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Viper Energy Partners LP (NASDAQ:VNOM)
Q3 2020 Earnings Call
Nov 3, 2020, 11:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Viper Energy Partners Third Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. [Operator Instructions] I would now like to hand the conference over to Adam Lawlis, Vice President, Investor Relations. Thank you and please go ahead, sir.

Adam Lawlis -- Vice President, Investor Relations

Thank you, Bridgette. Good morning and welcome to Viper Energy Partners Third 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, the participants may make certain forward-looking statements relating to the company's financial condition, results of operations, plans, objectives, future performance of 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 Viper Energy Partners Third Quarter 2020 Conference Call. The third quarter was a strong quarter for Viper as we saw a resumption of completion activity on our mineral and royalty acreage as commodity prices improved from the historic lows witnessed during the second quarter of this year. Viper's 10% increase in oil production during the third quarter was driven primarily by 38 of Diamondback's 41 completions in the quarter, having roughly 10% average royalty interest net to Viper, as third-party activity remained minimal, again showcasing the differential relationship between Diamondback and Viper.

The advantaged nature of the royalty business model with no required capex and only minimal operating expenditures further enhanced by Viper's best-in-class cost structure has been highlighted during this severe industry downturn as Viper has been able to reduce total debt by 10% in just the past six months. As a direct result of this and because of our confidence in the expected free cash flow to be generated in our forward outlook, the Board has elected to increase our distribution payout for the third quarter to 50% of our total cash available for distribution, up from 25% previously. The $0.21 per unit of total cash available for distribution implies a 12% annualized distributable cash flow yield based on our current unit price.

On the operations front, we continue to maintain a strong inventory of both work-in-progress and line of sight wells. Given that visibility, we have initiated average production guidance for the fourth quarter of 2020 and the first quarter of 2021 of 15.25 [Phonetic] to 16.25000 [Phonetic] barrels of oil per day. While production is already within the high-end of our previously guided range and we remain confident we'll exit 2020 with a strong production rate, Diamondback operated activity on Viper's acreage is expected to be slightly lower in the fourth quarter this year and into the first quarter of next year before returning to a more elevated level again starting in the second quarter of 2021. This is seen with only 3.5 net Diamondback operated wells in the work-in-progress bucket, which we define as wells expected to be turned to production within the next six to eight months, but 7.4 net line of sight wells, which are expected to be turned into production in the roughly six to eight month time period thereafter.

Further, we continue to be conservative in our forecasting of third-party operated production despite leading-edge indicators pointing to a return to increased activity levels and timing of operations. Despite this conservatism at $40 WTI and production held flat relative to our average fourth quarter 2020 and first quarter 2021 guidance, Viper is expected to generate approximately $200 million of free cash flow on an annualized basis in the first quarter of 2021. This equates to greater than 11% free cash flow yield as a percentage of enterprise value or roughly 18% based on our current market cap. Viper remains in strong financial shape with $461 million of liquidity and we'll continue to look for avenues to accelerate the deleveraging process so that we can continue to increase our return of this free cash flow to our unit holders over the upcoming quarter. Operator, please open the line for questions.

Questions and Answers:

Operator

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

Brian Downey -- Citigroup -- Analyst

Good morning. I hope everyone's well and thanks for taking my questions. You increased your implied payout ratio here to 50% in the third quarter. I noted in your deck that you expect to continue to maintain a portion of cash available to reduce debt. Any updated thoughts on how we should think about the pace of that payout ratio increasing over time? What guideposts you are watching and what the anticipated ceiling is given those debt reduction goals?

Travis D. Stice -- Chief Executive Officer And Director

Yeah, Brian, good question. I mean I think we're going to be patient. We did take the step from 25% up to 50% this quarter and I think we have a lot of confidence in keeping that kind of overall payout ratio going forward. Now I think the key is going to be Q1 and Q2 and our hedges roll off from 2020 and we start to realize a lot of higher oil price on a majority of our production and if we -- I think if we're [Phonetic] at current prices to higher from here I think it's logical that payout percentage rises a little bit. I think still we're probably focused on getting to kind of two times leverage at the end of 2021 which I think is a pretty logical first step or next step for us from a leverage perspective, but like we've said, the increased payout is not going to be mutually exclusive to that further debt reduction.

