The largest holding in a variety of our strategies, including Core Value, Strategic Value and Small Cap, is Texas Pacific Land Trust (TPL). It has attained this size in large measure because its price has increased by multiples from our average cost, and because we generally don’t sell shares to ‘trim’ when there are withdrawals from an account. It therefore deserves particular mention periodically. It also deserves mention now, after the release of its 2017 Annual Report just over a month ago, because that document shows that the Trust appears to be at an inflection point in its business development, in its profitability and, as well, in its capital allocation decisions.
Here are some figures.
- The volume of oil production underlying the Trust’s royalty income rose by 44% in 2017, after rising 48% in 2016.
- Gas production rose by 60% in 2017, following a 37% increase in 2016.
- Royalties, which are impacted by energy price fluctuations, were up 79% in 20177, following a 21% rise in 2016.
- Easement and sundry income on the Trust’s land holdings – which are substantially all tied to the drilling and exploration activity of other companies that require use of the Trust’s acreage – rose by 144% last year, after dropping by 31% the prior year. For clarity, vis-à-vis these year-to-year figures, the 2017 figure is 68% higher than the 2015 figure.
It must be explained, though, that the Trust defers recognition of non-current-year income from new easement contracts, recognizing the balance ratably over a 10-year period. If the increase in deferred easement income last year were added to the stated figure, then easement income last year would have been 136% above the 2015 figure. (Under new accounting regulations, as of 2018 new term easement contract revenue will be recognized all in one year.)
- Water sales and royalties rose by 214% last year, following a 69% increase the year before.
- The after-tax net income margin was 58%. Facebook’s net margin was 39%; Google’s was 23%.
It is a fascinating comment upon the separate reality, or unreality, of the indexation-based investment world, that there remains not a single published Wall Street analyst earnings estimate for Texas Pacific Land Trust. Not a single growth or momentum or energy or real estate or low volatility ETF holds the shares, although TPL is qualitatively and statistically highly suitable to any or all of these. One might be forgiven for thinking – without recourse to additional data – that results like this reflect an ordinary level of surging production activity in a new oil and gas field, but with a limit likely to be measured in a handful of years. TPL’s case is likely to be an exception.
On a narrow point, the recent annual 50-odd percent increases in oil and gas production volumes might well accelerate dramatically in the coming periods. This relates to what are known as drilled but uncompleted wells. Last year, there were 205 new wells developed on land subject to the Trust’s perpetual royalty interests. In addition, there are 206 drilled but uncompleted wells. With the size and technological capabilities of the operators active in this area, the latter wells can be completed at will in a short amount of time. However, because so little infrastructure has been built out in this area of West Texas, there is a paucity of gas gathering pipelines to capture gas that is brought up with a functioning oil well. Without a mechanism to collect and transport the gas for sale, it would have to be burned or flared off at the site. It would be uneconomic to complete all of the wells that have been prepared, when a modicum of patience will allow all of the well production to be monetized. Accordingly, there is a very large contingent supply simply awaiting that development. In that sense, the recent production volume progress strongly understates the rate of oilfield development in this portion of the Permian Basin
On a broader point, the following exhibits from the recent 4th quarter earnings presentations by ExxonMobil and Chevron speak to those companies’ expectations for the magnitude and duration of oil and gas production in this region. They speak for themselves.
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The Trust has also made some changes in its operations and capital allocation decisions. Changes that are unlikely to be one-time events. Last year at this time, the Trust had 10 full-time employees. It now has 32. The increased staffing is related to its water provision business. The Trust’s surface acreage endows it with water rights to the subsurface aquifer. Although this water is not potable, it is suitable for the needs of drillers; as well, there is demand for water treatment and recycling for those same customers. The demand in the Permian Basin is sufficient that the Trust has established a wholly owned company, Texas Pacific Water Resources LLC, and will be expanding this operation. Although the water business accounted for only 13% of the Trust’s revenues last year, it produced a 64% net profit margin. If that is indicative of its ongoing profitability, one should expect a rational capital allocator to invest additional capital to this activity.
A question of increasing importance to the Trust will be how to deploy its increasing earnings. The Trust has been repurchasing and cancelling shares for 120 years. Last year, it expended $34 million in that activity, versus $33 million the year before and $29 million the year before that. However, there is a limit to how much open market purchases can be made; average daily trading volume is less than 20,000 shares. The capital expenditure requirements are limited. The obvious remaining alternative is to allocate excess earnings to dividend payments.
In the three years prior to 2017, the annual dividends were, going backwards in time, $0.31, $0.29, and $0.27. In February 2017, the Trustees announced a regular annual dividend of $0.35 per share and, for the first time, a special dividend, which was $1.00 per share. In February of this year, the Trustees raised the regular dividend to $1.05 and paid an additional special dividend of $3.00. While the aggregate dividend of $4.05 is less than a 1% yield on a $500 share price, one doesn’t require a graph to infer the near-term slope of the line. It is quite possible that, in some number of years, TPL might also qualify for a dividend ETF or a REIT ETF – if anyone notices.
