Ladies and gentlemen, thank you for standing by, and welcome to the Viper Energy Partners third quarter 2020 earnings conference call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question and answer session. To ask a question during the session, you will need to press star one on your telephone keypad. Please be advised that this call is being recorded today. If you require any further assistance during the conference, please press star zero and an operator will be happy to assist you. I would now like to hand the conference over to Adam Lawlis, Vice President, Investor Relations. Thank you, and please go ahead, sir.
Thank you, Bridgette. Good morning, and welcome to Viper Energy Partners' third quarter 2020 conference call. During our call today, we will reference an updated investor presentation, which can be found on Viper's website. Representing Viper today are Travis Stice, CEO, and Kaes Van't Hof, President. During this conference call, the participants may make certain forward-looking statements relating to the company's financial condition, results of operations, plans, objectives, future performance, and businesses. We caution you that actual results could differ materially from those that are indicated in these forward-looking statements due to a variety of factors. Information concerning these factors can be found in the company's filings with the SEC. We will make reference to certain non-GAAP measures. The reconciliations with the appropriate GAAP measures can be found in our earnings release issued yesterday afternoon. I'll now turn the call over to Travis Stice.
Thank you, Adam. Welcome everyone, and thank you for listening to Viper Energy Partners' third quarter 2020 conference call. The third quarter was a strong quarter for Viper as we saw a resumption of completion activity on our mineral and royalty acreage as commodity prices improved from the historical lows witnessed during the second quarter of this year. Viper's 10% increase in oil production during the third quarter was driven primarily by 38 of Diamondback's 41 completions in the quarter, having roughly 10% average royalty interest net to Viper as third-party activity remained minimal, again, showcasing the differential relationship between Diamondback and Viper.
The advantaged nature of the royalty business model with no required CapEx and only minimal operating expenditures, further enhanced by Viper's best-in-class cost structure, has been highlighted during this severe industry downturn as Viper's been able to reduce total debt by 10% in just the past six months. As a direct result of this, and because of our confidence in the expected free cash flow to be generated in our forward outlook, the board has elected to increase our distribution payout for the third quarter to 50% of our total cash available for distribution, up from 25% previously. The $0.21 per unit of total cash available for distribution implies a 12% annualized distributable cash flow yield based on our current unit price. On the operations front, we continue to maintain a strong inventory of both work-in-progress and line-of-sight wells.
Given that visibility, we have initiated average production guidance for the fourth quarter of 2020 and the first quarter of 2021 of 15.25-16.25 thousand barrels of oil per day. While production is already within the high end of our previously guided range, and we remain confident we'll exit 2020 with a strong production rate, Diamondback-operated activity on Viper's acreage is expected to be slightly lower in the fourth quarter this year and into the first quarter of next year before returning to a more elevated level again starting in the second quarter of 2021.
This is seen with only 3.5 net Diamondback-operated wells in the work-in-progress bucket, which we define as wells expected to be turned to production within the next six to eight months, but 7.4 net line of sight wells, which are expected to be turned into production in the roughly six to eight-month time period thereafter. Further, we continue to be conservative in our forecasting of third-party operated production despite leading edge indicators pointing to a return to increased activity levels and timing of operations. Despite this conservatism, at $40 WTI and production held flat relative to our average fourth quarter 2020 and first quarter 2021 guidance, Viper is expected to generate approximately $200 million of free cash flow on an annualized basis in the first quarter of 2021.
This equates to greater than 11% free cash flow yield as a percentage of enterprise value, or roughly 18% based on our current market cap. Viper remains in strong financial shape with $461 million of liquidity and will continue to look for avenues to accelerate the de-leveraging process so that we can continue to increase our return of this free cash flow to our unit holders over the upcoming quarter. Operator, please open the line for questions.
As a reminder, ladies and gentlemen, if you have a question at this time, please press star and the number one on your touchtone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. Our first question comes from the line of Brian Downey with Citigroup. Your line is open.
Good morning. Hope everyone's well, and thanks for taking my questions. You increased your implied payout ratio here to 50% in the third quarter and noted in your deck that you expect to continue to maintain a portion of cash available to reduce debt. Any updated thoughts on how we should think about the pace of that payout ratio increasing over time, what guideposts you're watching, and what the anticipated ceiling is given those debt reduction goals?