Brian Downey -- Citigroup -- Analyst

Great, that's helpful and then it looks like from the deck and the cash flow statement that you sold a small number of third-party operated Delaware Basin acres for a few million dollars. Could you update us on the potential for further third-party operated asset sales and I guess more theoretically with the E&P consolidation we've seen within some of Viper's third-party operator cohort, has that changed how you're thinking about your third-party operated acreage footprint at all versus three or six months ago?

Travis D. Stice -- Chief Executive Officer And Director

I wouldn't say that the E&P consolidation has impacted our thought process on asset sales, but certainly the strength that we're seeing in the private market versus the public market or where we're trading has continued to give us confidence that selling some assets at these prices isn't the worst idea. I think overall we're selling assets that are completely undeveloped under operators with not a ton of visibility and not a lot of active development. We do have some larger packages that we're talking to people about, but we're going to be patient and like -- I think like we said last quarter, we're not a forced seller here, but we are recognizing where we trade versus where we can sell some of the stuff in the public markets with zero cash flow.

Brian Downey -- Citigroup -- Analyst

Great. I appreciate --

Travis D. Stice -- Chief Executive Officer And Director

Sorry, excuse me, in the private markets with zero cash flow.

Operator

Thank you. Our next question comes from the line of Derrick Whitfield with Stifel. Your line is open.

Derrick Whitfield -- Stifel -- Analyst

Hey, good morning guys.

Travis D. Stice -- Chief Executive Officer And Director

Good morning, Derrick.

Derrick Whitfield -- Stifel -- Analyst

Thinking about 2021 production, while clearly a lot can still change in the macro conditions, would it be fair to assume that your forward visibility including work-in-progress and line of sight wells with that visibility you could hold Q3, call it Q4 production relatively flat assuming a ratable conversion of that inventory?

Travis D. Stice -- Chief Executive Officer And Director

Yeah, Derek, I mean I think that's fair. There's obviously going to be some movement, you know, large pads at the Diamondback level do impact Viper uniquely versus a staple plan [Phonetic] at the parent co. I think the kicker is going to be non-op production and non-op volumes and we're still very conservative on how we're modeling those non-op volumes, but certainly our leading indicators permits and rig count and line of sight wells has improved slightly on the non-op side particularly in the last couple of months. While I won't commit to staying flat as guidance today, I think it's a potential outcome for the full-year.

Derrick Whitfield -- Stifel -- Analyst

In case, just staying on that point specifically, when you guys look at the permits to assess your third-party queue so to speak, does that support the notion that the rig counts largely bottomed from the third-party perspective and then also would it support the notion that your completion flow probably bottomed as well?

Travis D. Stice -- Chief Executive Officer And Director

I think that's fair and I think you've seen it in the data we put out that the Diamondback net wells really held up the company in Q2 and then, well, sorry, mainly in Q3 and will continue to do so in Q4. I certainly hope the rig count is bottom, but I also hope from an industry perspective, we don't go back to grow, grow, grow, grow and instead focus on maintaining production and hopefully Viper is the beneficiary of some of that non-op production getting turned in line here over the next few quarters.

Derrick Whitfield -- Stifel -- Analyst

That's great, very helpful guys. Thanks.

Travis D. Stice -- Chief Executive Officer And Director

Thank you, Derrick.

Operator

And your next question is from the line of Brian Singer with Goldman Sachs. Your line is open.

Brian Singer -- Goldman Sachs -- Analyst

Great, thank you. On the Diamondback call, I believe Diamondback said flattish type production until oil prices move higher and then more longer-term low single digit or just single-digit production growth and I just wondered, what's the longevity by which the Viper production profile can outperform Diamondback based on the focus of Diamondback on drilling higher interest wells from a Viper perspective. That was obviously a driver of the strong production here this quarter, but what's the longevity of that until potentially you start to see Diamondback growth equal Viper growth ex what happens on the non-operators?

