High-Quality Energy Income – Unlocking Double-Digit Yields With Kimbell Royalty Partners

Introduction

I like oil and gas stocks.

By now, that’s no surprise.

After a period of underperformance that lasted more than a decade, energy stocks haven’t underperformed the S&P 500 since 2019, as the ratio between the Equal Weight Energy ETF (RSPG) and the S&P 500 below shows.

Due to factors like strong long-term demand, increasingly favorable supply developments, and valuation advantages, I believe fossil fuels are the place to be for the foreseeable future.

Moreover, historically speaking, energy stocks are the best place to be when inflation is elevated.

While the entire energy sector has favorable tailwinds, I like one segment a lot. That segment is royalty companies.

Royalty companies are organizations that own mineral rights. They allow oil and gas producers to use them in exchange for royalties on produced oil and gas.

This allows them to benefit from oil and gas production without having to deal with capital expenses and operational risks.

I like this area so much that I made Texas Pacific Land (TPL), one of the biggest landowners in the Permian Basin, my largest investment, accounting for 12% of my entire portfolio.

After having discussed a few royalty plays, one stock was brought up a lot by readers. That company is Kimbell Royalty Partners, LP (NYSE:KRP), the star of this article.

Hence, in this article, I will explain how KRP makes money, what makes it so special, and why investors have a realistic opportunity to receive double-digit distributions (dividends).

So, let’s dive into the details!

What Makes Kimbell So Special

For starters, a lot of European investors – like myself – may be unable to invest in Kimbell due to its tax structure.

Unlike Texas Pacific Land, it is not a C-Corp. However, it is also not a “traditional” Master Limit Partnership.

While the company does not issue a K-1 firm but a Form 1099-DIV instead, it is a variable rate Master Limited Partnerships.

This also means dividends are called “distributions,” and shares are called “units.”

With that in mind, formed in 2015, Kimbell started this year with mineral and royalty interests in roughly 12.2 million gross acres and overriding royalty interest in 4.7 million gross acres.

• Mineral interests are perpetual property rights that give the company ownership of all oil and natural gas under the surface. Essentially, these interests allow KRP to lease exploration and production rights to oil and gas companies, receiving royalties from production without having to deal with operational costs. While the company does not have surface or water rights, it has access to the most valuable commodities and a massive cost advantage – in perpetuity(!).
• Overriding royalty interests are cost-free production rights that are carved from existing leases. These interests allow KRP to have a fixed percentage of production revenue. These typically last as long as the underlying lease remains active.

In other words, the company is what it calls a “pure play mineral company.”

Moreover, its assets are well diversified, with operations in all major basins, including the Permian, Eagle Ford, Haynesville, Bakken, Appalachia, and others.

The overview below shows the company’s production breakdown (i.e., 39% of production coming from the Permian) and its biggest operators, who include some of America’s largest energy companies.

In these areas, it has more than 16 years of drilling inventory – excluding any additional discoveries or M&A.

Speaking of M&A, the company’s strategy to improve long-term cash distributions is based on three pillars:

• Acquisitions: The company is leveraging relationships with Sponsors and Contributing Parties to buy high-quality mineral and royalty interests that allow it to grow production over time.
• Organic Growth: The company is capitalizing on the ongoing development of its properties by third-party operators to improve reserves and production without additional capital expenditure.

Since 1Q17, the company has improved average daily production growth from 3.1 barrels of oil equivalent (“BOE”) to 24.7 and added inventory through four major acquisitions.

• Conservative Capital Management: Related to the two points above, the company aims to maintain a healthy capital structure to support long-term growth and financial flexibility. After all, without a healthy balance sheet, it cannot engage in M&A or distribute its cash to unitholders.

Since early 2021, the company has lowered its net leverage ratio from 2.2x to 1.0x. It has kept its leverage ratio below its target since 3Q22 (including one outlier).

With that in mind, let’s take a closer look at shareholder benefits.

So Much Shareholder Value

The company is doing very well right now.

