Q4 2023 Texas Pacific Land Corp Earnings Call

Participants

Chris Steddum; CFO; Texas Pacific Land Corporation

Shawn Amini; VP of Finance & IR; Texas Pacific Land Corporation

Tyler Glover; President, CEO & Trustee; Texas Pacific Land Corporation

Hamed Khorsand; Principal & Research Analyst; BWS Financial Inc.

Nathaniel David Pendleton; Associate VP of E&P; Stifel, Nicolaus & Company, Incorporated, Research Division

Presentation

Operator

Ladies and gentlemen, good morning, and welcome to the Texas Pacific Land Corporation Fourth Quarter 2023 Earnings Conference Call. (Operator Instructions). As a reminder, this conference is being recorded.
It is now my pleasure to introduce your host, Shawn Amini, Finance and Investor Relations. Please go ahead.

Shawn Amini

Thank you for joining us today for Texas Pacific Land Corporation's Fourth Quarter 2023 Earnings Conference Call. Yesterday afternoon, the company released its financial results and filed its Form 10-K with the Securities and Exchange Commission which is available on the Investors section of the company's website at www.texaspacific.com.
As a reminder, remarks made on today's conference call may include forward-looking statements. Forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those discussed today. We do not undertake any obligation to update our forward-looking statements in light of new information or future events. For a more detailed discussion of the factors that may affect the company's results, please refer to our earnings release for this quarter and to our most recent SEC filings.
During this call, we will also be discussing certain non-GAAP financial measures. More information and reconciliations about these non-GAAP financial measures are contained in our earnings release and SEC filings. Please also note, we may at times refer to our company by its stock ticker, TPL.
This morning's conference call is hosted by TPL's Chief Executive Officer, Ty Glover; and Chief Financial Officer, Chris Steddum. Management will make some prepared comments, after which we'll open the call for questions. Now I will turn the call over to Ty.