Travis D. Stice -- Chief Executive Officer And Director

Yeah, Brian, I mean I think certainly the second half of this year, Viper's growth is going to outperform Diamondback's growth. Viper's operated production by Diamondback is going to outperform Diamondback's growth. This does go in waves and we had some really high interest wells come in on in Q3 that's going to help us going into Q4 but over the longer-term, I would hope that Viper's Diamondback operated production can slightly outperform Diamondback if Diamondback is staying flat or grow a couple of bips higher than -- a couple of hundred bips higher on a percentage basis than Diamondback's, but that's our job as a consolidated capital allocator to make sure the drill schedule is encompassing Viper minerals and what we see today is that there is going to be a lot of high interest pads coming on in 2021 continuing that trend of increased pro forma capital efficiency heading into 2021.

Brian Singer -- Goldman Sachs -- Analyst

Got it. Thank you. And then my follow-up, you talked about asset sales earlier and the understandable focus on deleveraging, part of which you've already shown here over the last six months, but can you just talk philosophically on the acquisition side about the interest level in further growth via M&A and how you expect that market to -- and your interest level to evolve?

Kaes Van't Hof -- President

I think M&A has been really important to Viper to achieve scale in the mineral space. I think we're going to echo the comments that Travis had on the Diamondback call is that Viper doesn't need to be the biggest mineral owner in Texas or the biggest mineral owner in the Permian, we need to be the best and that means that we're going to be reshaping our portfolio a little bit, buy minerals under Diamondback and selling non-op minerals and while I'm not going to -- like we said, we're not going to sell minerals at firesale prices, we do recognize that there is a bit of a value disconnect between where we're trading and where these minerals are trading in the private market under operators with no visibility, no line of sight, it's good acreage, but there is no control over the drill bit. So I'd rather have control over minerals that we operate with a 16% [Phonetic] forward yield and pristine visibility.

Brian Singer -- Goldman Sachs -- Analyst

Great, thank you.

Kaes Van't Hof -- President

Thank you, Brian.Our next question comes from the line of Chris Baker with Credit Suisse. Your line is open.

Chris Baker -- Credit Suisse -- Analyst

Hey, good morning. I realize it's hard to talk about 2021 without formal guidance from FANG, but just looking at that Slide 7 in the deck, it looks like historically, you guys have averaged call it 70% to 75% of Diamondback activity. What's a reasonable placeholder for Viper's exposure to FANG's program next year and could that sort of be biased above the historical average as we've seen over the past few quarters?

Travis D. Stice -- Chief Executive Officer And Director

I think it's going to -- it's going to move around, you know the Q3 number was as high as it's ever been. I think we had 93% exposure to Diamondback wells, but I think, Chris, over a longer period of time, two-thirds to three-quarters is a pretty safe baseline. Now, I do think our Viper team is going to be looking to increase that number by buying under Diamondback when the balance sheet allows it, but two-thirds to three-quarters exposure to Diamondback's completions is probably a safe bet.

Chris Baker -- Credit Suisse -- Analyst

Okay, great. And just as a follow-up, realizing the focus today is on the balance sheet, but once that sort of peak leverage is in the rear view mirror, is there a specific leverage target you talked about two times by the end of next year, but is there a specific leverage target that allows you to restart the acquisition program albeit and what it sounds like is a very thoughtful way?

Travis D. Stice -- Chief Executive Officer And Director

Yeah, I think being closer to two and getting three times in the rear view mirror is more important to us today. I think if we have a lot of confidence that that's going to happen over a couple of quarters and then we can restart the acquisition machine, but I also think part of the acquisition machine can be funded through asset sales rather than debt or external funding.

Chris Baker -- Credit Suisse -- Analyst

Okay, great, thanks.

Travis D. Stice -- Chief Executive Officer And Director

Thank you, Chris.