Yeah, Brian, good question. I think we're going to be patient. We did take the step from 25% up to 50% this quarter, and I think we have a lot of confidence in keeping that kind of overall payout ratio going forward. Now, I think the key is going to be Q1 and Q2 when our hedges roll off from 2020, and we start to realize a lot higher oil price on a majority of our production. I think if we're at current prices to higher from here, I think it's logical that that payout percentage rises a little bit. I think still we're probably focused on getting to 2 times leverage at the end of 2021, which I think is a pretty logical first step or next step for us from a leverage perspective.
Like we've said, the increased payout is not going to be mutually exclusive to that further debt reduction.
Great. That's helpful. Then, looks like from the deck and the cash flow statement that you sold a small number of third-party operated Delaware Basin acres for a few million dollars. Could you update us on the potential for further third-party operated asset sales? I guess more theoretically with the E&P consolidation we've seen within some of Viper's third-party operator cohort, has that changed how you're thinking about your third-party operated acreage footprint at all versus three or six months ago?
I wouldn't say that the E&P consolidation has impacted our thought process on asset sales. Certainly the strength we're seeing in the private market versus the public market or where we're trading has continued to give us confidence that selling some assets at these prices isn't the worst idea. I think overall we're selling assets that are completely undeveloped under operators with not a ton of visibility and not a lot of active development. We do have some larger packages that we're talking to people about, we're going to be patient, and I think like we said last quarter, we're not a forced seller here. We are recognizing where we trade versus where we can sell some of this stuff in the public markets with zero cash flow.
Great. I appreciate it.
Sorry. Excuse me, in the private markets with zero cash flow.
Thank you. Our next question comes from the line of Derrick Whitfield with Stifel. Your line is open.
Hey, good morning, guys.
Morning, Derrick.
Thinking about 2021 production, while clearly a lot can still change in the macro conditions, would it be fair to assume that your forward visibility, including work in progress and line of sight wells, with that visibility, you could hold Q3, call it Q4 production relatively flat, assuming a ratable conversion of that inventory?
Yeah, Derrick, I think that's fair. There's obviously going to be some movement, large pads at the Diamondback level do impact Viper uniquely versus a staple plan at the parent co. I think the kicker is going to be non-op production and non-op volumes. We're still very conservative on how we're modeling those non-op volumes, but certainly, our leading indicators, permits and rig count and line of sight wells has improved slightly on the non-op side, particularly in the last couple of months. While I won't commit to staying flat as guidance today, I think it's a potential outcome for the full year.
Kaes, just staying on that point specifically, when you guys look at the permits to assess your third-party queue, so to speak, does that support the notion that the rig count's largely bottomed from a third-party perspective? Then also, would it support the notion that your completion flow probably bottomed as well?
I think that's fair. I think you've seen it in the data we put out that the Diamondback net wells really held up the company in Q2, well, sorry, mainly in Q3 and will continue to do so in Q4. I certainly hope the rig count has bottomed, but I also hope from an industry perspective, we don't go back to grow. Instead, focus on maintaining production and hopefully Viper's the beneficiary of some of that non-op production getting turned in line here over the next few quarters.
That's great. Very helpful, guys. Thanks.
Thank you, Derrick.
Our next question is from the line of Brian Singer with Goldman Sachs. Your line is open.
Great. Thank you. On the Diamondback call, I believe Diamondback said flattish type production until oil prices move higher and then more longer term load single-digit or just single-digit production growth. I just wondered what's the longevity by which the Viper production profile can outperform Diamondback based on the focus of Diamondback on drilling higher interest wells from a Viper perspective? That was obviously a driver of the strong production here this quarter. What's the longevity of that until potentially you start to see Diamondback growth equal Viper growth ex the what happens on the non-operators?
Brian, I think certainly the second half of this year Viper's growth is going to outperform Diamondback's growth. Viper's operated production by Diamondback is going to outperform Diamondback's growth. This does go in waves. We had some really high-interest wells come in in Q3 that's going to help us going into Q4. Over the longer term, I would hope that Viper's Diamondback-operated production can slightly outperform Diamondback if Diamondback's staying flat or grow 200 basis points higher on a percentage basis than Diamondback's. That's our job as a consolidated capital allocator to make sure the drill schedule is encompassing Viper Minerals. What we see today is that there's going to be a lot of high-interest pads coming on in 2021, continuing that trend of increased pro forma capital efficiency heading into 2021.
