All participants, please stand by. Your conference is ready to begin. Good morning, ladies and gentlemen. Welcome to the Freehold Royalties Ltd. second quarter 2019 conference call. Please be advised that certain statements on this call constitute forward-looking information. These statements relate to future events or our expectations for future performance. All statements other than those of historical facts may be forward-looking, and we caution the listener. I will now pass the call over to Tom Mullane, Chief Executive Officer. Please go ahead.
Thank you, and good morning. Thanks for joining us. With me from Freehold are Alan Withey, our Chief Financial Officer, Matt Donohue, our Manager of Investor Relations and Capital Markets, and myself. We will summarize our second quarter results, and then we'll be happy to answer questions. Some quarterly highlights we wanted to expand upon include: On the operations front, Q2 2019 royalty production averaged 10,311 BOEs a day, up 2% versus the previous quarter. The increase in royalty volumes quarter-over-quarter was driven by strong activity levels during the first half of the year, particularly within the Alberta and Saskatchewan Viking and our liquids-rich portfolio. Royalty interest accounted for 97% of production and 100% of operating income in Q2.
Reflecting acquisition activity, which we will detail, we have increased our 2019 royalty production forecast from a range of 9,900 to 10,300 BOEs a day to 10,000 to 10,500 BOEs a day. We remain cautiously optimistic concerning activity levels through the remainder of the year, with the expectation our royalty portfolio will continue to outperform the Western Canadian Sedimentary Basin activity levels. Utilizing our free cash flow and the flexibility within our balance sheet, Freehold closed a CAD 30 million acquisition of a gross overriding royalty during the quarter. The transaction comes with drilling commitment on the part of the vendor on certain light and medium oil reservoirs in central and northern Alberta and southwest Saskatchewan. At the time of closing, the royalty was producing 215 BOEs a day with 94% of production being liquids.
Funds from operations in 2019 under actual and strip pricing associated with the acquired assets is estimated at CAD 3.8 million. Subsequent to quarter end, Freehold closed a CAD 9.8 million acquisition of certain royalty assets located in North Dakota, U.S. As part of the transaction, a half a million U.S. dollar acquisition deposit was paid in June 2019. Production and funds from operations in 2020 associated with the acquired assets is forecast to be approximately 200 BOEs a day and CAD 2.3 million, respectively. This represents our first royalty acquisition outside of Canada. Freehold has been looking at royalty opportunities in the U.S. for several years, and in the past two years, we have significantly improved our U.S. knowledge base and developed our U.S. entry strategy.
We will initially focus on royalty opportunities in the Williston Basin, which is an extension of the Bakken Three Forks plays found on our existing royalty acreage in southeast Saskatchewan. Our ability to understand the geology and play types make for a comfortable transition as we continue to build our expertise in doing business in the United States. Within Canada, Freehold saw continued strength and activity on our royalty lands during the first half of 2019. In total, we had 274 wells, 10.2 net wells, drilled in our royalty lands during the period. Of these, 127 or 2.9 net wells were drilled in the second quarter of 2019. This represents a 34% improvement on a net measure and a 15% decrease on a gross measure over the same period in 2018. Typically, the second quarter represents a period of slower drilling activity.
However, activity on our royalty lands outpaced expectations, particularly when compared to the same period in 2018. Together, Saskatchewan and Manitoba drilling represented approximately 51% of our gross drilling in the first half of 2019. Alberta activity has again been concentrated in the Viking and East Central Alberta, as well as in the Cardium in West Alberta. Moderate activity continues for Mannville oil plays throughout the basin. We continue to see activity emerging in the Duvernay and Clearwater, with 12 gross wells drilled between these two plays in the first half of 2019. Also, our top payers continue to represent some of the most well-capitalized upstream companies in Canada.
We are currently forecasting 20 net wells as part of our 2019 guidance, and while we are well ahead of our forecast year-to-date, we would like to see activity levels through the third quarter before making any revisions to this estimate. Both the Canadian Association of Oilwell Drilling Contractors and the Petroleum Services Association of Canada are forecasting material reductions in drilling activity in 2019, greater than a 25% drop in drilling year-over-year. We are not seeing that on our lands. Dividends represented 62% of funds from operations for the quarter. This compares to 64% during the previous period and 101% during the Q4 2018. We will continue to evaluate our dividend quarterly, but given the volatility associated with the Canadian energy industry, particularly activity levels and the outlook for light, heavy differentials, we have chosen to maintain our dividend at current levels.
Through 2019, we're forecasting a payout of approximately 60%-65%, versus our previous guidance of 60%, reflecting a weakened outlook for crude oil. We have set a dividend payout range of between 60% and 80% of funds from operations for 2019, so we remain at the low end of this range. I will now pass the call to Alan to walk through the financials.