Operator

Our next question comes from the line of Jeff Grampp with Northland. Your line is open.

Jeff Grampp -- Northland -- Analyst

Good morning, guys. Kaes, maybe just to build on the last thoughts on kind of leverage and payout ratios. What do you guys kind of view if you formalized any thoughts internally about kind of target leverage and payout ratios in a normalized world, however, you guys may want to define normalized?

Kaes Van't Hof -- President

Yeah, I mean in 2020, I don't know what normal is anymore, Jeff, but I do think it's kind of a mid-cycle oil price, $45 to $55 WTI, which is a long way from where we are today. We should be closer to a turn or a turn and a half levered at most and while I won't commit to a long-term payout ratio on this call, I do think it's something like the inverse of an E&P. So if an E&P is reinvesting 70% of its cash flow into maintenance capital and returns, maybe the mineral company can be the opposite.

I think we've heard a lot of talk about variable dividends in the E&P space and I ask investors to go look back at what we've done and Viper has been a variable investment vehicle, variable payout vehicle for five or six years now and it's returned a lot of cash back to shareholders. So I think a rule of thumb could be that it's the inverse of an E&P. I mean a mineral company certainly needs to continue to add inventory. This is a depleting business, but the urge to add inventory for a mineral company is much different than an E&P.

Jeff Grampp -- Northland -- Analyst

Got it. Appreciate that. And for my follow-up, how would you say a hedging philosophy integrates into some of those kind of longer-term goals. I know you guys put some on at the beginning of this pandemic, but it seems like it's been a little bit quieter on that front. Should we expect Viper longer-term to return to an unhedged entity or does hedging have a role going forward?

Kaes Van't Hof -- President

I think through downcycle, you always have to look at the decisions you made and figure out what were you doing before the downcycle that was good, bad or indifferent. And one of the lessons learned I think for us at Viper is that if you have debt, you should probably hedge more than less and Viper was always an unhedged vehicle because there was not a lot of debt.

When we added that bond, we should have hedged and that's a shame on me for not doing that, but I do think lessons learned is that, while I don't want to trap Viper into a specific cash flow number, I do think protecting the downside from some sort of wide range of collars that guarantees our investors some form of return of capital on the downside and doesn't limit their exposure to oil prices on the upside is probably going to become part of the story along with continued debt reduction or if you use debt to buy something, a clear path to paying back that debt over a short period of time.

Jeff Grampp -- Northland -- Analyst

All right. That sounds good. Thanks for the time guys.

Kaes Van't Hof -- President

Thank you, Jeff.

Operator

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

Gail Nicholson -- Stephens -- Analyst

Good morning. Most of my questions have been asked, but just kind of curious when you look at the volatility in the commodity that you experienced in '20, how are you guys thinking about that maybe not hoarding cash, but the need to potentially build cash on the balance sheet on a go-forward basis just to have as a safety net?

Kaes Van't Hof -- President

Yeah, Gail. I mean it's a good comment. I think it's probably less important at Viper than Diamondback to build cash just because the first step at Viper is to get that revolving credit facility down to almost zero and reduce our reliance on bank funding. I mean you've seen obviously the banks have had a tough time with energy companies through this down cycle and we want to be as low touch as possible with those banks. So I think we're a long way off from getting the revolver to zero, but certainly having the ability to buyback bonds in the open market, pay down debt and also call debt because Viper is not investment grade has a little less of a need to hoard cash, but I do recognize that having cash for a rainy day isn't the worst thing in running an energy company.

Gail Nicholson -- Stephens -- Analyst

Great, thank you.

Operator

Our next question comes from the line of Neal Dingmann with Truist Securities. Your line is open.

Neal Dingmann -- Truist Securities -- Analyst

Good morning, all. Kaes, hey, how many recurrent rigs are currently lapping [Phonetic] Viper acreage and are you thinking that will be about the same -- you assuming sort of going into next year?

Kaes Van't Hof -- President

Can you repeat that question?

Neal Dingmann -- Truist Securities -- Analyst

How many current rigs? How many rigs are you operating right now? [Speech Overlap].

