The Texas and Pacific Railroad earned a charter in 1871 to connect West Texas to California. Jay Gould, the infamous Robber Baron, took control of the company in 1876 and completed the rail line. The successful completion unlocked the 3.5 million acres of West Texas land granted to it in its charter.
West Texas was sparsely populated at that time and the railroad didn’t have enough traffic to stay in business. But the company still owned all this land. The company went into receivership and they formed the Texas Pacific Land Trust to manage the bankrupt Railroad's land.
Over time the company would sell parcels of land and return the money to the owners of the trust certificates. But then in 1920 the land sales slowed. They discovered oil!
Texas Pacific sold over 75% of its original landholdings but it is still the largest landowner in Texas. The remaining land Texas Pacific owns is in the Permian basin the most productive oil field in the world. A large portion of Texas Pacific’s land is in the Delaware Basin of the Permian which is the premier section of the Permian.
Texas Pacific now leases its land to oil companies and collects royalties from them.
In 2021 the trust converted into a C Corp.
Texas Pacific Land Trust is not our normal dividend-paying investment. It pays a small regular dividend and a special dividend at the same time. Usually, the payout is once a year but sometimes it pays out another special dividend that same year. What looks like a dividend cut in the chart above is not a dividend cut. We need to add the two 2020 payouts together.
The slide from TPL’s recent investor presentation puts 2020’s payout into perspective. And this is with oil prices going negative earlier in the year.
Texas Pacific Land just misses our 60% cutoff for the dividend payout ratio and our cash dividend payout ratio. But we’re ok with that given its zero debt and high free cash flow to equity coverage ratio. Also, for a royalty company like Texas Pacific Land, we want the payout ratio as high as possible. They don’t need to retain earnings.
Catalysts for Future Price Appreciation & Dividend Growth
Texas Pacific Land doesn’t drill. They lease their land to the other oil companies that incur the costs to drill the wells. On average, TPL collects a 1/16th royalty off the revenue generated by the well. TPL has minimal operational costs. A handful of employees run the company. Texas Pacific is an extremely profitable company.
Texas Pacific has tremendous operational leverage if the price of oil continues to rise. But if the price of oil stays where it is Texas Pacific is still cash flow positive.
C Corp. Conversion
Texas Pacific Land operated as a trust when it came out of its bankruptcy. A trust is a pass-through entity and the structure disqualified Texas Pacific Land for inclusion in major indexes. Recently Horizon Kinetics, a large shareholder, pushed for the trust to convert to a C Corp. so it will qualify for inclusion.
On Dec. 31, 2020, Texas Pacific Land announced that the trust will officially convert into a C Corp on January 11, 2021. Texas Pacific can now be added to indexes. This should provide a short-term positive price catalyst as a wide range of new shareholders and indexes can own the name.
Back in April, the price of West Texas crude oil went negative for the first time in its history!
Oil was under pressure from a supply shock. Russia and Saudi Arabia increased production in an oversupplied market. Then oil hit a demand shock with the coronavirus lockdowns.
We saw both events as self-correcting. Excess supply takes marginal production offline. Demand will come back when the economy opens back up with the roll-out of the vaccines. 2020 was the worst year for oil demand. 2021 could be one of the best years on record.
A DUC is a Drilled-Uncompleted-Well. The operating company incurred most of the costs to drill. The well is ready to produce oil, but the operating company is not ready to bring it 100% online. 85% of Texas Pacific's DUCs are completed within 12 months. A DUC is a proxy for the short-term inventory coming to market from Texas Pacific Land.
Texas Pacific currently has 582 DUCs. The average Permian Basin well is producing 1.2 million Barrels of Energy (BoE). As I write this, Oil is trading at $53 per barrel and Texas Pacific Land earns a 1/16th royalty. Performing the same exercise as Horizon Kinetics.
582 DUCs x 1.2 million BoE x $53 x 1/16th = $2.31 billion in revenue.
Texas Pacific’s 10-year average Free Cash Flow Margin is currently 58%.
Over the next 12-18 months, Texas Pacific Land could have $1.4 billion in cash flow, 20% of its current market capitalization, to distribute back to shareholders.
Texas Pacific’s royalty revenue depends in part on the price of oil. Lower prices mean less revenue and cash flow to return to shareholders. Also, the price of oil must be high enough for a company to want to drill wells on Texas Pacific’s land.
Texas Pacific estimates that the breakeven oil price for the bulk of their reserves is $40 per barrel. If the price of oil stays above $40 Texas Pacific should see increased drilling activity on its land and revenue growth. But any future supply or demand shocks will affect how much capital Texas Pacific can return.
Oil reserves are finite resources. One day Texas Pacific’s oil reserves will be gone or at least only economically viable with a high price of oil. Right now, Texas Pacific projects that they have 19 years of reserves at a $40 per barrel breakeven price.
And in the latest EIA outlook report, they project the Southwest Region, where the Permian Basin is located, to maintain current production levels for at least the next 20 years.
Texas Pacific’s reserves will decline but we have a long time before that happens. We just need to make sure we don’t overpay for current expected cash flows.
The expectation is the emergence of electric vehicles will cause oil demand to fall off a cliff. Despite all the recent market hype, electric vehicles are still an expensive niche product. We need a step change in battery technology to bring the cost per vehicle down and to increase their range to make it a daily driver for the average person. Even then a car is a major purchase that takes years to pay off. It will take a long time for the average person to swap out their internal combustion engine for an electric vehicle. The base case for vehicle oil demand is expected to remain relatively flat for the next 30 years. Driven by fuel efficiency gains in traditional cars and light trucks.
Our estimate of fair value for Texas Pacific Land is $861 per share.
We also think the company could surprise us to the upside with world oil demand growing again and the previous excess supply glut turning into a supply shortage.