Diamondback Energy, Inc.

Ladies and gentlemen, thank you for standing by and welcome to the Rattler Midstream 3rd Quarter 2020 Conference Call. At this time, all participants' lines are in a listen-only mode. Please be advised that today's conference is being recorded. After the speaker's presentation, there will be a question and answer session. To ask a question during that time, you will need to press star 1 on your telephone. If you require any further assistance, please press star 0. I would now like to hand the conference over to our first speaker for today, Mr. Adam Lawless, Vice President for Investor Relations. Thank you, sir. Please go ahead.

Thank you, AJ. Good morning, and welcome to Rattler Midstream's third quarter 2020 conference call. During our call today, we will reference an updated investor presentation which can be found on Rattler's website. Representing Rattler today are Travis Guy, CEO, and Case Vantoff, President. During this conference call, the participants may make certain forward-looking statements relating to the company's financial conditions, 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. In addition, we will make reference to certain non-GAAP measures. The reconciliations with the appropriate gap 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 Rattler's midstream third quarter earnings call. The third quarter of 2020 witnessed a normalization of Rattler operations after the disruption caused by the historic volatility during the second quarter of this year. With Diamondback resuming completion operations in the third quarter, sourced water volumes rebounded strongly and volumes in the produced water, crude oil and natural gas gathering segments stabilized after declining sequentially in step with Diamondback's volumes in the second quarter of 2020. This normalization was reflected in the 32% quarter over quarter increase in EBITDA to over $71 million in the third quarter. Net income of almost $39 million also more than tripled quarter over quarter. This level of activity and cash flow can be seen as a baseline for Rattler's business for the coming quarters as Diamondback plans to maintain relatively flat production and activity levels at current commodity prices. Moving forward, Rattler is well positioned due to the strength of its parent company, Diamondback, who has a strong balance sheet, an industry-leading cost structure, and downside protection offered by its hedge book. Even when discounting the potential for Diamondback to resume volume growth in the future, Rattler will grow free cash flow through its declining operated CapEx program in completion of its equity method investments build cycle. We currently estimate Rattler's 2021 operated CapEx program will be approximately half the level of the 2020 program in less than a third of the 2019 budget. Additionally, with three of five equity method investment joint ventures in full service, distributions from these projects should exceed the remaining contributions by the first quarter of 2021. Wink to Webster will further add to this cash flow inflection when it enters into full service in late 2021. Turning to capital allocation, this quarter, the board of directors of Rattler's general partner elected to reduce the annual distribution by 31% from $1.16 to 80 cents per unit. While we believe the current outlook would have supported the distribution while keeping leverage around our two times leverage target, the current distribution yield of our equity indicated that such a view was not supported by the market. Accordingly, We elected to reduce the distribution and offensively reallocate the retained cash flow to a common unit repurchase program with 100 million authorization through year end 2021. To be clear, this is not a buy-in of Rattler by Diamondback and Diamondback will not be selling its position as part of this program. This is instead a reallocation of capital to the best returning project in our portfolio, which is retiring units with an over 18% forward return. Should the dislocation between the internal view of our forward outlook and the market perception of that outlook realign, we will return to distributing more cash flow on a per unit basis than prior to the implementation of this buyback program. We have studied the relationship between E&P parent companies and captive subsidiaries in our industry very closely and hope this buyback program is seen as further aligning the interests of parent and subsidiary. With this buyback, our partners are presented with an option. Remain partners and hold or increase your position or sell to us. In conclusion, When we created Rattler to build out the infrastructure necessary to develop Diamondbacks assets, we envisioned a midstream entity that combined conservative financial management, visibility to bonds, and a clear and honest relationship with its sponsor, the low-cost independent producer in North America. We still believe that each of these attributes apply today and is a clear advantage as Rattler adapts its business model from accommodating growth to optimizing operations. The resiliency of this business model will be proven out in the quarters ahead. With these comments now complete, operator, please open the line for questions.

As a reminder, to ask a question, please press star 1 on your telephone. Again, that's star, then the number 1 on your telephone. To withdraw the question, you can press the pound or the hash key. Please stand by while we compile the Q&A roster. First question comes from the line of Jeremy Tenet from JP Morgan. Your line is now open.

Hey, good morning, guys. This is James on for Jeremy. I just want to start with the buyback, and I may just confirm that the program is active now, so maybe we can expect any buybacks for this quarter. And you touched upon it in your prepared remarks, but just looking ahead to 2021, what factors kind of impact the pace of buybacks that you're looking to execute on?

Yeah, James, you know, we, you know, our window is still closed with earnings, but the buyback's in place. It's authorized. It's ready to start once the window opens in a couple days. So we expect to be active in the fourth quarter and pretty consistently active, you know, through next year. So I think, you know, for us, you know, we wanted to frame this as obviously leverage neutral. So, you know, using free cash to buy back shares in an offensive fashion and, And I think, you know, we'll be consistently buying back stock probably starting next week.

