OGIB BULLETIN #206 April 16,2018

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1 OGIB BULLETIN #206 April 16,2018 VIPER ENERGY PARTNERS; VNOM-NASDAQ COMPANY ANALYSIS Updated April 16, 2018 There are two very important reasons to own Viper right now one long term, and one short term. Short Term: the company is transforming from an MLP into a regular C-Corp. MLPs usually trade at a high, trailing yield like 8-10%. High quality C-Corps trade at a leading yield of 4-6%. I m expecting some serious yield compression. Let s say Viper distributes $2.35 in 2018 which I think is very realistic. That s a $23.50-$28 sttock as an MLP. As a C-Corp, that s a $47 stock ($2.35 /.05). BIG difference. The stock jumped 6% on March 29 when it said it would change. I confess that may be a little aggressive as they will likely continue to have a variable rate payout only what they think they can afford as opposed to a set dividend the Market can count on. That strategy usually means a bigger yield. Long term, I truthfully tell people I never know where the price of oil is going. That s a mug s game. But I do have a lot of confidence that the oil and gas industry will drill like mad in the Midland and Delaware Basins in the Permian for years to come which is where Viper is concentrated. These are the best shale oil plays in the country. Viper Energy Partners is literally a royalty on production growing in these two basins. Viper is a royalty streaming business. The company is attractive for both what it does and does not have. Let s start with what it doesn t have. That would be any capital spending and a large number of employees. That means very few cash expenses..which is TERRIFIC! Viper s business is owning the mineral rights to land in the Permian. Most of its ground comes from Diamondback (FANG-NASD), as Viper is 65% owned by FANG. But now it has bought royalties from other major operators as well. It

2 started mostly in the Midland Basin but has rapidly grown its presence in the Delaware Basin as well. Those mineral rights mean that the oil producers that are operating on Viper s lands pay them a royalty of roughly 20% of revenue from production. I like to call Viper The Permian Landlord. Now what does this business result in Viper having? That would be lots of free cash flow, a sizable dividend and direct exposure to production growth in the top shale oil plays in the country. Viper can generate free cash flow and pay a dividend at $30 per barrel oil. It can generate a lot more free cash flow at $70 per barrel oil. This company is a way to get long oil prices and long Permian production growth with a lot less risk than owning oil producers carries. I have been buying this stock since $15 a year ago. I just bot more at $26. I think it has a great chance of going past $47 in the next 18 months. QUICK FACTS (As At April 16, 2018) Share Price: $28.18 Basic Shares Outstanding: 116 million Market Cap: $3.27 billion Net Debt (Includes Q Acquisitions): $213 million Enterprise Value (EV): $3.34 billion 2018 Q1 Production: 14,100 boe/d (71% oil) 2018 EBITDA (Estimates): $231 million Annualized Q1 Distribution: $1.92 Current Yield: 6.8% POSITIVES - Excellent balance sheet - No capital expenditures - Exposure to the highest rate of return shale oil plays - 20 years of drilling locations already identified

3 - Lots of opportunity to acquire additional mineral rights accretively - Unhedged oil exposure (could be a negative) NEGATIVES - Not necessarily a cheap valuation - Diamondback Energy controls the majority of shares (small float) - Doesn t control the rate of development - Unhedged oil exposure (could be a positive) BACKGROUND A FREE CASH FLOW BUSINESS Viper Energy which had its IPO on June 18, 2015 at $26.00 per share is majority owned by Diamondback Energy (NASDAQ:FANG). Diamondback is an oil and gas producer focused on the Permian Basin. Diamondback owned roughly 64% of Viper s shares as of April Viper is not an oil and gas producer. This is a royalty company that leases its properties to oil and gas producers who do all of the work and then pay Viper a royalty on production. I love that business model. The older I get the more I like passive income. I ve been focusing more and more on adding dividend paying investments to my portfolio. Viper is one of those. The primary things that I like about royalty companies is what they don t have which would be all of the things to dislike about oil and gas producers. I m talking about things like: - Big capital spending requirements - Lots of employees - Large amounts of corporate overhead cost - Usually large amounts of debt

