Freehold Royalties Ltd.

All participants, please stand by. Your meeting is ready to begin. Good afternoon, ladies and gentlemen. Welcome to the third quarter results conference call. I would now like to turn the meeting over to David Spiker. Please go ahead.

Good afternoon, everyone, and thank you for joining us. With me on the call from Freehold are David Henry, our CFO, Rob King, our Vice President of Business Development, and Matt Donahue, our Manager of Investor Relations and Capital Markets. Before we get into the highlights of the quarter, and it was a really good quarter for us, we wanted to note that alongside government and public health officials, we are actively monitoring COVID-19 updates and following the latest guidance. We prioritized the health and safety of our workforce by directing all employees to work from home initially. Now the burden of public health measures were relaxed in June, our return to office task force worked diligently to develop office safety protocols in alignment with government and public health guidelines. We were able to reopen our office in July with a reduced staff complement and will continue to monitor COVID-19 updates and follow the latest guidance to move to our next phase of return to office. We sincerely appreciate the continued efforts of our staff during this time and we want to thank our shareholders for their ongoing support. So despite these ongoing concerns associated with COVID-19 and the prevailing commodity price environment, Freehold continues to deliver strong returns to shareholders over the quarter. We remain focused on the sustainability of our dividend and providing a consistent income source for our shareholders, while reducing the overall risk profile by reducing leverage and positioning our royalty lands ahead of the drill bit. We continue to highlight that during these periods of weaknesses, our strong margins and simple business models stand the test of time. Operationally, Production on our royalty lands averaged 9,096 BWE a day, essentially flat versus the previous quarter and down approximately 10% versus the same period last year. Shut-in production on our royalty lands averaged about 5% during Q3, an improvement from 9% in the previous quarter, and we exited the quarter with only about 3% shut-ins. Through the remainder of the year and into 2021, we see volume stabilizing in our core plays like the Viking, the Clearwater, Southeast and Southwest Saskatchewan, and North Dakota. This is driven by volumes coming back online and the resumption of third-party drilling on our royalty lands. We were encouraged with the level of drilling on our royalty lands during the third quarter with 32 wells drilled. Recall, the previous quarter had no drilling activity after excluding adjustments as producers responded to weaker crude oil prices. For the first nine months of 2020, we had 261 wells drilled on our royalty lands, slightly higher than our initial expectations. What we're seeing is activity continue to be focused on our core Viking-plated dog land, but we also saw increased drilling in core plays in southeast Saskatchewan, western Saskatchewan heavy oil, cardium oil in west central Alberta, and in liquids rich in natural gas in the deep basin. We believe that with the lower volatility within the crude oil price environment and the stronger natural gas pricing through the winter months, producers will continue to remain active on our royalty lands into breakup of 2021. Given the backdrop for shutting volumes and uncertainty around the pace of third-party drilling, Freehold announced early in Q2 its previously released 2020 guidance was no longer applicable. We're continuing to spend 2020 guidance at this time with the expectation that we will resume 2021 guidance as more information is unveiled on spending levels associated with some of our top drillers. We expect to provide the next update to investors as part of our Q4 2020 results, which will be released in March 2021. As part of our Q3 results, We are increasing our monthly dividend by 33% from 1.5 cents to 2 cents per share, starting in January 2021 for shareholders on record as of December 31, 2020. At the revised monthly dividend level, freehold funds from operations are forecast to be at the low end of the annual payout range of 60% to 80%. With two months remaining in the year, it is our expectation that dividend levels will be at the low end of our payout range for 2020 as well. While increasing the dividend, we continue to maintain the strength of our balance sheet and will continue to pursue value-enhancing acquisitions. At current commodity prices and the revised dividend levels, we expect to pay down approximately $2 to $2.5 million in debt per month, with leverage remaining below 1.5 net debt to funds from operations. I'll now pass the call to Dave Henry to walk through some of the financial highlights.