In the first quarter, the company reported fantastic numbers, including record revenues ($87.5 million, +4.2% Q/Q), record EBITDA, and a run rate production of 24,678 BOE per day (a record), which implies 1.4% organic growth compared to 4Q23 (5.6% on an annualized basis).

Moreover, the company ended the quarter with 98 rigs actively drilling on its land. This represents a 16.3% market share of all land rigs drilling in the Continental United States!

As the Portfolio Overview in the first part of this article showed, 50 of these rigs are located in the Permian.

The company also affirmed its 2024 guidance, with a midpoint daily production target of 24,000 BOE per day.

It also used the earnings call to make clear that it remains optimistic about the development prospects, supported by the number of rigs actively drilling on its acreage and positive operator sentiment, particularly in the Permian Basin.

We continue to believe that industry trends, overall demand for energy and positive operator sentiment represent a positive outlook for the royalties and mineral space and Kimbell specifically. We are pleased with our start to 2024, and we are focused on a long-term horizon for continued growth and opportunities to enhance unitholder value. – KRP 1Q24 Earnings Call

Especially with support from healthy demand, the company remains in a fantastic spot to grow the business and reward shareholders, which is exactly what it has been doing.

This includes enough drilled but uncompleted wells (“DUC”) to support organic growth.

With regard to shareholder income, in the first quarter, the company announced a $0.49 per unit cash distribution.

That’s 75% of its available cash for distribution, with the remaining cash being used to reduce borrowings under its secured revolving credit facility.

This distribution is 14% higher compared to 4Q23 and implies a 12% yield.

Moreover, and this is somewhat unique, 79% of this distribution will be considered a return of capital, which is NOT subject to dividend taxes.

With that said, the company has an attractive upside – and a lot of yield at subdued prices.

Using the handy overview below, we see the company’s expected distribution at various oil and gas prices – based on 2024E production numbers, a 75% payout ratio, and the current unit price ($16.42).

• In the current environment of $80 WTI and $2.50 Henry Hub, the company has an implied annualized payout of $1.67, which is $0.42 per unit per quarter. This implies a 10% yield based on the current price.
• In a highly favorable pricing environment of $90 WTI and $4.50 Henry Hub, that number rises to $2.09 (12.7% yield). Personally, I believe we could be looking at WTI close to $100 and $5.00 Henry Hub once we get stronger global growth.
• Even in an environment of subdued prices ($60 WTI, $1.50 Henry Hub), the company is able to distribute $1.16 per unit. This translates to a yield of 7.1%!

This is one of the most favorable income projections of any energy stock in North America, making it a great source of both income and favorable returns for its investors – especially if oil and gas prices appreciate over time.

Based on the company’s attractive distribution outlook – even at subdued prices, I give the company a Strong Buy rating, as it perfectly aligns with my outlook of long-term support for output growth and pricing benefits.

Takeaway

For various reasons, investing in oil and gas stocks remains a top choice for me.

Among these, royalty companies stand out, which offer major benefits without the operational risks oil and gas producers face.

Kimbell Royalty Partners is especially appealing due to its diversified assets, strategic growth through acquisitions, and impressive distribution outlook.

When adding favorable market conditions, I rate KRP a Strong Buy.

Pros & Cons

Pros:

• Attractive Income: KRP offers substantial distributions, with potential double-digit yields even at subdued commodity prices.
• Diversified Assets: The company has operations across major basins, including the Permian, Eagle Ford, and Bakken.
• Low Operational Risk: As a royalty company, KRP benefits from production without dealing with elevated capital expenses and operational risks.
• Tax Benefits: Currently, a significant portion of distributions is considered a return of capital, which lowers tax liabilities for KRP investors.

Cons:

• Tax Structure: Non-U.S. investors, like myself, might face difficulties due to its variable rate Master Limited Partnership structure. However, to others, it could be a benefit.
• Commodity Price Dependence: Earnings and distributions are highly sensitive to fluctuations in oil and gas prices.