4 Oh, and almost always.. zero free cash flow. That is the curse of most of these shale producers. Production declines so fast that every penny of cash flow that production creates (and then some) has to be put back into the ground as fast as possible just to maintain production..even more if they want to try and grow production. The shale production business is like running 24/7 on a treadmill that never turns off. Sounds exhausting doesn t it? I ve been able to successfully invest in some of these shale producers because I ve been focused on the rare companies that have the very best oil and gas properties. Properties that pay back the money that goes into drilling wells exceptionally quickly. The reality is though..such companies are rare. Even the best producers, given the intensive capital spending requirements of the shale business operations really don t generate the free cash flow to support a decent dividend. The royalty business that Viper is in is very different, it is all about free cash flow and dividends. CONVERTING FROM AN MLP TO A C-CORP Viper was founded as a Master Limited Partnership --- an MLP. An MLP is an entity that does not pay any income tax because it passes through all of its profits to its unit holders. Effective early May 2018 Viper is going to change its federal tax status from a pass-through MLP to a taxable corporate entity. The reason for doing this is to help the Viper share price by making it ownable for a larger number of investors. The reason it s NOT ownable for institutions is the tax reporting unit-holders have to fill out tax forms so onerous that most institutions don t bother owning ANY of these MLPs.

5 So by definition, the pool of capital chasing MLPs is much smaller some $90 billion vs the amount of money chasing dividend paying energy sector corporations at $6 trillion about 65 times as much. Making Viper an investment option for trillions more of institutional money could see a mark-up in the way the market values Viper don t you think? There a couple of other benefits of the new corporate structure. One is that it will allow for easier and less expensive sources of capital which would expand Vipers ability to accretively acquire mineral rights. A second is that it may shake the negative implications associated with old E&P MLPs which was a group riddled with bankruptcies during the downturn. This transition should have no impact on Viper shareholders; all of Viper s cash flows will still be distributed as dividends. Despite being a taxable corporation Viper is not expected to pay any income taxes for several years thanks to tax shields allocated from Diamondback. Diamondback has agreed to allocate $300 million of such tax shields.

6 With this move Viper will be structured like a typical U.S. exploration and production company, but investors should quickly note that there is nothing typical about Viper. There are no other E&Ps with an 7% yield, a high rate of growth and no capital expenditures.

7 VIPER ENERGY THE DISTRIBUTION The chart below shows the dividend/distribution history of Viper. The time period covered includes some incredibly low oil prices. Viper s underlying production is 70% oil, and revenue is almost entirely oil given the pricing disparity between oil and natural gas. Viper s distribution continued through the worst of the oil collapse. It has fluctuated as you can see. In Q3 2014, which was pre-crash Viper, paid out $0.25 per unit/share. In Q when oil actually spent some time under $30 the distribution was down to $ But even when oil was under $30 there was still a distribution, and it was a distribution funded by free cash flow..not by ringing up more debt. As you can imagine the ability to do that makes Viper a rare animal.

8 Viper is completely unhedged which is why the distribution fluctuates. If cash flow increases the distribution goes up. If it goes down the distribution goes down. I feel like that is how a sensible business would set its dividend policy. You pay out what you can afford. The beauty of the Viper business model is clearly demonstrated by the company s incredibly fat margins. For every dollar of revenue generated, only 8% is eaten up by expenses.

9 THE UNDERLYING ASSETS HIGH QUALITY, GROWTH As a royalty company, you want companies to drill like mad on your property. Cash flows are driven by: 1. producer production levels 2. underlying commodity price. The beauty of being the royalty company is that you don t have to pay for any of that drilling. You just kick your feet up and wait for the producers to start mailing you royalty cheques. (Viper actually takes it in kind, in oil, and sells it themselves, but you get the picture) The royalty producer is the landlord of the energy business. 90% margins baby! Obviously then, the best royalty businesses to own are the ones that control the land that the producers actually want to drill --- the properties with the best economics. In that sense the royalty business is similar to the producer business. The best assets will dictate who has the best results.

10 The assets that Viper owns the mineral rights on are exactly where you would want them to be. In the Permian, both the Midland Basin and Delaware Basin. When Viper first came public all of the acreage related to the Midland Basin. Since then Viper has been busily acquiring properties with royalty acreage growing from 3,172 to 10,470. The company continues actively adding to this all of the time. Being a publicly traded entity has a huge advantage for Viper in making acquisitions. Viper trades in the market at $319,000 per acre of royalty land that it controls. Meanwhile the company has been acquiring acreage at prices that are one-third of that. That is how you make being a publicly traded company that can tap into the capital markets work for you. Issue shares at $319,000 per acre, use the proceeds to buy royalty acreage at a much lower price. With the conversion to a corporate structure likely to improve Viper s valuation.this recipe for success gets even better. Most of Viper s initial Midland Basin acreage was operated by Diamondback. In July of 2016 Viper made the first expansion of its asset basin into the Delaware Basin --- also a top drawer horizontal oil play.