Thanks, Dave, and good afternoon, everyone. Financially, as crude oil prices stabilize and natural gas prices improve, freehold continues to deliver on the core aspects of its return proposition, a meaningful dividend while providing investors with a lower risk investment, differentiating itself from traditional oil and gas E&P companies. In the third quarter, Freehold generated $23.1 million in royalty and other revenue, up 56% versus Q2 2020, reflecting improved liquids and natural gas pricing, lower cash costs, and stable production volumes. Our royalty portfolio generated an operating net back of $27.20 per BOE during the third quarter, up 61%, when compared to Q2 2020. Funds from operations for Q3 2020 totaled $19.9 million, or 17 cents per share, up 87% and 89%, respectively, versus Q2 2020. Our payout on a dividend paid basis was 27% in the third quarter of 2020, down from 92% during Q2 2020. We target freeholds payout to remain at the lower end of our outlined range of 60 to 80% for 2020 with our year-to-date payout at 67%. As previously mentioned, we increased our monthly dividend for 2021 from 1.5 cents per share to 2 cents per share, reflecting an improved and less volatile crude oil price environment and positive momentum associated with third-party capital on our royalty lands, while still remaining cautious and measured. Cash costs for the quarter totaled $3.70 per BOE, an all-time low for freehold. This was down noticeably from $4.79 per BOE in Q2 2020, the decrease versus Q2 2020, reflects both lower operating and financing charges. The reduction in cash costs was most materially impacted by the disposition of working interest production during the previous quarter, with the forecasted impact on operating costs expected to be approximately $0.35 per BOE. Freehold closed the quarter with $14.4 million reduction in net debt from Q2 2020. Net debt totaled $81.7 million at September 30, 2020, representing a one-time net debt to funds from operations. The decrease in net debt quarter over quarter reflects stronger funds from operations. With oil prices likely to remain range bound for the remainder of 2020 and into the first half of 2021, we expect our long-term debt to EBITDA ratio to comfortably remain covenant compliant. Freehold's prudent strategy of maintaining long-term debt to cash flow below 1.5 times and a dividend payout range of 60% to 80% of funds from operations, providing cushions for potential volatility that may pick up in commodities. Updating our Canada Review Agency reassessments, amounts are consistent with those recorded last quarter. Freehold's Corporate income tax filings for 2015, 2018, and 2019 were reassessed by the CRA in 2021. Pursuant to these reassessments, deductions of $92.6 million of non-capital losses by freehold were denied, resulting in reassessed taxes, interest, and penalties totaling $29.3 million in addition to a denial of $129.9 million of carried forward non-capital losses. Freehold has filed its objection of the reassessment, which required deposits totaling $14.7 million to have been paid to the CRA during the third quarter. Freehold has received legal advice that it should be entitled to deduct the non-capital losses, and as such, Management remains of the opinion that all tax filings to date were filed correctly and that it expects to be successful in its objection to these reassessments, and therefore the deposits paid to the CRA should be refunded with interest. Freehold anticipates the proceedings through the CRA will take approximately one year to resolve. Furthermore, the payments of these deposits does not impact freehold earnings or funds from operations or net debt. Now back to Dave for his final remarks.

Thanks, Dave. So looking forward, we expect the next three to six months to remain challenging for the industry, although improving sharply from the oil price lows of Q2. Setting ourselves apart, freehold provides investors relative stability as royalties represent a higher margin business. We continue to maintain flexibility in our balance sheet while maintaining sustainability in our dividend. At current share price levels, we feel the return proposition is an attractive entry point for investors. With today's increase to our 2021 monthly dividend, we highlight how the royalty model is sustainable through all commodity cycles, as we have demonstrated since we went public in 1996, nearly 25 years ago. We continue to execute on the core aspects of our strategy moving forward with the goal of maximizing returns for our shareholders. In addition, we would also like to encourage all people to take a moment tomorrow to remember some of the sacrifices made by our Canadian heroes through Remembrance Day ceremonies. While many of us may not be able to attend in person, given some of the restrictions associated with COVID-19, we think it is important for people to take a moment to recognize some of the tremendous sacrifices Canadian soldiers have made to provide us with the incredible freedom and quality of life we maintain in Canada today. We would now entertain any questions that you may have.

Thank you. We will now take questions from the telephone lines. If you have a question and you're using a speakerphone, please lift your handset before making your selection. If you have a question, please press star 1 on your device's keypad. If at any time you wish to cancel your question, please press the pound sign. Please press star 1 at this time if you have a question. There will be a brief pause while the participants register for questions. Thank you for your patience. And the first question is from Jeremy McRae. Please go ahead. Your line is now open.

Yeah, hi, guys. Can you give me an indication of how many new lease agreements you've signed here for the quarter or looking to sign? And just have you noticed any increase in activity on some of your gas-weighted lands here? I'm thinking maybe Edson or in some of those other areas there.

Yeah, thanks, Jeremy. It's Rob speaking here. Maybe I'll answer your first question first. In terms of gas-oriented drilling, we've seen a little bit of activity in the deep basin with a couple of the producers that we're close with. I'd say that's probably not been the key focus of our activity. It's really continued to be in the Viking, in the Cardium. in southeast Saskatchewan, and we're beginning to see more activity in Clearwater. Those are certainly the big four that continue to be the most dominant in the portfolio, but some of those cardium locations obviously have a fair amount of gas in them as well. So whether it's the gas economics or the liquids economics that are driving it, unclear, but the important thing is they are being drilled. And as far as the new leases, let me get that number to you. I don't have it handy here. It was a modest amount in terms of what we were able to secure in terms of new leases, certainly from a dollar amount in terms of new lease bonus revenue.

Yeah, it was just more just trying to see how much activity has really started to pick up. Have guys started to come approach you and say, we're getting comfortable with drilling again today? let's look to find these new leases or these lands over here. That's just generally how that's changed.