James, you know, just as a reminder, you know, we intend to maintain and grow the distributions from here, but we just think that today using this excess cash flow is really taking advantage of an extraordinary opportunity. You know, we're doing this because we think that long-term the strategy rewards, you know, our unit holders.

No, that makes sense. Thanks for the call there. And then maybe, you know, just given the M&A consolidation upstream and pivoting to Permian, I just maybe want to hear your thoughts on, you know, if Dimeback is involved on that end on either side of the deal, you know, if you just talk to the sponsor relationship and the confidence you have that, um, you know, the current contracts in place, you know, won't be impacted. Um, and then you just, just talk to the strength of the relationship there.

Sure, James. Well, you know, I was pretty clear in the Diamondback call on Tuesday, you know, Diamondback's perception, you know, or our view of, of base and consolidation, you know, we're, we're only going to do, grow our asset base like we always have, which is when we can drive, you know, shareholder value. And, uh, And I think the relationship that we have with Rattler is going to benefit with that, you know, laser-like focus on driving shareholder value at the parent level.

Yeah, and I think, you know, Rattler's assets are so integral to Diamondback's operations that they're going to be, you know, vital to any, you know, acquirer or, you know, continue to be vital to us. So, you know, I think Rattler will benefit if Diamondback should consolidate or And I don't see a lot of downside if Diamondback is consolidated just because all of these assets are integrated into, you know, the seven big development areas that we have today.

Got it. Make sure the questions are always there.

Thanks, James. Next question comes from Jeff Grant from Northland. Your line is now open.

Morning, guys. Hey, Jeff. I was curious – hey, Travis – Diamondback on their call, and I think for months now it's kind of talked about getting to a 4Q, kind of stabilized maintenance mode, keeping through 2021. I know that's maybe a little bit fluid here given how the commodity is bouncing around, but should we think about Rattler volumes largely kind of keeping to that cadence, or is there an opportunity to maybe outperform the parent given enhanced economics of Diamondback relative to areas where maybe there's third-party midstream?

Hi, Jeff. You know, I think the base case is that, you know, Q4 volumes will be a good run rate for, you know, for the next few quarters for both Rattler and Diamondback. And I think, you know, overall, while Diamondback's moving a little bit to the Midland Basin from the Delaware Basin from a capital allocation perspective, you know, I think investors will be surprised at the resiliency of the water business and water production in both basins.

All right. Thanks, Case. And for my follow-up on the capital side, you guys talked about, you know, kind of half of 20 levels next year. Should we think about that as being pretty sustainable to the extent Diamondback stays in maintenance mode? And, you know, if there was a situation in the commodity where, you know, Diamondback let volume slide, does Rattler still have that flexibility to rein in capital further? Or is that level we're talking about for 21 kind of the low end of the spectrum?

No, I think, you know, it's logical that if Diamondback stays flat longer or even declines, the Rattler budget is going to react even further. You know, we kind of put out this number of at least half of 2020 for 2021. And I think, you know, with the security yielding 18%, you know, this kind of ties to our buyback capital allocation philosophy. You know, there's not a lot of capital projects that we have in the portfolio that generate a higher return than that year one. So, capital dollars are going to be very scarce at Rattler, and if we continue in a maintenance mode for 2022, you know, it's anyone's guess, but if that were the case, capital will continue to come down at Rattler from even the 2021 levels.

Okay. Great. That's all I got. Thanks, guys.

Thank you, Jeff. As a reminder to ask a question, please press star 1 on your telephone. Next question comes from Diane of Ujwal Chafan from Bank of America. Your line is now open.

Hi, everyone. This is Alex on for Ujwal. Maybe just starting off on capital allocation. Should we anticipate you to renew the buyback program after it expires in 21, and what would kind of be the puts and takes of further capital return there?

Yeah, Alex, what the board's committed to is the $100 million, and we'll evaluate that just like anything. you know, any other investment decision that we make. We'll evaluate that, you know, probably on a quarterly basis, but the board's very comfortable with the $100 million allocation right now.

Understood. Thanks for that. And then maybe just one more. Regarding some of Diamondback's comments with reducing flaring in the Permian, is there an incremental opportunity for Rattler to capture some more gas heading into 21?

Yes, certainly. The benefits that we've seen in The, you know, almost 75% reduction in flaring from this time last year at the parent level is in large part through the efforts of what Rattler has done. And as we continue to see whether there are emerging technologies in methane monitoring or methane rogue gas capturing, you know, I expect Rattler to be on the front of that conversation.

Perfect. Thank you both. Thank you, Alex.

Next question comes from the line of Pierce Hammond from Simmons Energy. Your line is now open.

Good morning, and thanks for taking my questions. Just a quick statement. I think it's smart to cut the distribution and allocate the capital to buy back. So I think that's a smart capital allocation decision. The first question, though, is when you think about growth opportunities over the next few years above and beyond Diamondback, Do you see opportunities to grow your third-party business, and are there opportunities to make maybe small acquisitions or bolt-ons that would help facilitate that?