Tyler Glover

Good morning, everyone, and thank you for joining us today. TPL ended 2023 with the best quarter we had all year. Performance was led by oil and gas royalty production of approximately 26,300 barrels of oil equivalent per day which represents 20% sequential quarter-over-quarter growth and a new company record. We also received excellent contributions from our surface and water-related businesses as they accounted for over 40% of quarterly consolidated revenues. For produced water, we generated a royalty fee on 2.7 million barrels per day during the quarter, also a record. On source water, we recorded 517,000 barrels per day of sales volumes, of which 62% were off of our footprint as demand for both brackish and treated water remain elevated. Our surface leases, easements and materials segment, which we refer to by acronym SLEM, generated $19 million of revenues, representing 5% growth sequential quarter-over-quarter.
Performance for full year 2023 highlights the virtues of TPL's unique business model, especially during periods of volatile commodity prices. Despite oil prices falling by 18% year-over-year and natural gas prices declining by 64%, our water and SLEM businesses collectively grew revenues by 30%.
For fiscal year 2023, our source water revenues grew by 32% year-over-year. Produced water royalties grew by 17% and SLEM grew by 48%. The strong performance from our water and surface endeavors helped to substantially offset the negative impact from lower commodity prices.
Overall, TPL's business continues to operate efficiently with fiscal year 2023 adjusted EBITDA and free cash flow margins of 86% and 66%, respectively. As we look ahead to 2024, TPL is well positioned to benefit from ongoing activity in the Permian Basin.
Our land and water teams remain busy, and thus far, customers have indicated intentions to maintain strong levels of development on our royalty and surface acreage. Super major operators, in particular, continue to execute on robust, growth-oriented development pacing. This is especially relevant for TPL as these large operators account for a majority of the development of TPL's royalty acreage. With respect to recent commodity price volatility, it's important to remember that TPL's royalty and surface acreage overlaps with some of the most highly economic shale within both the Delaware and Midland Basin and North America more broadly. Should we see a prolonged period of weak commodity prices, we would expect operators to maintain healthy development levels across their core Permian leaseholds while triaging other parts of their non-Permian portfolio.
Should oil prices remain supportive at current levels are higher, and we'd expect activity levels to support higher production. We're optimistic and encouraged by what we see so far, and we're looking forward to maximizing our opportunities for this year. Chris will have more to share later on our outlook for the Permian as the TPL's business into 2024.
I would also like to spend some time this morning reiterating and elaborating on TPL's capital allocation priorities. First, our North Star is maximizing shareholder value. That's always been the goal and that dictates everything we do here. On that point, we believe the key to maximize TPL shareholder value is to maximize free cash flow per share.
Cash is finite. Over the long term, what the company can pay in dividends, repurchasing shares and invest in itself are fundamentally limited to the cash it generates. Thus, if we can expand free cash flow on a per share basis, and not just near term but also long-term productive capacity for future free cash flow per share, then we will be able to sustainably and consistently increase our capacity to return greater amounts of capital back to shareholders. The more cash we can ultimately return to shareholders, the more valuable to enterprise. If maximizing free cash flow per share is the goal, the question then becomes how do we achieve it. Our primary options are to invest in organic opportunities, buy back our stock, acquire external assets or pay dividends or some combination thereof. Each one of those options contains an economic and strategic reality.
Our job is to determine the long-term returns for each option and then allocate capital accordingly. If we can do that well, we create shareholder value. In practice, there are no simple answers, but we try and solve these items with the fundamental bottoms-up intrinsic value approach.
So let's quickly go through our capital allocation options, deconstruct how we evaluate returns and where those returns and priorities stand today. Starting with organic investment. Here, we look at what opportunities are available to leverage the company's existing assets, people and expertise to expand this business. Potential organic investments are predicated on generating double-digit returns on capital while also balancing our preference for high margins and a capital-light business model. Our investment into the water business serves as a great case study. For most of TPL's long history going as far back as the 19th century, there was basically zero organic investment.
In 2017, that changed as we began to take advantage of TPL's unique ownership of both royalty and surface acreage. Without diving too deeply into the commercial and competitive dynamics that drove why we structured the individual pieces that make up the water business, namely an operated source water business and a contracted throughput royalty for produced water. The key takeaway is that each business was deliberately and carefully commercialized to provide the optimal balance between generating high returns on investment, moderating capital requirements, enhancing the overall business profile and ultimately maximizing long-term free cash flow per share.
Since 2017, we have cumulatively invested approximately $140 million of capital into the water business. The water business and returns generated about $470 million of cumulative after-tax cash flow.
And that does not include any of the significant benefits we derived both from sourcing water for operator completion activities or from facilitating essential produced water solutions for oil and gas wells on TPL royalty acreage.
For fiscal year 2023, our Water Services and Operations segment closed with a net PP&E balance of about $84 million from which we generated $99 million of net income during the year, resulting in excellent returns on capital. As it stands today, we've developed the largest source water network in the broader Northern Delaware Basin. We invest approximately $5 million to $10 million annually towards various growth and cost savings initiatives with each project individually assessed to determine economics as we continue to explore various opportunities and ideas to enhance our business. Overall, the growth of the water business has provided us with substantial free cash flow growth to the overall enterprise.
With that growth in free cash flow over the years TPL has been able to pay out increasingly larger dividends and execute on larger buybacks, all the while maintaining high cash flow margins, low capital intensity and a net cash balance sheet. Beyond water, we're also searching for new opportunities to leverage our surface ownership. The many fan lines we've discussed in the past are a good example. Consistent with our current makeup, the overwhelming preference is to commercialize new projects and a capital-light high cash flow margin manner. To the extent there's a project that can provide both exceptional returns and is strategically critical within the context of the overall enterprise then we have the wherewithal to strategically deploy capital just like we did for the water business.
