The Rational Cloning: Mosaic Musings #3
Royalty Companies: "Inflation, I Win; Disinflation, I Don’t Lose Much." [Inflation Crisis Series]
Last week, I put out Mosaic Musings #2: Disinflation → Inflation Inflection Point?
The piece looked at both sides of the disinflation vs. inflation debate; and frankly, both sides are justified since no one knows what inflation will look like. This tweet pretty much sums up my view:
Yet, I think if we take a step back, I think the course of action as an investor is fairly clear.
We want to bet on inflation without taking an explicit binary bet on inflation. To paraphrase Mohnish Pabrai: “Inflation, I win; Disinflation, I Don’t Lose Much.”
In essence, we want to position our portfolio in a way such that if persistent inflation does emerge, we stand to benefit; but if inflation is transitory, we do okay.
Too good to be true?
After much reading and browsing, there’s one (fairly rare) asset class that I’ve come across that satisfies the above condition: mineral and royalty companies. (Note: I am by no means saying this is the only way. Just one that I’ve come across.)
To see just how rare they are:
I’ve only found them in Canada, the US, and Australia.
In the US, there are only 7 publicly traded oil/gas mineral and royalty interest companies (TPL, VNOM, MNRL, BSM, KRP, FLMN, DLMP; ~$17B market cap in total) and ~11 oil/gas royalty trusts (~$2.5B).
Royalty companies are a lot more prevalent in Canada. (I don’t have a number, but it should be fairly easy to assemble a list.) As James Davalos of Horizon Kinetics put it:
Canadians understand royalties. They get it. The rest of the world doesn’t get it.
Canadians understand what a great business model this is. [23:42]
What are mineral and royalty companies?
Simply put, royalty companies own the rights to receive a percentage of revenues (or resources) generated from the extraction of an underlying commodity.
For example, let’s say Company A is a royalty company and company B is a company that produces oil. B goes out and spends money to produce oil on A’s land; for every barrel of oil B produces, A gets a check for 15% (usually 15-20%). In other words, for every $100 of oil B produces, A gets $15 (all without breaking a sweat).
In short, royalty companies are just fantastic businesses. If done right, royalty companies have limited expenses since they have no need to invest in labor, equipment, technology, etc. Their only assets are pieces of paper that give them a right to the minerals or oil/gas extracted from the ground, some employees and maybe some office space.
As a result, revenues for royalty companies are entirely derived from the following equation: (price of underlying commodity) x (volume extracted).
And since these companies have little expenses, most of the revenue gets converted into free cash flow; most sport FCF margins of ~70/80/90%. For comparison, Apple has a FCF margin of ~27% and Microsoft ~33%.
“Inflation, I win”
So how do royalties tie back into inflation?
Research shows that commodities tend to be most positively correlated with inflation (as calculated by CPI). So higher commodity prices means higher revenues and FCF for royalty companies.
Inflation causes a lot of inputs into businesses to go up: labor, equipment, commodities, etc. That’s why even when businesses raise prices, they might not actually earn more because expenses also go up (sometimes ever faster). But since royalty companies don’t require additional expenses , higher revenues straight up means higher FCF.
Higher commodity prices would incentive producers to increase production, which means more revenues and FCF for royalty holders.
In short, royalty companies are passive beneficiaries of commodity price increases, as well as production increases. Horizon Kinetics dub these companies “asset-light, hard-asset inflation beneficiaries”. Other terms to describe them include: “send-a-check-of-Omaha companies”, “mailbox money”, and “tollbooths”.
As Buffett describes in his 1980 Letter to the Shareholders:
Our acquisition preferences run toward businesses that generate cash, not those that consume it. As inflation intensifies, more and more companies find that they must spend all funds they generate internally just to maintain their existing physical volume of business.
There is a certain mirage-like quality to such operations. However attractive the earnings numbers, we remain leery of businesses that never seem able to convert such pretty numbers into no-strings-attached cash.
The tweets below should indicate how some businesses are now feeling the increased costs required just to maintain existing operations:
Just as I was writing this, Viper Energy Partners’s came out with its 2021 results, which contains a section that summarizes the benefits of royalty companies when it comes to inflation:
Looking ahead to 2022, Viper is uniquely positioned within the industry to be able to capture numerous tailwinds and return substantial amounts of cash back to our unitholders.
With zero capital requirements and only limited operating costs, royalty companies will be advantaged in 2022 as we will not face inflationary cost pressures.
“Disinflation, I Don’t Lose Much”
So how do these royalty companies do when there’s low inflation?
Let’s start with some observations:
Most have little to no debt
Most are always profitable (the breakeven is pretty low)
As a result, they actually have a built-in countercyclicality. When prices are low, royalty companies can redirect their FCF to acquire royalties at cheaper levels
In short, you have these companies that can:
Survive multiple commodity cycles without the risk of going bankrupt
Benefit from both upswings and downswings in commodity prices
Constantly generate positive FCF
There aren’t many companies in the world that can do that. Almost seems too good to be true.
Well, that’s how it is supposed to work. In theory.
Though certain companies, notably TPL and FNV (mainly players with scale), have shown that the model does work. For the last decade, TPL has outperformed oil producers / oil and FNV has outperformed gold miners / gold.
Source: TPL Investor Presentation, FNV Investor Presentation
Below are a few excerpts taken from various oil/gas royalty companies:
BSM: ~$3.6B returned to investors through distributions over the past 20 years (current market cap: 2.42B, yield: 7.75%)
DMLP: “Small, Quiet and Boring Outfit Distributes a Billion Dollars to Its Partners” (as of the August 12th, 2021) (current market cap: 767.58M, yield: 8.8%)
In short, royalty companies seem to do okay.
Valuation
Frankly, I have no idea how to value royalty companies and I don’t think traditional valuation methods quite do the trick.
If you take a step back, these growth-oriented royalties (as opposed to royalty trusts that liquidate when certain criteria are met) are essentially perpetual options on both:
Commodity price growth and
Production growth (which includes improvements in technology for enhancing resource extraction)
In other words, if you plug in oil prices for the next few decades into Black-Scholes, I’m sure you will get some value far above what these companies are trading for now (adding this to my to-do list).
Buffett seems to have reached the same conclusion:
And if you live in Texas, and your grandfather is close to dying, and he calls — he calls the grandchildren, children around him, and in his final words, he always says, “Don’t sell the mineral rights.”
As have others:
Michael Kao of Akanthos Capital Management in an interview in August 2021 on the oil supercycle:
There is one sector of the [oil] market that benefits from that [OPEC engineered dynamic of short-term supply inelasticity and longer-term supply insecurity].
It’s not the shale guys. It’s actually the minerals guys…. The minerals plays are companies that just - they don’t hedge, typically- they just pay out what the production is of the underlying minerals. If you want a domestic play on oil that benefits from the oil curve the same way OPEC benefits, then the purest play is through the minerals. [1:03:43]
Geoff Gannon of Focused Compounding on inflation:
Anything that’s a royalty. I mean, you know Buffett’s talked about that. Anything that’s a royalty benefits [from inflation].
…
Anything that’s is just a pure royalty. And that’s what I was saying with the resource things that pure royalties are more beneficial that way. And Nathan’s [Famous] is a rare example of that but there are probably some other companies that are mostly licensing businesses.
Write-Ups / Tweets
Below are some additional write-ups on various royalty companies:
Additional Resources
Conclusion
That’ll be all for now. I hope you enjoyed this issue.
Until next time,
The Rational Cloner