Got it. Thank you. My follow-up, you talked about asset sales earlier and the understandable focus on de-leveraging, part of which you've already shown here over the last six months. Can you just talk philosophically on the acquisition side about the interest level in further growth via M&A and how you expect that market and your interest level to evolve?
I think M&A has been really important to Viper to achieve scale in the minerals space. I think we're going to echo the comments that Travis had on the Diamondback calls, that Viper doesn't need to be the biggest mineral owner in Texas or the biggest mineral owner in the Permian. We need to be the best. That means that we're going to be reshaping our portfolio a little bit, buying minerals under Diamondback and selling non-op minerals. While, like we said, we're not going to sell minerals at fire-sale prices, we do recognize that there's a bit of a value disconnect between where we're trading and where these minerals are trading in the private market under operators with no visibility, no line of sight. It's good acreage, but there's no control over the drill bit.
I'd rather have control over minerals that we operate with a 16% forward yield and pristine visibility.
Great. Thank you.
Thank you, Brian.
Our next question comes from the line of Chris Baker with Credit Suisse. Your line is open.
Hey, good morning. I realized it 's hard to talk about 2021 without former guidance for a fact but just looking at that slide seven in the deck, it looks like historically, you guys have averaged call it 70%-75% of Diamondback activity. What's a reasonable placeholder for Viper's exposure to Fang's program next year? Could that sort of be biased above the historical average as we've seen over the past few quarters?
I think it's going to move around. The Q3 number was as high as it's ever been. I think we had 93% exposure to Diamondback wells. I think, Chris, over a longer period of time, two-thirds to three-quarters is a pretty safe baseline. I do think our Viper team is going to be looking to increase that number by buying under Diamondback when the balance sheet allows it. Two-thirds to three-quarters exposure to Diamondback's completions is probably a safe bet.
Okay, great. Just as a follow-up, realizing the focus today is on the balance sheet, but once that sort of peak leverage is in the rearview mirror, is there a specific leverage target? You talked about two times by the end of next year, but is there a specific leverage target that allows you to restart the acquisition program, albeit in what it sounds like is a very thoughtful way?
I think being closer to two and getting three times in the rearview mirror is more important to us today. I think if we have a lot of confidence that that's going to happen over a couple of quarters, we can restart the acquisition machine. I also think part of the acquisition machine can be funded through asset sales rather than debt or external funding.
Okay, great. Thanks.
Thank you, Chris.
Our next question comes from the line of Jeff Grampp with Northland. Your line is open.
Morning, guys.
Hey, Jeff.
Kaes, maybe just to build on the last thought on leverage and payout ratios, what do you guys view if you formalized any thoughts internally about target leverage and payout ratios in a normalized world, however you guys may want to define normalized?
In 2020, I don't know what normal is anymore, Jeff, but I do think at kind of a mid-cycle oil price, $45-$55 WTI, which is a long way from where we are today, we should be closer to a turn or a turn and a half levered at most. While I won't commit to a long-term payout ratio on this call, I do think it's something like the inverse of an E&P. If an E&P is reinvesting 70% of its cash flow into maintenance capital and returns, maybe the mineral company can be the opposite.
I think we've heard a lot of talk about variable dividends in the E&P space, and I ask investors to go look back at what we've done, and Viper's been a variable investment vehicle, a variable payout vehicle for five or six years now, and it's returned a lot of cash back to shareholders. I think a rule of thumb could be that it's the inverse of an E&P. A mineral company certainly needs to continue to add inventory. This is a depleting business, but the urge to add inventory for a mineral company is much different than an E&P.
Got it. Appreciate that. For my follow-up, how would you say a hedging philosophy integrates into some of those kind of longer-term goals? I know you guys put some on at the beginning of this pandemic, but it seems like been a little bit quieter on that front. Should we expect Viper longer term to return to an unhedged entity, or does hedging have a role going forward?
I think through a down cycle, you always have to look at the decisions you made and figure out what were you doing before the down cycle that was good, bad, or indifferent. One of the lessons learned, I think, for us at Viper is that if you have debt, you should probably hedge more than less. Viper was always an unhedged vehicle because there was not a lot of debt. When we added that bond, we should have hedged. That's shame on me for not doing that.
I do think lessons learned is that, while I don't want to trap Viper into a specific cash flow number, I do think protecting the downside from some sort of wide range of collars that guarantees our investors some form of return of capital on the downside and doesn't limit their exposure to oil prices on the upside is probably going to become part of the story, along with continued debt reduction. If you use debt to buy something, a clear path to paying back that debt over a short period of time.