Next, let's discuss share repurchases. When you buy back company shares, you're basically still buying assets. It's just that these assets are already owned by the company. The question is, what is the return generated by buying back your own shares? We look at share buybacks in a similar manner as we look at purchasing external assets. If buying back TPL stock, we're buying a claim on over 20,000 net royalty acres on an 8/8ths basis and nearly 1 million surface acres. Those assets generate a cash flow stream. What we do is, go piece by piece and evaluate the full cash flow potential over the life of each asset. After aggregating the various components of the business, we can measure that value against the price to acquire. That price for a buyback is our publicly traded share price. There's just as much art as science to this given all the various inputs and we do our best to generate reasonable assumptions.
We run various scenarios, sensitizing important factors, commodity prices, of course, being a major item. We have reservoir engineers on staff to assess resource potential track-by-track for our royalty acreage. We run a bottoms-up life cycle analysis across our water and spud businesses. We also own a [forever] land asset that we are actively working to monetize, and that is basically an option value for future revenue potential. So we account for that. After aggregating everything, we have an internal appraisal of our intrinsic value. We can then measure that against the stock market's appraisal of those exact same assets. If we can generate a double-digit IRR at a mid-cycle oil price of approximately $75 oil and $3 gas, then buybacks become an extremely attractive option to deploy significant capital.
We still have over $200 million remaining on our current buyback authorization, so we have the tools in place to quickly execute a robust share repurchase program. Beyond just these opportunistic parameters, we do anticipate maintaining some level of buybacks throughout the year. There are still benefits to buying more of the assets we know so well into just being in the market supporting stock. We have a long history of repurchasing shares. We recognized that has been an important element of the TPL story through the years, and that's something we want to reinforce.
On that point, we received feedback from some investors on why TPL doesn't just stick to what it did in the past and just used all of its cash to buy back shares. After all, that strategy was a core factor in driving some phenomenal returns through the decades. It's a fair point and it's worth diving into the buyback strategy of TPL of yesteryear versus the buyback strategy today.
For most of its existence when TPL was effectively just a liquidating trust, the strategy back then was to take the modest cash it generated from some vertical oil and gas wells, grazing leases and asset sales and to use those proceeds to repurchase shares. With the benefit of hindsight, those buybacks worked incredibly well because a few knew or understood that 1-day modern horizontal drilling and hydraulic fracturing would unlock the ocean of oil that was locked in a shale flying underneath the trust royalty acreage. Thus, you were buying back assets that would later become some of the best shale assets at a valuation that only reflected some minor ancillary operations. It was quite a deal.
Today, the extent and quality of the shale resource on TPL land is widely recognized, so much so that our stock trades at a meaningful premium to peers. That's also become evident recently with nearly $100 billion of Permian lease operator acquisitions occurring just in the last few months. Although we resolutely believe TPL has a unique irreplicable set of assets and an outstanding team that justifies a premium, buying back our stock today isn't the same steel that it was decades ago, not to say that it isn't a good deal to that. Buyback economics from decades past aside, we will not hesitate to aggressively ramp buybacks when the opportunity arises. Furthermore, if returns across organic CapEx, M&A, dividends or buybacks were all equivalent, our preference would be to lean into buybacks. Our bias is buybacks.
Turning to external acquisitions. Over the last few years, we've been candid in our interest in evaluating potential opportunities. We have a huge service and royalty footprint. We have a talented team of industry professionals. We have capabilities to monetize land like few others can, and we have the technology and systems to efficiently scale. It's for all of those reasons why we believe we are in a prime position to consolidate high-quality Permian surface and royalty assets. We approach M&A similar to buybacks. We evaluate each asset from a bottoms-up intrinsic value approach. The same assumptions we use to value our own assets, whether it's commodity prices track-by-track, resource potential or surface and water opportunities, we use to analyze third-party assets.
Again, the goal here is to generate at least double-digit IRRs in invested capital and incremental free cash flow per share. For any package that's a meaningful interest to us, in addition to extensive financial analysis, we also performed significant asset and operational due diligence. Because TPL already owns great assets, we have no interest in diluting down our asset quality, our growth prospects or our unique business model.
For any deal, the economics have to work, it has to make this a better enterprise and it has to enhance shareholder value. It's a very high bar, and we'll keep it high.
And finally, if the company only has modest opportunities to deploy capital towards organic or external growth and if buybacks are relatively less attractive then dividends are another effective way to return capital back to shareholders.
A good example was back in May of 2022. WTI crude was over $100, nat gas over $7 both basically at highs over the last decade. Valuations then for external assets were based on essentially peak commodity prices and peak multiples. Buybacks during this time were also relatively less attractive given this above-cycle commodity price. We had modest capital needs for our organic endeavors without great options to use the capital ourselves, we paid a $20 per share special dividend and gave that cash back to shareholders. We find ourselves in a similar situation in the future than a large special dividends are readily available. Our capital allocation strategy will adapt this industry and market fundamentals evolve. Our cash balance at year-end has grown to $725 million as we've harvested cash flows over the last couple of years during this period of relatively high commodity prices and as we've held back on large procyclical spending.
Today, commodity prices are lower and we have an opportunity to deploy substantial capital countercyclically as weaker competitors pull back as valuations fall and as opportunities grow. Or if commodity prices rise, our business will benefit tremendously. We're very much in a position of strength and the company will excel the most in any environment. With that, I'll turn the call over to Chris.