Thank you, Tom. Good morning, everyone. This quarter, we continued to demonstrate strong financial flexibility at Freehold. During the second quarter of 2019, Freehold generated funds from operations of CAD 30.1 million, or CAD 0.25 per share. Revenue from oil and NGL production increased to 93% of total revenue in Q2 2019. A retreat in natural gas prices during the quarter, along with a focus towards more activity within oil plays, impacted this weighting, a weighting that has become more valuable over the last two years. Continuing a multi-year trend, Freehold's royalty production amounted to 97% of total production and 100% of operating income in the second quarter. That's up from 95% of total production and 99% of operating income in Q1 2019.
Freehold declared dividends of CAD 18.7 million, or CAD 0.1575 per share in Q2 2019, implying a 62% payout ratio within the targeted payout range Tom mentioned earlier. In conjunction with our Q2 2019 results, we updated our WTI and Edmonton oil price assumptions for the full year of 2019, along with the 60%-65% payout ratio expectation at the low end of our targeted payout range. Freehold closed the quarter with net debt of just over CAD 98 million, representing 0.9 x net debt to funds from operations. The net debt figure increased just over CAD 20 million versus the prior quarter, reflecting acquisition activity closed late in the quarter, partially offset by free cash flow generated in excess of dividends paid during the period.
For year-end 2019, based on our forecast and including the United States expansion closed subsequent to the quarter end, we forecast net debt to funds from operations of approximately 0.8 x. Net income for Freehold in the second quarter was CAD 3.4 million, or CAD 0.03 per share. As discussed in our call last quarter, Freehold received a proposal letter from Canada Revenue Agency, or CRA, where CRA stated that it intends to reassess and deny Freehold's deduction of certain non-capital losses claimed and carried forward in the tax return filed for the year end December 31st, 2015. Freehold is and will continue to vigorously defend its tax filing position. It anticipates the proceedings with CRA could take considerable time to resolve. We firmly believe Freehold will be successful defending its position, and therefore, any amounts paid to CRA should be refunded, plus interest.
No provisions have been made in the financial statements relating to the proposal letter. I'll turn it back to Tom for his final remarks.
Thanks, Alan. In closing, we executed on our strategy in Q2 2019. We were able to grow our royalty production organically quarter-over-quarter. We provided a sustainable dividend to our unit holders. We executed on our acquisition strategy utilizing free cash flow while unveiling our first U.S. royalty transaction. We reiterate to our shareholders that the move to the U.S. will be measured with the goal of improving the quality of our royalty portfolio. We see the Williston Basin as providing a strong near-term opportunity set for our shareholders. Looking forward, we will continue to strive to maximize value for our shareholders by investing our free cash flow in the form of dividends, value-enhancing acquisitions, and/or paying down our debt. Overall, Freehold offers investors a lower-risk oil and gas investment vehicle with upside oil prices, and we feel we have furthered this during the quarter.
I'll now pass it over to the moderator for questions.
Thank you. We will now take questions from telephone lines. If you have a question and you're using a speakerphone, please lift your handset before making your selection. If you have a question, please press star one on your telephone keypad. If at any time you wish to cancel your question, please press the pound sign. Please press star one at this time if you have a question. There will be a brief pause while the participants register for questions. Thank you for your patience. Our first question is from Dennis Fong with Canaccord Genuity. Please go ahead.
Hi. Good morning, and thanks for taking my questions. The first one that I have is just on the U.S. royalty acquisition and kind of your view therein. How do you guys see the buildup of essentially your U.S. business now that you've kind of done your first foray into the North Dakota Bakken? How should we think about the pace of acquisition growth, especially if you're able to complete transactions at a 3.5x - 4.5 x cash flow rate, and on assets that show production growth over time? I've got a follow-up. Thanks.
Hi, Dennis. Good morning. This is Tom. Thank you for the questions. First of all, when you look at our U.S. royalty acquisition strategy. We're just looking to add assets that improve the quality of our existing portfolio. We look in Canada and in the U.S. to find those. We do believe right now that there is plenty of opportunity on both sides of the border, but we have been looking at the U.S. for some time, and we'll continue to look in the Williston Basin area, primarily in our first go into the U.S. As far as the pace, we just use excess free cash flow, as you know, Dennis, to buy acquisitions, and we've used a little bit of our balance sheet as well. Don't expect every deal that we have is 3.5x - 4.5x times cash.
It all depends on the upside and the pace of drilling on lands, as you know. That cash flow range can range as low as this to double this as well for quality assets which have lots of drilling opportunity. We'll just allocate cash to the best opportunities that we see coming. Some could be in the Williston Basin and some could be in Canada.
Okay, perfect. Just quickly as a follow-up, in terms of using a little bit of your balance sheet to potentially fund transactions, if you wouldn't mind reminding us as to what the debt target that you would like to stay within to potentially pursue some of these potential acquisitions?