Yeah, Pierce, I mean, I think there certainly are smaller opportunities on our existing asset base, you know, to improve margins. You know, we pay a lot of royalties to, you know, the landowners for disposal and for fresh water. So, you know, trying to reduce that burden will increase margins. Outside of that, small bolt-ons to our existing systems, if we need capacity, is certainly on the table, but we have to then do the build versus buy analysis, and most of the time it's cheaper for us or a higher return for us to build than buy. Overall, on top of that, I don't think we're trying to keep this business model pretty simple, and buying third-party exposure is reduces that line of sight that we like, you know, to our operations, and that starts to cloud it a little bit. So I think staying pretty consistent on the story that, you know, Rattler should benefit, should Diamondback be a consolidator, but outside of that, you know, sticking to the base business rather than a lot of third-party exposure.

Yeah, you know, Pierce, if you just circle back to my opening comments, and I think it was in the first question, you know, Rattler can always look at things that can drive unit holder value, just like at the parent level. That singular focus of trying to deliver value to people that own the company is first and foremost on our minds. Case's comments are entirely correct, but let's not forget that we're always here to try to drive unit value and shareholder value creation.

Thank you, Travis and Case. Then my follow-up question is you've done a good job on reducing costs during the downturn and becoming more efficient. Are there still opportunities to further do that in a meaningful way that could impact cash flows, or is a lot of that behind you at this point?

Yeah, you know, Pierce, that's a laser focus always, regardless of external factors, is to reduce costs across the board. whether it's at the DynaVac level or you're at the Rattler level. I think cost reduction is actually geared faster at the Rattler level than it is at the DynaVac level. What is the case? A penny is $2.5 million?

Yeah, Pierce. I mean, you know, the stuff, you know, the things we're looking at, you know, operating costs on disposal, one cent of operating cost reduction is $2.5 million of EBITDA. net to Rattler. So, I mean, that's, you know, that's 1% or so of our, of our EBITDA. And so that, as Travis was saying, that gearing is a lot higher on the Rattler side than even Diamondback.

And, you know, Pierce, we're actually reallocating some internal resources, you know, from Diamondback into, into Rattler to, you know, to help, to help focus on all of that. You know, Rattler was on such a meteoric, you know, trajectory on, on growth over the last, you know, 18 months. Now we've got the extra eyes, you know, really focused on cost reduction, as Kate just highlighted. You know, a penny makes a big difference. So that's what we're looking to do currently.

Well, thanks, guys. Great quarter.

Thank you. Cheers.

As a reminder, to ask a question, you will need to press the star, then the number one on your telephone. Again, that's star one on your telephone to ask a question. Last question comes from the line of Tristan Richardson from Truly Securities. Your line is now open.

Hi, good morning. Really appreciate the commentary on capital priorities and the return profile you're seeing in projects out there. Curious, to the extent you remain active on the repurchase, as you look out into 21 and 22, I'm just curious your thoughts on use of free cash flow net of distributions in a maintenance mode environment. Is there a level – is there a balance sheet level that would be suboptimal, such that you might actually add leverage to accelerate repurchase or, you know, return of cash to shareholders in other ways?

Yeah, Tristan, I mean, I think for us, you know, being around two times levered, versus other midstream companies is best in class. I don't think, you know, we're looking to step on that and increase it in any meaningful way, just given, you know, how we think about leverage on a consolidated basis with the parent company and our two subsidiaries. So I think growing, you know, leverage to buy back more stock is not on the table. But I think, you know, should be in the fortunate position to have free cash flow above the distribution and get through the buyback program I think we're going to bring back the distribution and with lower units, that distribution is going up. So, you know, we've created this vehicle to be a cash return vehicle. That's still the base case, you know, particularly with 70% of our free cash flow still going towards the distribution. But, you know, with a forward yield of 18%, 19%, you know, we had to put our hand up and say, I think, you know, I think allocating some capital to bond back stock at these levels is the right decision. Now... Longer term, do we go back to more of a distribution model? I hope so, but it's a rare opportunity to be able to buy back stock at the bottom of the cycle.

Yeah, using debt to buy back stock or buy back units has never been part of the strategy. I go back to my opening comments, Tristan, that this is just taking advantage of an extraordinary opportunity. and the board still intends to maintain and grow the distribution from here. That has been unwavering, you know, from the very beginning.

That's helpful. And, Casey, you kind of touched on my follow-up there, but do you see this model evolving into somewhat of a variable model where you adjust the payout on a more regular basis depending on what you see in the stock, what you see in capital project returns, profiles, et cetera?

You know, we're familiar with the variable model with Diamondback, or sorry, with Viper, excuse me, but I think we planned on this being a pretty fixed distribution model, and this opportunity that presented itself because of the market dislocation is probably the exception versus the norm. You know, I hope we don't have to go through 2020 again in a few years, so hopefully we're you know, bringing back the distribution and growing it with a reduced unit count and hopefully happy unit holders.

Helpful. Thank you guys very much.

Thank you, Tristan. Thank you for all those questions from the participants. I'm now turning the call back over to our CEO, Travis Seitz.

Thanks again to everyone participating in today's call. If you've got any questions, please reach out and contact us using the information provided.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.