All right. That sounds good. Thanks for the time, guys.
Thank you, Jeff.
Our next question comes from the line of Gail Nicholson with Stephens. Your line is open.
Good morning. Most of my questions have been asked, but just kind of curious, when you look at the volatility in the commodity you experienced in 2020, how are you guys thinking about that maybe not hoarding cash, but the need to potentially build cash on the balance sheet on a go-forward basis, just to have as a safety net?
Yeah, Gail, it's a good comment. I think it's probably less important at Viper than Diamondback to build cash just because the first step at Viper is to get that revolving credit facility down to almost zero and reduce our reliance on bank funding. You've seen, obviously, the banks have had a tough time with energy companies through this down cycle. We want to be as low touch as possible with those banks. I think we're a long way off from getting the revolver to zero. Certainly having the ability to buy back bonds in the open market, pay down debt, and also call debt because Viper's not investment grade, has a little less of a need to hoard cash. I do recognize that having cash for a rainy day isn't the worst thing in running an energy company.
Great. Thank you.
Our next question comes from the line of Neal Dingmann with Truist Securities. Your line is open.
Good morning, all. Hey, how many current rigs are currently operating Viper acreage, and are you thinking that'll be about the same you're assuming sort of going into next year?
Rig count? Can you repeat that question?
How many current rigs? How many rigs are operating right now?
Neal, we got 21 rigs running today. Four of which are Diamondback operated. Yeah, four Diamondback rigs, and I think we've seen something like 60 permits put on our position here in the last three weeks.
Wow, okay. That's what I was going to follow up. Great details. Secondly, I know Viper has always benefited from Diamondback's FT on EPIC and Gray Oak, and I know the pricing that's linked there. I was just wondering, are you expecting much change? I think these are long-term contracts, would there be much change in how we think about this for Viper going forward or not really given sort of the length and duration of these contracts?
I don't think there'd be a change. We set this Viper up to receive the same pricing as Diamondback. Other E&Ps have marketing entities that take possession of the barrel in their local market and then sell it to the international market or wherever they end up selling the barrel to. In order to have full alignment between the two public entities, we sell at the wellhead, and therefore, Viper receives the same price as Diamondback. I think Viper, because of Spanish Trail being such a large piece of our production, Viper gets a little more MEH exposure versus Diamondback receiving more Brent exposure. Those are long-term contracts, and we want to make sure parent and sub are aligned on what they receive.
Very good. Thank you.
Thanks, Neal.
Our last question comes from the line of Leo Mariani with KeyBanc. Your line is open.
Hey, guys. Just wanted to follow up on a comment you made around the production guide for 4Q 2020 and 1Q 2021. Did I hear you guys right that you're really not assuming much in the way of non-op activity at all in those numbers, despite the fact that you're seeing these encouraging permitting trends here?
Yeah, Leo, we're assuming some non-op activity. We're certainly not assuming we get back to levels seen in the end of 2019 or early 2020. I think non-op's going to help a little bit in Q4 and Q1, but Q4 will probably be mainly driven by the follow-through of these high NRI pads from Diamondback benefiting Q4. Q1's still a little bit far away from us right now to make any bold predictions. I do think Q4 is likely a bit stronger than Q1.
Okay, that's helpful. I guess just from a perspective of the payout ratio, just kind of wanted to make sure I understood you guys correctly here. You obviously took it up from 25% to 50%, which is nice to see. I guess basically just saying that we're likely to kind of stay at this 50% for a while until we really see oil prices kind of recover to that sort of $45 plus type timeframe?
Well, yeah. I think a while in our industry is a relative definition. We have confidence that Q1 and Q2 strip starts to improve and that we're going to receive a much higher price for our commodity, high $30s, low $40s. I think it's on the board to look at that forward outlook and see if we're reducing debt to that two times leverage kind of target at strip pricing, and can we protect that a little bit via hedging? If we can do that, let's increase the payout even further.
Okay. Thanks for your time.
Thank you, Leo.
Thank you. I'm not showing any further questions, so I'll now turn the call back over to Travis Stice, CEO, for closing remarks.
Thank you again to everyone participating in today's call. If you've got any questions, please contact us using the contact information provided.
Ladies and gentlemen, this does conclude the program. You may now disconnect. Thank you for participating, and have a wonderful day.