natrot/iStock via Getty Images

natrot/iStock via Getty Images

Black Stone Minerals (NYSE:BSM ) is the US’s largest pure-play oil and gas royalty and mineral rights owner. With over 20MM royalty acres and working interests in 41 states, Black Stone expects to produce~35M Boe/d in 2022. Black Stone recently missed production and cash flow expectations, resulting in its share price lagging and trading at a lower valuation vs. comps than historically, and at a high distribution yield. However, management made a concentrated bet on the Haynesville natural gas resource play years ago, and that is paying off as activity and production are rapidly growing. This may lead to further increased distributions and a re-rating of BSM shares higher.

Black Stone is paid a designated portion of revenues from each barrel of oil or gas produced from properties for which it owns the mineral rights. Black Stone is paid this by oil and gas producers (E&Ps) that drill and produce on its lands. Royalty ownership is advantageous, as Black Stone does not need to invest in or bear the risk associated with drilling, infrastructure and equipment for oil and gas production, resulting in much lower capital expenditures. Additionally, operating costs are much lower for royalties than for traditional E&Ps, as there is no extraction business to operate, resulting in higher margins. As such, fixed costs are predominantly items such as G&A (management and supervision), resulting in low costs and high margins.

However, royalty companies have their drawbacks as well. Black Stone is a flow through entity, meaning that it is exempt from income taxes. Instead, individual investors are responsible for declaring taxes on income earned through distributions, and so there are tax implications associated with the ownership of these shares that can vary between investors. This reduces access to capital markets for BSM, which is somewhat offset by the high yield and lower risk nature of the business.

Black Stone has a significant portion of its production hedged at comparatively low commodity prices, which are weighing on cash flow. For the rest of 2022, more than 75% of Black Stone’s production is “locked in.” This reduces Black Stone’s commodity price leverage, limiting near term upside to higher commodity prices, while also offering some downside protection to cash flow if commodity prices were to fall. Looking forward to 2023, some of the existing hedges “roll off,” and may be replaced by production at the market price or with new contracts at higher price levels.

Challenges related to Black Stone’s corporate structure and earnings and production misses have weighed down share prices, resulting in material underperformance vs. peers over the last 5 years:

At a 9%+ yield more than covered by cash flow, these issues are likely more than priced in by the market, with potential for BSM to re-rate in line with peers as these are resolved. Other near-term catalysts may help and are discussed below.

Black Stone posted disappointing results for Q1 2022 , driven by lackluster production which came in at 32.9M Boe/d, below the lower bound of management’s 2022 guidance of 34-37M Boe/d and Q1 2021 production of 39.1M Boe/d. While this news was perceived negatively by the market, the production decline was attributable to the timing of new wells being brought online, with 4 new wells being brought online after the end of the first quarter (as opposed to during the first quarter as was expected). Black Stone continues to guide to its full year production target of 34-37M Boe/d. If it hits this guidance, it is likely that production and cash flow will be higher than consensus for 2022 and moving forward.

Black Stone is better positioned to benefit from the recent run up in gas prices than peers, despite hedges it currently has in place. This is because gas production comprises a meaningful proportion of total production, as can be seen below:

Black Stone’s higher proportion of gas production appears to have been overlooked by the market, as indicated by its relative performance vs natural gas focused E&P’s and the Henry Hub natural gas spot price:

And while Black Stone appears to have been penalized for its hedges, it’s important to note that many of these comps are hedged as well. As more unhedged natural gas production comes on this year, the steep valuation discount may narrow along with this share price performance gap.

It is also likely that gas production in absolute terms may surprise to the upside, due to higher drilling activity in the gassy Haynesville region, particularly on Black Stone’s Shelby Trough East Texas land:

Black Stone Minerals Presentation Black Stone Minerals Presentation

Despite only a quarter of Black Stone’s gas production currently unhedged, incremental production will be sold at full price and provide significant upside to cash flow. It is also likely that gas production in the Haynesville is on the verge of inflecting way higher, as rig counts in the region are up materially while production has been flat:

With an almost 10% distribution yield Black Stone is a comparatively safe way to get exposure to ramping drilling activity and production in the Haynesville and soaring natural gas prices, which may drive higher than expected cash flow in 2022 and beyond.

Black Stone has room to increase its distributions, which could “force” the share price higher to the extent dividend yields remain in line with peers. There would be excess distribution coverage even if commodity prices fell from here, a benefit of the current hedges that are otherwise encumbering cash flow. This is on display in an investor presentation from Q1 2021, which showed excess distribution coverage despite much lower than current commodity prices:

In our analysis, at current market prices and production, Black Stone has the potential to generate ~$465MM in distributable cash flow in 2022, as can be seen below:

And while Black Stone has just recently announced an increase in distributions to $1.6 / unit per year, there is room to increase this even higher moving forward, particularly as debt is paid down, production increases, and hedges roll off or are reset to higher prices. As can be seen above, accounting for hedges and using current commodity prices, there is room to increase distributions by $0.62 / share, or 39%, using conservative estimates. While some of this cash flow would likely be used to pay down debt, this is an indication that there is substantial upside to distributions. Should commodity prices remain elevated and management exercise restraint in implementing further hedges, there could be another distribution increase on the horizon.

Black Stone offers high yield exposure to the rapidly growing Haynesville shale play. It may continue to grow its distribution while paying off debt and it is a beneficiary of higher current natural gas prices. BSM shares have lagged vs. royalty company competitors and natural gas producers, which may change as fundamentals continue to improve, with rising cash flow reflected in rising unit-holder distributions and further reduced debt. It is also worth noting that while we were researching Black Stone, we encountered several Black Stone competitors and small private royalty buyers who personally owned BSM units. They viewed it as a “safe” way to generate yield on their cash, while potentially benefitting from recently increased activity on Black Stone’s land. We like to “co-invest” with industry insiders!

This article was written by

Disclosure: I/we have a beneficial long position in the shares of BSM either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Important Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment adviser capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment adviser. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication and are subject to change without notice. The author and funds the author advises may buy or sell shares without any further notice.