Travis D. Stice -- Chief Executive Officer And Director

Neal, we got 21 rigs running -- 21 rigs running today --

Kaes Van't Hof -- President

Four of which are Diamondback operated.

Travis D. Stice -- Chief Executive Officer And Director

Four Diamondback rigs and I think we've seen something like 60 permits put on our position here in the last three weeks.

Neal Dingmann -- Truist Securities -- Analyst

Wow. Okay, that sounds good. Great details. And then secondly, I know Viper has always benefited from Diamondback's FTI, EPIC and Gray Oak and I know the pricing that's linked there. So I was just wondering, are you expecting much change. I think what these are longer-term contracts, so would there be much change in how we think about this for Viper going forward or not really given sort of the length and duration of these contracts?

Travis D. Stice -- Chief Executive Officer And Director

No, I don't think there will be a change. Neal, we set this Viper up to receive the same pricing as Diamondback. Other companies have -- other E&P's have marketing entities that take possession of the barrel in their local market and then sell it to the international market or wherever they end up selling the barrel to and in order to have full alignment between the two public entities, we sell at the wellhead and therefore Viper receives the same price as Diamondback. I think Viper because of Spanish Trail being such a large piece of our production, Viper gets a little more NEH exposure versus Diamondback receiving more Brent exposure, but those are long-term contracts and we want to make sure parent and sub are aligned on what they receive.

Neal Dingmann -- Truist Securities -- Analyst

Very good. Thank you.

Kaes Van't Hof -- President

Thanks, Neil.

Operator

Our last question comes from the line of Leo Mariani with KeyBanc. Your line is open.

Leo Mariani -- KeyBanc -- Analyst

Hey guys, just wanted to follow-up on a comment you made around the production guide for 4Q '20 and 1Q '21. Well, I hear you guys right that you're really not assuming much in the way of non-op activity at all in those numbers despite the fact that you're seeing these encouraging Permian transfer?

Travis D. Stice -- Chief Executive Officer And Director

Yeah, I mean, Leo, we're assuming some non-op activity. We're certainly not assuming we get back to levels seen in the end of 2019 or early 2020. I think non-op is going to help a little bit Q4 and Q1, but Q4 will probably be mainly driven by the follow through of these high -- high on our high-pads [Phonetic] from Diamondback benefiting Q4 and then Q1 is still a little bit far away from us right now to make any bold predictions, but I do think Q4 is likely a bit stronger than Q1.

Leo Mariani -- KeyBanc -- Analyst

Okay, that's helpful. And I guess just from a perspective of the payout ratio just kind of wanted to make sure I understood you guys correctly here, you obviously took it up from 25% to 50%, which is nice to see. Are you guys basically just saying that we're likely to kind of stay at this 50% for a while until we really see oil prices kind of recover to that sort of $45 [Phonetic] plus type time frame?

Kaes Van't Hof -- President

Well, yeah, I mean I think a while in our industry is a relative definition. So we have confidence that Q1 and Q2 strip starts to improve in that we're going to receive a much higher price for our commodity, high-30s, low-40s and then I think it's on the Board to look at that forward outlook and see if we're reducing debt to that two times leverage kind of target with -- at strip pricing and can we protect that a little bit via hedging and if we can do that, then let's increase the payout even further.

Leo Mariani -- KeyBanc -- Analyst

Okay. Thanks for your time.

Kaes Van't Hof -- President

Thank you, Leo.

Operator

Thank you. I'm not showing any further questions. So I'll now turn the call back over to Travis Stice, CEO for closing remarks.

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 contact us using the contact information provided.

Operator

[Operator Closing Remarks]

Duration: 26 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

Brian Singer -- Goldman Sachs -- Analyst

Chris Baker -- Credit Suisse -- Analyst

Jeff Grampp -- Northland -- Analyst

Gail Nicholson -- Stephens -- Analyst

Neal Dingmann -- Truist Securities -- Analyst

Leo Mariani -- KeyBanc -- Analyst

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