Rattler midstream
When looking at oil and gas, there are a lot of bargains out there. And also a lot of value traps. The only two asset types that look attractive to me are midstream companies and royalties. One such attractive midstream company is Rattler Midstream (RTLR). RTLR is yielding about 18%, which looks pretty cheap. But there are a ton of midstream companies yielding >10%, that are in my opinion value traps.
RTLR is a gathering and processing midstream company to Diamondback Energy (FANG), and holds a 60% interest in midstream assets right outside of FANG’s acreage. And minority stakes in various other long range pipelines in the Southeast region of the US. Gathering midstream’s can be even more risky than for example interstate pipelines. On top of that, RTLR is a captive midstream, FANG owns a majority of RTLR’s shares. So why is RTLR still a bargain and not a value trap?
To answer we need to identify what the red flags are in the processing and gathering midstream industry. In my opinion, when it has the following:
High debt (greater than 3.5x EBITDA)
Connected to high cost oil/gas fields
Short term contracts
Management of the producer they are gathering for, not holding enough shares in Midstream company
Shallow drilling inventory in the area that midstream company has assets in
Now what is great here is that RTLR has none of the above.
Net debt is only 2x EBITDA
RTLR is connected to some of the lowest cost oil and gas fields in the US that have full cycle costs of about $20-25 per BOE, vs current oil price of $35-45.
15 year fixed fee contracts for all of FANG’s 400k acres
Management of FANG owns enough shares in RTLR that their interests are aligned with RTLR minority holders
FANG has enough drilling inventory to keep production at 2019 and 2020 levels for almost 30 years at $40 oil, and still generate a 10%+ return (see page 12-13).
Additionally what is interesting is that in the Permian, where RTLR has its pipes, oil and gas wells both need and produce enormous amounts of water. And water production increases by a factor 2 over the life of a well vs oil production. This is good for RTLR since 70% of its revenue comes from water gathering and disposal. So decline rates of RTLR’s revenue are significantly lower than that of an average Permian oil well. On top of that, pipelines generally need very little maintenance capex and their useful lives are usually measured in decades. Most of RTLR’s core infrastructure is built out already, since utilization is quite low. So capex requirements will come down drastically to a fraction of depreciation.
So what are the risks? Mainly that FANG’s drilling inventory isn’t as deep as they say and that FANG finds a way to screw RTLR holders by taking out the remaining minority shares they don’t own. I think the first risk isn’t really a concern, even if they only have 10 instead of 30 years worth of inventory, that is still enough to get more than your money back at this valuation. And as for FANG screwing RTLR, it seems that both CEO and CFO are pretty entrenched at FANG. And they own enough RTLR units directly that if FANG would take out RLTR at a low ball valuation, they would shoot themselves in the foot. FANG shareholders have actually probed management to do this, and management has affirmed that they will treat RTLR minority holders as partners and not as pinatas.
Another potential perceived risk is that FANG can simply ignore RTLR and build out their own infrastructure. This also seems unlikely because FANG has committed its entire acreage in long term 15 year contracts. But even if there is a loop hole, it still isn’t really a concern as there is a network effect, since wells are often neatly grouped together (around 250 meters or 850 feet distance). RTLR already has a network of pipes in the area, and will have a low cost advantage where they can simply plug new wells into existing ones. Even when there are competing networks nearby, there is generally not a whole lot of choice. So this industry generally has a monopoly/oligopoly like structure. And FANG is incentive to use RTLR here
Furthermore risks are also mitigated by the distributions and low debt levels. If FANG really does not have as many drilling locations as they say they have, it will take some time before this becomes obvious. And you will likely get a portion or all of your money back in distributions before this becomes an issue, due to the nearly 20% yield.
So I am long RTLR at an average price of about $6.5 per share.