11 As Viper has acquired acreage it has lowered its exposure to Diamondback. Diamondback is now operator on 59% of Viper s acreage down from 81% at the start of The diversification away from Diamondback is likely a good thing, but I have no issues with the Diamondback exposure. That company is a first-class Permian operator; Diamondback usually trades at THE highest valuation of any E&P in the US, on a per barrel basis. That definitely helps Viper s valuation and business model.

12 In the maps above the Midland Basin is on the right, the Delaware Basin is on the left. See how since the end of 2016 Viper has increased its Delaware acreage.

13 Producers pay Viper from 14 to 25% of production. The Midland and Delaware are the two basins where I would want to own royalty rights. There has been no more telling signal of where the best oil assets are in the United States than where drilling rigs have been active since oil collapsed. Here are the 15 most active individual counties in all the USA for drilling: This is dominated by the Permian today with 134 horizontal rigs today in the Midland Basin (above just shows Midland County) and a similar amount (153) in the Delaware Basin. You would be interested to know that when I first wrote this report in January of 2017 those two rig counts were only 93 and 87 respectively. That s important for two reasons. It obviously shows the economics here are great. The top formations in the Permian are the best in the business. They have the lowest breakeven costs and the fastest paybacks. But it also means the # of rigs drilling for Viper is going up and was doing so even before oil started its run from $45-$65 in August of 2017.

14 The relationship with Diamondback should continue to provide a steady source of acquisition opportunities for Viper. It s attractive for Diamondback to sell acreage to Viper and bring in cash flow today. As a producer Diamondback has a lot of spending to do so this is a viable funding means. Viper will raise funds in the public market to make that acquisition (and now that they re a C-Corp that will hopefully be done at a much higher valuation/lower cost of capital), but Diamondback retains a long term interest in the cash flow through its ownership of Viper. Diamondback is effectively selling its own mineral rights to itself given that it owns the majority of Viper. The royalty business model is attractive at low oil prices because the company can continue to generate free cash flow at almost any oil price. That makes this a less risky investment than a producer which has much larger spending requirements. Viper s oil royalty business also offers direct exposure to rising oil prices since it is completely unhedged and 90% oil weighted production. There isn t the leverage here to rising oil prices that a producer has, that is the trade-off you get for taking on less risk. As oil prices rise, Viper s distribution will also rise since it pays out 90% of revenue and has no capital spending commitments.

15 I d like to share a slide from Diamondback s most recent corporate presentation because it is a great visual for understanding why these Permian wells are superior see that this is at just $50/b realized pricing. The three bars on the left walk up the three major costs of drilling and fracking a 7,500 foot Lower Spraberry formation Permian well. You ve got the cost of drilling, the cost of completion and the cost of the equipment/infrastructure being put in place. On the right in red we have the revenue that this well generates in the first year less the royalty cost on it. Then deduct the $9.15 per barrel operating cost and you arrive at total cash flow for year 1. At $50 WTI these wells recover 89% of the cost of the wells in one year. The Bakken and Eagle Ford weren t doing this at $90 WTI. Those are the numbers today. If oil prices rise and activity levels really pick up, then all of those costs on the left are going to increase and offset some of the improvement in revenue per barrel produced.

16 The payback will be faster at higher oil prices, but you need to be aware that those costs on the left are not fixed. They follow industry activity levels. One thing that won t change is that these wells are paying back that invested capital really quick that is important. AS OF Q VIPER IS IN THE EAGLE FORD In Q Viper announced that it had spent $123 million acquiring 681 net royalty acres in the Eagle Ford. Before we get too excited we should remember that this is $123 million being spent by a company with a $3 billion plus Enterprise Value (EV=market cap + debt). This isn t a needle mover in percentage terms. It is however interesting in that it is the first move by Viper outside of the Permian. The 681 royalty acres acquired are mainly in DeWitt and Karnes Counties which have oil weighted production. The properties are operated by producers that are well capitalized and have publicly disclosed multi-year drilling plans.

