Speaker 1:
Welcome to TD Cowen Insights, a space that brings leading thinkers together to share insights and ideas shaping the world around us. Join us as we converse with the top minds who are influencing our global sectors.
Aaron Bilkoski:
We're here at the second annual TD Energy Conference in New York. We're having a series of conversations with leaders shaping the Canadian energy landscape, and I'm excited to be here with Dave Spyker, CEO of Freehold Royalties. Freehold is one of the original Canadian royalty companies in Canada. Freehold has been at the forefront of the royalty sector, which has been quickly followed by a handful of competitors in the market.
Dave, thanks for joining me.
David Spyker:
Yeah, thanks for having us on the podcast today.
Aaron Bilkoski:
So I'm going to start out with a very high level question. Can you tell the audience a little bit about what differentiates a royalty entity from a traditional E&P?
David Spyker:
Yeah, so a royalty entity essentially has no capital costs, so we don't drill any wells. We don't operate any wells. We don't pay any royalties ourself. We don't have any end of life liability. So what we do is in exchange for letting someone drill on the land that we own, we collect a royalty. So almost like collecting rent. It's just a way participating in the oil and gas sector without all the capital costs and the operating costs that a traditional E&P would have. And so with that, we're able to spread our risk amongst many plays. We're positioned across North America. We have 350 different operators that are drilling and operating on our land. So it's just a different way to participate. You get multi-basin exposure, multi-operator exposure, and yet you're actively participating in the oil and gas space.
Aaron Bilkoski:
Would it be a mischaracterization to say investing in Freehold or other royalty vehicles essentially provides the same exposure that the governments often have in the oil and gas resources within their jurisdiction?
David Spyker:
Yeah, that's a good way of looking at it. And on the Canadian side with 80% of the land that people are developing is actually crown land, so it's owned by the government. We help finance transactions, help finance people's drilling programs in exchange for a royalty. In the US, it's a little bit different where it's the opposite where it's primarily almost 90% mineral title. So we actually own the underlying land and we lease it out for people to drill on it. So there's two different ways of collecting royalties depending on what side of the border you're on.
Aaron Bilkoski:
But the underlying structure is essentially that you collect the revenue from the oil and gas and you pay very little costs associated with it.
David Spyker:
Right. So a royalty company, just by its nature, would have the highest margin barrels in the business because we don't have the OPEX. We don't have marketing costs. We don't have royalties that we're paying. And so if we look at our peers in Canada, we would have the highest margin barrels and a couple of reasons is that our Canadian barrels, we get eco pricing and we tend to be a little bit heavier oil barrel. In the US, we get about a 30% pricing premium because they're lighter oil barrels. They don't have to pay transportation to get them down to the Gulf Coast. And right now the NYMEX, the US gas markets are just much stronger than the Canadian markets.
Aaron Bilkoski:
Maybe if I rewind a little bit, several years ago you made a fairly drastic strategic direction change and said, "We need to acquire assets in the United States and diversify away from Canada." What drove that decision?
David Spyker:
The main thing that drove that is that, again, if you look at the royalty structure in Canada and the ability to buy mineral title, it's very limited. It's in the hands of us big royalty companies, whether it's ourselves or a [inaudible 00:03:37] or Topaz would have a little bit. Heritage has a bunch. It was just getting harder and harder to build of scale. And so in Canada, when an opportunity came, it was fiercely competed for by the three public royalty companies. And so you're paying a premium price. And if you look on the North American side, we found that just having that broader opportunity set available to us, we could drive much better returns.
So we're acquiring assets net five to seven times cash flow versus Canadian asset that had some opportunity to grow on it. We're up in that 10 to 12 times range. And we also wanted to really increase the payer quality that we had on our land. So if you look today, our top 10 payers, which drive 60% of our revenue on the US side are Econoco, Phillips and ExxonMobil, Devon, and Oxy. And that pairs nicely with our top payers in Canada, which are terminally in CNRL, Tamarack, Valley, Teine, and Whitecap. And so when you look at a business that we're not controlling the pace of capital, but we're rewarded by where we buy assets, if we buy the best assets, the best operators are going to be attracted to them and develop those assets through a broader range of commodity price cycles. We really set ourselves up to do that. Rewind 5, 10 years ago, we wouldn't have had that sustainability that we have through the commodity price variations.
Aaron Bilkoski:
And since you made your first acquisition in the United States, what have you learned? What do you know now that you didn't know prior to that first deal?
David Spyker:
Probably the biggest thing is that just the depth of resource, particularly in the Permian with 10 to 12 different reservoir zones of shale, when we first entered the US, we are underwriting through those benches. Today, we've had quite an active leasing program year to date in the Permian and setting record levels of leasing for our company. And what's being targeted is a Woodford zone that wasn't even getting drilled five years ago. And we're starting to see wells licensed on those new leases. And so we're seeing that.
We're seeing just the new technology. When we first started down there, typical well was two miles long. A lot of our wells now are getting to that four mile range. Exxon's talking about drilling eight mile wells. The way they approach and frack a well has changed materially. And probably the other thing that we've learned, Aaron, to be honest with you, we thought that when we first went down there, we'd have probably a little bit more production growth from the assets, but much more capital discipline.
