cash to shareholders, and that big shareholder being Diamondback and we intend to get back to that, as soon as we can.

Travis D. Stice -- Chief Executive Officer and Director

Yes, the driver's always maximizing unit over value, and we'll continue to emphasize that, as we talk about distributions.

Leo Mariani -- KeyBanc -- Analyst

Got you. OK. And just as a follow-up, in terms of an earlier comment you guys made, I just want to make sure I sort of understood. So when you guys were looking at the guide here for VNOM for the rest of the year, I don't know if I heard you correctly, but did you guys say that, there was an assumption that there were no turn-in lines in the second quarter of '20, and those resume in the second half? Just want to make sure I understood that right.

Kaes Van't Hof -- President

Yes, that's correct.

Leo Mariani -- KeyBanc -- Analyst

OK. Is that on both an operated basis and non-op basis? Or is this not really any line of sight on the non-op right now?

Kaes Van't Hof -- President

On non-op, we're assuming zero. Diamondback, we're assuming the existing schedule, which -- Diamondback's not completing a lot of wells in the second quarter.

Leo Mariani -- KeyBanc -- Analyst

OK. Thanks, guys.

Travis D. Stice -- Chief Executive Officer and Director

Thanks, Leo.

Operator

Your next question comes from the line of Pearce Hammond with Simmons Energy.

Pearce Hammond -- Simmons Energy -- Analyst

Good morning, and thanks for taking my questions. Kaes, appreciate that you're not very heavily drawn on your revolver right now, but it definitely seems like the debt market has improved quite a bit with the Federal Reserve, the activity that they are engaged in. And so, are you seeing opportunities to maybe go do a debt issuance, and then pay down the revolver? And if you did that, would that give you a little bit more flexibility on the distribution?

Kaes Van't Hof -- President

That's good question, Pearce. Unfortunately, not because the revolver covenant is based on total debt. So we can't be replacing secured with unsecured debt, and I think Viper's bonds are still trading a little below par and that might be an opportunity to buy back some debt below par here.

Pearce Hammond -- Simmons Energy -- Analyst

OK. And then, my follow up is just housekeeping, when do you expect to file the 10-Q?

Kaes Van't Hof -- President

End of this week.

Pearce Hammond -- Simmons Energy -- Analyst

Thank you.

Travis D. Stice -- Chief Executive Officer and Director

Thanks, Pearce.

Operator

[Operator Instructions]. Your next question comes from Welles Fitzpatrick with SunTrust.

Welles Fitzpatrick -- SunTrust -- Analyst

Hey, good morning.

Travis D. Stice -- Chief Executive Officer and Director

Good morning Welles.

Welles Fitzpatrick -- SunTrust -- Analyst

Just one quick one for me. I mean, I would imagine that most of your leases have pretty ironclad force majeure clauses. But do the shut-ins -- do they create any opportunity for incremental leasing revenue, either from companies proactively trying to extend those leases that already exist, or potentially from broken leases then being able to be released?

Kaes Van't Hof -- President

Yes, the lease would have to be broken, and it really depends on each lease, and what the cessation of production clause is in that lease. So it's various forms of cessation of production and I will say, with my Diamondback experience, where we're curtailing volumes, you're not getting close to those cessation of production issues. Now, I think if you're forced to shut in for two months, three months, four months consecutively, then you start to trip those cessation of production clauses in the leases.

Travis D. Stice -- Chief Executive Officer and Director

Yes Welles, I can tell you just from a historical perspective, that's one of the first decision notes that our land organization goes through, is cessation of production clauses and all these leases, and that's standard operating procedure for all operators. So the only time that would occur would be, by omission or by accident from other operators. It's certainly nothing we can plan on.

Welles Fitzpatrick -- SunTrust -- Analyst

OK, that's what I figured. Thanks, guys.

Kaes Van't Hof -- President

Thank you, Welles.

Operator

At this time, there are no further questions. I would like to turn the call back over to Travis Stice, CEO.

Travis D. Stice -- Chief Executive Officer and Director

Thank you again to everyone participating in today's call. If you've got any questions, please reach out using the contact information provided.

Operator

[Operator Closing Remarks].

Duration: 27 minutes

Call participants:

Adam Lawlis -- Vice President, Investor Relations

Travis D. Stice -- Chief Executive Officer and Director

Kaes Van't Hof -- President

Brian Downey -- Citigroup -- Analyst

Derrick Whitfield -- Stifel -- Analyst

William Thompson -- Barclays -- Analyst

Brian Singer -- Goldman Sachs -- Analyst

Jeff Grampp -- Northland Capital Markets -- Analyst

Gail Nicholson -- Stephens -- Analyst

Jason Wangler -- Imperial Capital -- Analyst

Leo Mariani -- KeyBanc -- Analyst

Pearce Hammond -- Simmons Energy -- Analyst

Welles Fitzpatrick -- SunTrust -- Analyst

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