Chris Steddum

Thanks, Ty. Consolidated revenues during the fourth quarter of 2023 were approximately $167 million, representing 6% sequential quarter-over-quarter growth. Adjusted EBITDA was $151 million and free cash flow was $116 million. Free cash flow for the quarter grew 15% on a year-over-year basis, driven by higher royalty production, source water sales, produced water royalties and SLEM revenues and partially offset by lower oil, natural gas and NGL prices.
Since Ty have already reviewed some of our other highlights for the quarter and full year 2023, I'll spend some time now on how we're thinking about things for 2024. As it relates to development in the overall Permian, our general view is that if oil prices stay around or above $75 per barrel that is generally constructive for continued growth. If oil prices weakened to $70 or less for an extended period of time, we would expect overall Permian activity levels to flow and overall production volume to flatten.
Specific to TPL, our business overall tends to be dominated by super majors and large independents, which tend to maintain development plans even during times of sideways commodity prices. Over 50% of our current drilled but uncompleted wells, otherwise known as DUCs, are held by super major Chevron, Exxon, Conoco, BP and Occidental. 80% of our current DUCs are held by operators with an enterprise value of at least $15 billion. Although rig counts have fallen in the overall Permian compared to a year ago, we have seen rig counts on our acreage remains stable. New spud activity on a net basis in the fourth quarter was a company record and our overall near-term well inventory remains robust. We are seeing persistent strong activity in Loving and Northern Culberson and in the Central Midland subregion. In addition, continued operator efficiencies have condensed Permian to production pacing even despite wells with increasingly longer lateral lengths.
Our water team today is just as busy as last year and indications that they've received from operators is that development activity will remain at high levels. Our land agents also remain active as demand for pipeline easements, surface leases, wellbore easements and caliche are strong. As we previously indicated, we believe that TPL royalty production can grow at a level that exceeds overall Permian growth, although like we've experienced over the past year or so, short-term quarter-to-quarter performance, can be somewhat volatile due to greater co completion developments, operator short-term development patterns, specific net revenue interest for various tracks and check spud timing.
To conclude, TPL is in a great spot today. Our balance sheet arguably has never been stronger. The business still maintains strong cash flow and profitability margins. TPL still remains unhedged on commodity prices so we capture the full upside as commodity prices improve. And if commodity prices weaken, then we have ample means and multiple ways to take advantage. And with that, operator, we will now take questions.

Question and Answer Session

Operator

(Operator Instructions). Our first question is from Hamed Khorsand with BWS Financial.

Hamed Khorsand

So first off, could you just talk a little bit more about the water business and what you're doing there as far as the cost structure goes, I noticed that if I combine both water line items on the sales side and then look at your cost basis, the cost is more than outpace the sales growth. So if you could just comment there on what your expectations are?

Chris Steddum

Hamed, this is Chris. I think as Ty had said in his prepared remarks, at the end of the day, what we are trying to do is grow our free cash flow. And last year was a bit unique. There was a few times where depending on where that water was moving and some of the contracts, it was a little bit more expensive. As we continue to reach out further into the basin, some of the expenses to get water to the further reaches of the Permian have increased.
On the flip side, we continue to electrify a lot of the operations, which helps regulate and even bring down some of the costs through the ability to automate systems, have less personnel required to run them. But at the end of the day, the cost to deliver some of that water as we expand has come down. But I think the good news is that still leads to increased cash flow for the business.

Hamed Khorsand

Okay. And then my other question was as far as the oil side of the business goes oil and gas. Was there any supply chain issues that you can see that could hamper production or are you just seeing that production can stay steady with weather as electricity is permitting.

Tyler Glover

I think most of the supply chain issues that we've seen over the last few years have been worked out. Obviously, there's still a lot of infrastructure build out that needs to be done in the Permian. But talking to our operators and midstream operators as well. I think infrastructure planning is going well and companies seem to be making the right moves to prevent those bottlenecks in the future. So I think most of those issues overall have been worked out.