And what we're seeing is when we're buying these assets, it's almost like stacking pancakes. You get this flat profile that just goes forever. And so a little bit difference where when we first modeled it, we had some growth and then we had decline like a typical asset and we're just not seeing those characteristics at all. So when you put those two together, that first 525 million that we invested in '21 and '22, we'll recoup that investment 100% mid next year. So that's a less than five year payout. And those assets are still doing 4,600 barrels a day of production, like a material amount of production.
Aaron Bilkoski:
At least when I'm looking at royalties, I view two separate categories. I view diversified royalty packages and very concentrated royalty packages, and they both have their advantages. When you're looking at royalties in the acquisition market, do you have a preference for one relative to the other? Is there a better value in one group relative to the other?
David Spyker:
Yeah. The nice thing about the marketed packages or the bigger packages is that it is a step change. You're making a material shift when you're buying one of those packages. What you are getting though is a little bit more of a scattering of assets. And so what we see to buy those bigger packages, it's kind of a mid-teens rate of return. The work that we did, particularly last year, has been focused more purely in the Permian, purely looking for white space or lands that hadn't been drilled so much.
But now what we're doing is that we've got a ground game going. So we're actually out there knocking on doors and acquiring mineral title from landowners in the Permian. And that's a slower pace of deployment. Year to date I think we deployed about 35 to $40 million on that. But we're seeing low to mid 20s rate of returns and we're getting the exact parcel of land that we want in the exact kind of area of the reservoir we want by the operator that we want. And so we think that we can build a much higher quality portfolio with that approach, but it's a slower approach. When
Aaron Bilkoski:
It comes to returning capital, one of the benefits of a royalty company is they're generating a ton of free cash flow and that leaves a ton of free cash flow that can be returned to shareholders. You obviously have a dividend payout policy. Could you talk about what your dividend payout policy is?
David Spyker:
Yeah. When we think of the dividend payout, we like to think like a 60% is a ideal payout ratio over the long term. And so we recognize we're in a commodity price industry and that can fluctuate. We look at that year to date, our payout ratio is 72%. So a little above that, but certainly in an area that we're comfortable operating in.
And we have a view that $60 oil isn't the long-term price of oil. And you get up into that 70 to $75 range and you get a little bit of strengthening back in the Canadian gas price side of things, that payout ratio does come down into the low 60s. And so that'll sort itself out with commodity prices and it'll also sort itself out as we continue to build the portfolio with these tuck-in type acquisitions that we talked about.
Aaron Bilkoski:
And is that what investors should expect with the incremental 40% of free cash flow that isn't going towards the dividend, incremental tuck-in?
David Spyker:
Yeah, I think when we look at our cost of debt right now, it's in that 4% range. When we look at our payout, our yield rate now on the dividend, it's about 7.4%. We can invest that money at mid 20% and build the company. We think that makes the most sense. We did put an NCIB in place in May of this year that we have not bought any shares back. It's just simply a function of seeing these opportunities that exist right now in the Permian and to be able to buy those assets.
Aaron Bilkoski:
Earlier this year, you announced a bit of a shakeup in the corporate structure. Can you talk a little bit about what motivated that and what are the benefits for Freehold as a standalone entity?
David Spyker:
So that relationship was put in place in 1996, and it made a lot of sense back in that time when Freehold was 100% Canadian royalty. We had as much working interest production as we did have royalty production when we started out. So Freehold had an active drilling program that they were operating, they were operating in the field. And that's changed. We really exited the working interest part of the business in 2020 and focused 100% on high margin royalty barrels. And then we expanded into the US where today over 50% of our revenue comes from the US.
And so those synergies just didn't exist anymore. And so the only benefit that we were getting was we had some efficiencies just with shared accounting services. But when we stepped back and we said, when we focus, we deliver. We've had that mantra for quite a while. That having everybody focused on the Freehold assets and not worrying about some accounting efficiencies, we thought that we could drive a better business going forward.
And so we're just about finished that kind of detangling of 30 plus years of business overlap. And we think that as a result of that, we're much leaner on a G&A basis. We're going to be lower year over year than we were when we were under the relationship with CNID. And CNID still is our major shareholder at 16%. They still have a board seat. They're still very committed to the business and like the business that we've evolved. And so it was just time. It was just a natural progression, Aaron, as our business has really evolved over the last five years.
Aaron Bilkoski:
What's the single most important strategic decision your company's making today to set you up for outperformance over the next five years?
David Spyker:
The single most is continued investment in the Permian, into the US. We think that when we look at just the structural differences and the resource that's in place, we think that's quite complimentary to the Canadian business. I think most people don't appreciate that if the Permian were a country, it would be the fourth largest oil producing country in the world. It'd be the third largest gas producing country in the world. So both well ahead of Canada. And so when we think about that, of having that ability to be active in world-class basins on both sides of the border, we think that that sets us apart. And there's lots of talk about Canadian energy infrastructure, and I think that time will come where that does get built. But the interim, we can build our US portfolio, take advantage of the commodity pricing that exists there right now, and it just gives us a much more sustainable platform.
Aaron Bilkoski:
Perfect. Thank you for taking the time. I appreciate this.
David Spyker:
Yeah, thanks. [inaudible 00:12:55], Aaron.
Speaker 1:
Thanks for joining us. Stay tuned for the next episode of TD Cowen Insights.
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