17 I trust that Viper management would not have made this move without being confident that this is good acreage that is going experience growing production and royalty revenues production from this acreage is expected to by 900 boe/day. Management says that the cash flow yield relative to the $123 million purchase price will be 14% in that is better than the 7% cash flow yield that Viper generates so the deal is very accretive. As to whether this move signals that Viper will be looking to move in a major way outside of the Permian management said this in the Q4 earnings call: Our strategy has not changed, we will continue to focus on acquiring minerals in the Permian Basin, but we'll selectively look for sizable acquisitions in oil weighted basins with cash flow accretion and forward visibility, all of which described this acquisition. I would read that to mean that management is looking to acquire acreage that offers very clear visibility on production growth. The best place to find that is in the Permian, but if they find it elsewhere they will take it. The bottom line is that high quality acreage with top economics is what will be developed. FINANCES The royalty business model with its non-existent capital spending requirements could certainly support some debt. However Viper s management team does not plan to use much, if any. Q financials have not yet been released but it looks to me like Viper will end the quarter with $213 million in net debt. That is just shy of 1X 2018 EBITDA. They have shown they like to run with NO debt, but now as a C-Corp I can see them using a 1-1.5x Debt:EBITDA ratio. If they can get their yield down to a Once the transformation to a corporate structure is complete I would expect that we will see an equity issuance to take this debt down to almost zero. That has been what Viper has done historically.

18 Hopefully that equity issuance will be done at a higher share price thanks to the new corporate status. Viper s revolving credit facility has a $400 million limit, so lots of room there. Keep a clean balance sheet and the market will give you a premium valuation. If you have a premium valuation on your shares you can use them to make accretive acquisitions consistently. Sell your shares high, buy assets low. You are sick of me telling you that I like expensive stocks, but that s why. Too many investors get focused on valuation metrics and it gets them trapped into companies with sub-par assets and no ability to make a deal using equity. A rich valuation is a powerful weapon with which to make acquisitions. Protecting that valuation with a great balance sheet is a great strategy. As I mentioned before Viper is completely unhedged so it offers direct exposure to rising oil prices. VALUATION The most obviously attractive thing about Viper is the dividend --- currently yielding almost 7%. What investors should be more excited by is the growth. The chart below shows Vipers 261% increase in production per share (or unit as an MLP) since early 2014.

19 Usually a stock paying 7% is going to offer very little growth potential. More accurately, a 7% yield often means that even the current dividend isn t secure. Viper s ability to repeatedly make accretive acquisitions has created an impressive rate of growth. The company s goal is to grow production faster than the overall production growth in the Permian Basin. That goal has been blown out of the water. The 261% production growth from Q through Q has been 3x the Permian.

20 Based on 2018 production guidance of 15,000 bopd, annualized distributions per unit look something like this: at $50 oil: $1.60 (5.7% yield on current unit price of $28.18) at $60 oil: $2.03 (7.2% yield on current unit price of $28.18) at $70 oil: $2.35 (8.3% yield on current unit price of $28.18) The yield by itself will provide a stellar return. Multiple expansion from the move to a corporate structure and further growth on a per share basis can add some capital appreciation to that yield. Other than yield, the stock is fairly valued on per flowing barrel basis, by acreage but it s growing every quarter. STOCK CHART next page

21 WHAT THE ANALYSTS SAY FIRM TARGET PRICE Credit Suisse $29.00 Imperial Capital $30.00 Simmons & Company $32.00 SunTrust $32.00 UBS $29

22 CONCLUSION It s an interesting time for Viper as they change to a C-Corp. Hopefully the valuation goes up based on yield compression short term, but long term, if there is one thing that I have a lot of confidence in is that the Midland Basin and Delaware Basin are going to be the most active oil plays in the country over the next decade. Viper is the best way for me to get direct exposure to that and they have no costs! I d say that owning Viper is like getting long oil but that wouldn t quite do the company justice. Viper does have completely unhedged exposure to oil prices, but the fact that it is also long production growth in this region provides an even more important source of cash flow growth. A big yield, great balance sheet, rapid growth, no capex, gushing cash flow, solid at low oil prices and upside if oil prices increase dare I say this is the best risk/reward stock in the oil sector?