Since oil and gas prices have declined considerably from their 2022 highs, we want to reassess the prospects for the mineral and royalty companies in our coverage universe. Dorchester Minerals, L.P. (NASDAQ:DMLP) is one of our favorites due to its uniquely conservative management style.
DMLP is conservative in virtually every variable that is meaningful for unitholders, from its arrangement with its general partner to its rock-solid financial position to its geographically diversified portfolio, as shown below.
Dorchester Minerals, L.P. generates spectacular returns on capital and equity. They rose above 80% over the twelve months ending September 30, 2022, as shown in the table below.
The high returns are evidence that management has acquired DMLP’s assets at low prices while keeping costs low. Moreover, the absence of any impairments whatsoever is a remarkable achievement in the energy sector, let alone among royalty companies. It indicates that management has accounted for its assets conservatively, which we view as very important in appraising public royalty companies.
DMLP Unit Valuation
We value Dorchester Minerals, L.P. units by estimating distributable cash flow per unit and then determining where its units would trade to yield 10% using reasonable production and commodity price assumptions. We use a 10% yield for valuation purposes because it is high enough to account for the various uncertainties involved in valuing publicly owned royalty companies.
In DMLP’s case, estimating distributable cash flow involves some complicating factors. For one, the company operates with a large cash balance that can impact the amount of cash it pays out in any given quarter. Furthermore, its cash inflows are far lumpier than its revenues because it maintains significant accounts receivable owing to the structure of net profits interest agreements. These agreements tend to involve a several-month lag between when oil and gas are produced and when DMLP receives its cash payment associated with that production.
In the third quarter, distributable cash flow was boosted by an unusually large $7.3 million lease bonus payment that is not likely to be repeated anytime soon. The lease bonus amounted to $0.19 per unit, all of which was distributed to unitholders. Going forward, we assume quarterly lease bonuses of $500,000, which is more closely in line with DMLP’s historical trend.
Yesterday, DMLP announced its fourth-quarter distribution of $0.884339 per unit, down from its previous quarterly distribution of $1.135019 per unit. Both of these distributions are in line with our estimates of DMLP’s production and realized commodity prices, as shown in the table below.
For the current quarter, we assume oil prices of $78.50 per barrel oil and natural gas prices of $3.50 per mcf. We also assume royalty production volumes increase by 5% from the previous quarter due to recent acquisitions and that net profits interest production volumes bounce back slightly from the dip they experienced in the third quarter. Under these assumptions, we estimate that DMLP will generate $0.78 per unit of distributable cash flow, or $3.12 per unit on an annualized basis. At a 10% yield, DMLP units would trade at $31.20, implying 7.5% upside from the $29.00 at which they trade today.
When oil and gas prices were high in the first half of 2022, we valued mineral and royalty companies using lower prices in our base scenario. Now that prices have come down, we feel comfortable using recent prices as a reference point for estimating distributable cash flow. We, therefore, believe the current quarter’s $0.78 per unit, which assumes natural gas prices of $3.50 per mcf and oil prices of $78.50 per barrel, is appropriate for valuing DMLP units.
In the event that natural gas remained at $2.50 per mcf, with oil at $78.50 per barrel, DMLP’s annual distribution would fall to $3.00. Its units would generate a 10% yield at a unit price of $30.00. We, therefore, believe the distribution yield is safe even in today’s harsh commodity price environment.
As an alternative to our yield-based valuation, we can use a discounted cash flow scenario to value DMLP units. If we annualize the first quarter distributable cash flow of $30 million to $120 million, our valuation indicates the units are worth $31.27, in line with our previous valuation and 7.8% above their current market price of $29.00.
When it comes to estimating DMLP’s intrinsic value, a few points bear mentioning. Using the depreciated asset value on the balance sheet and depletion rate from the income statement implies the company has approximately ten years of asset life at current production rates. However, over its history, DMLP has been successful at replacing reserves on attractive terms for unitholders. As recently as the fourth quarter of 2022, it closed on a new lease transaction in the Midland Basin of the Permian. Our valuation assumes the company can continue to transact for royalties and net profits interests on favorable terms for its unitholders.
But this isn’t a foregone conclusion, particularly in light of the recent retirement of DMLP’s CEO, William Casey McManemin, who has been an outstanding steward and allocator of unitholder capital. Since 2002, McManemin has made smart acquisitions while keeping costs low and adeptly navigating the best and worst market conditions. The verdict is out as to whether his replacement, Bradley Ehrman, can be as successful. He clearly has some big shoes to fill.
If instead, we assume the company decides to stop replacing reserves and runs off its current production, its terminal value would fall to zero, and our discounted cash flow valuation drops to $19.22 per unit, 34% below their current price.
This is an unduly harsh downside scenario. Like much of long-term analysis of commodity producers, it is complicated by unknown variables such as Dorchester Minerals, L.P.’s long-term production rate, production mix, realized commodity prices, the creditworthiness of its operators, and the extent to which its accounting approximates economic reality. All of these are subject to wide misestimation, which is what makes valuing oil and gas properties so difficult.
We don’t view a runoff scenario as a realistic way to determine intrinsic value, but it can be instructive for gauging downside risk. We believe DMLP’s management is committed to replacing the company’s reserves, and that they’re capable of doing so in a manner that is favorable for unitholders.
As a rule, we don’t like to buy equities trading at fair value. We would rather buy Dorchester Minerals, L.P. units when a cyclical downturn or some other event sends their market price significantly below our estimate of intrinsic value. That said, Dorchester Minerals, L.P. is very conservatively managed and is one of the safest royalty owners we have come across in North America. Current DMLP holders who bought at lower prices would do well to hold on. We reiterate our Hold rating and $31.20 price target for DMLP units.