Yeah. Our debt, as you know, Dennis, our debt target is to be less than 1.5x debt to cash flow. We won't push it right to that limit. We'll stay comfortably underneath that as we have done in the past.
Okay, perfect. Then last one here is just in terms of looking at the activity levels in Canada, I was just curious as to how the initiatives that you were indicating, and that you're pursuing to drive more committed wells and capital on your lands, how that's faring along. Thank you.
Yes. This is a long-term process for us, Dennis, to energize our land. We're working with producers. If producers can commit to drilling wells, we might offer a small break in the royalties to encourage development.
Okay, thanks.
Thank you. Our next question is from Amir Arif with Cormark Securities. Please go ahead.
Thanks. Good morning, guys. Just a quick question for you, Tom. Can you just give us a little more color about the opportunities you do see in the Williston Basin, just in terms of the fragmented nature of any royalty opportunities that are there, splits between mineral versus GORRs that you see and just the maturity of the play in general, just as you contrast that to what you've seen on the Canadian side?
Oh, yeah. Thanks, Amir, for that question. In Canada, there's more crown land than there is mineral title land, freehold land, about probably 80/20. It's flipped in the U.S. As far as opportunities, most of the opportunities in the Williston Basin are mineral title. As far as fragmentation of land, usually we look at land that's already got their drilling spacing units in order and stuff like that. Usually there's already a lot of the hard work that's done, and we kind of come in just before the drilling starts.
Okay. For this specific acquisition, is the royalty for all the zones, or is it just the Bakken versus the Three Forks? Is there any split?
Yeah, it would be all zones, but the target here is Three Forks Bakken.
Okay. Just a final question on the Canadian acquisition, the CAD 30 million acquisition with the drilling commitments. Do those drilling commitments, based on your projections, does that hold production and/or cash flow flat as you move out a year?
It grows or is slightly or is flat in the near term.
Okay. The reserve life to that production?
Oh, many years. I actually do not know that, but the reserve life index would be over 10 years for sure.
Okay, sounds great. Thank you.
Yeah.
Thank you. Once again, please press star one at this time if you have a question. Our next question is from Jeremy McCrea with Raymond James. Please go ahead.
Hey, guys, it's a couple of questions on these acquisitions here as well, too. The first question is just more of a high level, what do you guys and how do you guys approach acquisitions in today's market versus what you guys would have done a couple of years ago when you looked at acquisitions? Has your hurdle rate for acquisitions changed? What exactly or do you think there's different, more important things with acquisitions nowadays? Maybe if you can just kind of go along those lines.
Thanks, Jeremy, for the question. As far as when we look at acquisitions, with every acquisition, we want to improve the quality of our assets. That's number one. Number two is where we've traded down, everything's traded down. Everything has to be accretive. We do demand a higher rate of return for our assets. I think a couple of years ago, we'd say high single digits, low double digits. Today, it's low double-digit rate of return after tax is what we look for.
Okay.
Also quality counterparties as well. We've always wanted quality counterparties, but we're just more attuned to that in this day and age.
Okay. Are you more inclined to have royalties on future inventory or more inclined to have near-term cash flow? Just with the follow-up, are you able to give any kind of indication of how many locations these royalty rates may apply to that aren't kind of producing now?
Oh, okay. Yeah, we've done several deals where it's mostly raw land. They're usually typically small deals, usually they have drilling activity forecast in the near term, not four or five years down the road. It's something that has near-term cash flow projected. Some of the assets we have bought that has These ones in the U.S., that's good cash flow today because that's why we have such a low multiple on the deal. It's a balance. It's all driven by net asset value and the quality of the asset.
Okay. Are you able to provide any kind of future location that you see on these acquisitions?
Yeah. Well, I guess when we do a bottoms-up analysis, there's always future locations that we put on the acquisitions.
Okay.
As far as the CAD 30 million royalty we just put in, we do have a 100-well commitment. If that isn't met, then the royalty percentage goes from 1.7% - 2.7%.
Okay.
Well, if they don't drill 100 wells, it's a good deal for us. If they do drill 100 wells, it's a good deal for us, too.
Yeah. Okay. Okay. Okay, thanks, Tom.
Yeah.
Thank you. There are no further questions registered at this time. I would like to turn the meeting back over to you, Mr. Milne.
Yes. Well, thank you very much. Thank you everybody for joining us on the call. We're excited about our acquisitions that we did in Q2. We generated increase in production on a per-share basis or organic growth quarter-over-quarter. We're pretty excited about that in this environment. Thanks for the call, and everybody have a great weekend.
Thank you. The conference has now ended. Please disconnect your lines at this time, and we thank you for your participation.