Hamed Khorsand

And then last question is on your easement side. Is there anything of a onetime nature there this past quarter that won't repeat in Q1 or in 2024?

Tyler Glover

I mean, for the most part, big part of that is pipeline easements, material sales have increased as well, but those should be ongoing. Like I said, talking to our midstream operators, there's still a lot of infrastructure build-out that they have planned for 2024. Material sales continue to be strong. We're growing our sand royalties as well. So I would anticipate that staying strong through 2024 and really over the next few years.

Operator

Our next question is from Nate Pendleton with Stifel.

Nathaniel David Pendleton

Congrats on the strong quarter. Starting with production. Coming off a strong Q4 and understanding that historically production has been lumpy. How should we think about the production trajectory heading into Q1 versus full year.

Chris Steddum

Yes, I think what you said is right. We still expect that production is going to kind of remain lumpy through time. Just the nature of how the wells get completed, the big co-completions, the way that operators are moving around and which pads they select can have a lot of impact quarter-to-quarter as to what our production looks like. But again, I think we would just reaffirm a couple of things that Ty had mentioned in the prepared remarks. One would be, we still think overall, over the long term, we've got a good chance to outperform the overall Permian in terms of production.
And when we look at 2024 and we look at kind of our current backlog of net wells, it looks really strong. We've seen a big build of DUCs occurring and so all of those things would lead us to believe that, at least over the course of the year, there's going to be plenty of inventory to continue to deliver strong production results.
But as to whether that happens each quarter like clockwork is always a more difficult thing to predict. And so I think there is going to be some lumpiness when exactly that occurs. It's hard to know but the overall trend we still feel really good about. And I think like we said, if we have a supportive commodity price environment this year, we would expect a continued strong production performance.

Nathaniel David Pendleton

Got it. And then staying on the activity trends with your net well inventory that you mentioned, with that around 17 net wells in various stages of development entering 2024 can you provide a rule of thumb for the number of net wells that would need to be turned in line to hold production flat, all else equal?

Chris Steddum

Yes. I think in the past, we've probably said that, that number was something like 8 net wells. But obviously, as your production base grows, that number is going to trend up. So I think we would tell you now but something in the neighborhood of probably 9 net wells is going to roughly be your whole flat number that you need. But as you stated, with 17 right now in the backlog, that's certainly feels pretty good to us as far as having plenty of inventory available to again support strong production.

Nathaniel David Pendleton

Got it. And then shifting over to the water business. Looking back at some of your acquisitions over the past year, can you provide any color on how you see the A&D market for additional SWD infrastructure and what opportunities there are to further expand your leading position there.

Tyler Glover

Yes. Most of our focus on the produced water side has been acquiring additional pore space. So you saw a couple of surface acquisitions of pore space easement that we did last year. And so we just want to make sure that we stay out in front of our operators' needs and have the appropriate amount of pore space available to meet those needs. So that's kind of how we view our part in that business is just continuing with the same business model, being a pore space owner and using our network and relationships to put people together to make sure that, that water has a place to go and just support the overall development of the basin.

Nathaniel David Pendleton

Got it. And then you mentioned pore space. So staying on that for just a second and taking the CCS angle. Now that the U.S. EPA has started approving Class VI permits, and there are some operators injecting CO2 for storage today in Class II wells that qualify for the same credits. Can you provide any updates on how you are viewing that opportunity given your expansive ownership?

Tyler Glover

Yes. I mean we've talked a little bit about it in the past. We think it's a great opportunity for us as well. We view it similar and business model to produce water, where we'll continue to be a pore space owner. No real interest in building out any infrastructure in that space but leasing on our pore space for royalty, I think it's a great opportunity for the company. And so I think any time we can add pore space, whether it be for produced water or carbon sequestration, it just continues to add more runway to our business long term.

Nathaniel David Pendleton

Got it. And the last one for me. Is there any update you can provide regarding the status of the appeal related to the stockholders' agreement litigation?

Tyler Glover

Not too much other than oral arguments were yesterday. So at this point, we're just waiting on a decision from the quarter.

Operator

Ladies and gentlemen, as there are no further questions, that concludes the conference of Texas Pacific Land Corporation. Thank you for your participation. You may now disconnect your lines.