Black Stone Mineral Stock: Undervalued, 10% yield Haynesville Natural Gas Play (BSM)

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Black Stone Minerals: Overview

Black Stone Minerals (New York Stock Exchange: BSM) is the largest holder of mineral rights and oil and gas royalties in the United States. With over 20 million royalty acres and working interests in 41 states, Black Stone expects to produce ~35 million boe/d in 2022. Black Stone recently missed production and cash flow expectations, causing its share price to lag and traded at a lower valuation against competitors than in the past, and a yield of high distribution. However, management made a focused bet on the Haynesville natural gas resource play years ago, and it is paying off as activity and production are growing rapidly. This may lead to a further increase in distributions and a revaluation of BSM shares.

The oil and gas royalty sector

Black Stone receives a designated portion of the revenue from each barrel of oil or gas produced from properties for which it holds the mineral rights. Black Stone is paid by the oil and gas (E&P) producers who drill and produce on its land. Royalty ownership is beneficial because Black Stone does not need to invest in or bear the risk associated with oil and gas drilling, infrastructure and production equipment, resulting in much lower capital expenditures . Additionally, operating costs are much lower for royalties than for traditional E&P because there is no mining activity to operate, resulting in higher margins. As such, the fixed costs are mostly things like G&A (management and oversight), resulting in low costs and high margins.

However, royalty companies also have their downsides. Black Stone is a flow-through entity, which means it is exempt from income tax. Instead, individual investors are responsible for reporting taxes on income earned through distributions, and so there are tax implications associated with owning these shares which may vary from investor to investor. This reduces access to capital markets for BSM, which is somewhat offset by the high return and low risk nature of the business.

Commodity hedges weigh on cash flow

Black Stone has a significant portion of its production hedged at relatively low commodity prices, which is straining cash flow. For the remainder of 2022, over 75% of Black Stone’s production is “blocked”. This reduces Black Stone’s commodity price leverage, limiting short-term upside in commodity prices, while also providing some protection against cash flow declines should commodity prices fall. to lower. Looking forward to 2023, some of the existing hedges “collapse” and could be replaced by production at market price or by new contracts at higher price levels.

Historical performance and valuation

Challenges related to Black Stone’s corporate structure and lost profits and production have weighed on share prices, leading to a significant underperformance against its peers over the past 5 years:

BSM returns vs peers

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With a return of over 9% more than cash flow covered, these issues are likely more than priced in by the market, with potential for BSM to reassess against its peers as they are resolved. Other short-term catalysts can help and are discussed below.

Higher production in the future

black stone posted disappointing results for Q1 2022, driven by lackluster production which stood at 32.9 M boe/d, below the lower limit of management’s 2022 forecast of 34-37 M boe/d and Q1 2021 production of 39 .1 Mboe/d. Although this news was perceived negatively by the market, the drop in production is explained by the timing of the commissioning of new wells, with 4 new wells commissioned after the end of the first quarter (instead of the first quarter as expected ). Black Stone continues to move towards its full year production target of 34 to 37 boe/d. If it achieves this guidance, it is likely that production and cash flow will be above consensus for 2022 and beyond.

Higher gas volumes

Black Stone is better positioned than its peers to take advantage of the recent spike in gasoline prices, despite the hedges it currently has in place. Indeed, gas production represents a significant part of total production, as can be seen below:

comp chart showing % oil and gas

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

relative returns for Black Stone vs natural gas and comps

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And while Black Stone appears to have been penalized for its hurdles, it’s important to note that many of these comps are also covered. As unhedged natural gas production increases this year, the steep valuation discount could narrow along with this stock price performance gap.

Exhibition at Haynesville Upside

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

number of active platforms over time

Introducing Black Stone Minerals

new wells activated per quarter

Introducing Black Stone Minerals

Although only a quarter of Black Stone’s gas production is currently unhedged, the additional production will be sold at full price and provide a significant increase in cash flow. It is also likely that gas production in Haynesville is about to dip much further, as the number of rigs in the area has increased significantly while production has remained flat:

gas production vs number of rigs in haynesville

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With a distribution yield of nearly 10%, Black Stone is a relatively safe way to gain exposure to the ramp-up in drilling activity and production in Haynesville and soaring natural gas prices, which which could generate higher than expected cash flow in 2022 and beyond.

Upside of higher distributions

Black Stone has the option of increasing its distributions, which could “force” the share price higher as long as dividend yields remain in line with those of its peers. There would be excess distribution coverage even if commodity prices fell from here, a benefit of current hedges that otherwise strain cash flow. This is exemplified in a Q1 2021 investor presentation, which showed excess distribution coverage despite commodity prices well below current prices:

dcf coverage and growth

Introducing Black Stone Minerals

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

black stone mineral cash flow projection

Bison interest analysis

And while Black Stone just announced an increase in distributions to $1.6/unit per year, there is scope to increase this amount even further in the future, particularly as debt is paid down, as production increases and hedges disappear or reset to higher prices. . As can be seen above, taking hedging into account and using current commodity prices, it is possible to increase distributions by $0.62/share, or 39%, using conservative estimates. Although some of this cash flow is likely used to pay down debt, this indicates that distributions have a substantial benefit. If commodity prices remain high and management exercises restraint in setting up new hedges, another increase in distributions could be on the horizon.

Summary

Black Stone provides high yield exposure to the rapidly growing Haynesville shale play. It can continue to grow its distribution while paying down its debt and it benefits from the current higher natural gas prices. BSM shares have lagged royalty company competitors and natural gas producers, which could change as fundamentals continue to improve, with increased cash flow reflected in the increased distributions to unitholders and further debt reduction. It’s also worth noting that while we were researching Black Stone, we came across several Black Stone competitors and small royalty private buyers who personally owned BSM units. They saw it as a “safe” way to generate a return on their money, while potentially benefiting from the recent increase in activity on Black Stone land. We like to “co-invest” with industry insiders!


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