Sure. Maybe I'll answer it a bit of a different way in terms of actual drilling because where we've seen activity pick up in Q4 here, we're now on pace halfway through Q4. We have about 50% more drilling on our lands relative to Q3. Same areas are still the dominant areas of activity, biking, Sparky, Cardium are kind of the big three, followed by southeast Saskatchewan. We've talked to a number of our Clearwater players where they're, you know, two in particular have talked about 10, 15 wells in the winter drilling program here. So, yeah, I think we certainly are seeing signs of activity picking up in terms of drilling.

Okay. No, that's good. Thank you.

Thank you. Once again, please press star 1 on your device's keypad if you have a question or comment. The next question is from Zai. Please go ahead. Your line is now open.

Hey, folks. Great quarter. Just wondering, why not institute an NCIB? Just given Prairie Sky has been doing something similar, and it seems like there's not many acquisitions going on.

Yeah, I think... Our perspective on the NCIB is that our preferred method of returning value to shareholders is through the dividend. So that's a first priority. We want to continue to manage our balance sheet as a second priority. And I think that we're actually seeing quite a good number of opportunities that are out there right now. And so we do think that there are opportunities to further enhance our portfolio with select acquisitions and we're taking a long-term view that we think by allocating some capital to making our portfolio even more resilient and durable than it is right now by key acquisitions and we think that's a better allocation of capital than NTIB at this point in time. Certainly every opportunity that we look at, we compare it to an NTIB, but right now we think that there's opportunities to do business out there that would make our company better.

Totally understood, and thanks for that, Collar. Just wondering, as we get past OPEC and you have more line of sight on COVID, would you be targeting a 60% to 80% payout ratio on the dividend? Because the two... The $0.02 increase was good, but just thinking about it longer term.

Yeah, definitely. Our strategy is still that 60% to 80% payout. What we're looking at here is more of a bit of a measured dividend increase. We still have a conservative view on commodity prices. We're not 100% sure how COVID is going to play out, despite some of the optimism this week with the Pfizer announcement. And so really we need to see how that plays out. We need to see how our quarter plays out. And we're going to reevaluate in Q1, you know, once we have a little more confidence that the environment ahead of us is stabilized and is sustainable. So the target is still there, 60 to 80%. You know, how we ramp up to that through a measured approach is how we're going to handle that.

All right, thanks. That's all from me.

Thank you. The next question is from Luke Davis. Please go ahead. Your line is now open.

Hey, thanks for taking my questions here. Just a few quick ones for me related to the last caller. How are you thinking about setting the dividend just from a modeling perspective? Are you typically kind of targeting the lower end at 60% and then thinking about the balance, the 80% as kind of a volatility cushion? Or how should we be thinking about that going forward?

I think that's a fair comment, Luke. Definitely, for now, given just the rapidly evolving business environment that we're a little bit more comfortable operating at that bottom end, low end of the payout range, provide ourselves a little bit of cushion in case we do see a retracement of commodity prices again. But also, we think that there's a good opportunity to make some small changes smaller acquisitions that enhance our portfolio. So we want to just leave a little bit of room there as well. So it's a number of factors that are driving us initially to sit in that lower end as we just watch how the environment unfolds.

Right. Makes sense. And then I guess to follow on that, any change in terms of how you're thinking about hedging, particularly when you see commodity pricing that sort of appears more constructive and I would say more so on the gas side?

Yeah, we've not historically hedged and it's not an area of focus right now. I think that the prices are still volatile enough in either direction that we don't think that hedging is the right thing for us right now and And by the nature of our conservative business model and the high net back that we achieved, hedging is not as a key part of our portfolio as it would be, say, for a traditional E&P producer where we've got a really good, stable production base that doesn't have an operating cost component to it and doesn't have a capital draw associated with it. So for us, hedging is not a priority right now.

Right, makes sense. And then I guess final one for me, just can you maybe frame out what you've seen in the acquisition markets to date? Any kind of changes in recent months and can you kind of frame out how we should be thinking about that going forward?

I'm going to just turn that over to Rob. He's got him and his team have been really looking at a lot of opportunities in the last little bit here and maybe just give some color on what you're seeing. Yeah, exactly.

In terms of since our last update in August, we've certainly seen an uptick on both sides of the border as it relates to potential transactions. These are both marketed processes, but also proactive conversations that we've been having. On the Canadian side, a lot more, as you guessed, on the manufacturer decor opportunities and and probably a lot more receptivity as it relates to proactive conversations with a number of counterparties, particularly on the private side. So a fair amount of dialogue. I think there's still a fair bit of spread that's definitely out there. But with every month, we're optimistic that that spread will narrow significantly. In the U.S. side, a lot of opportunities are coming across our desk. I would say more packages that are also fairly attractive that have a pretty interesting mix of near-term production, tangible upside, and future upside. That's not just a lock-in comment. We've really been expanding our efforts and our capabilities to be looking outside of North Dakota and have been looking at a number of opportunities that are in other basins that are seeing capital being actively allocated in this current commodity price environment and that's providing some encouraging opportunities that we're actually looking at.

Right, makes sense. And then I guess final one, I can appreciate this might be a little bit more sensitive, but when you speak to spreads, can you maybe provide some broader ranges in terms of where the market's sitting and around where you'd like to execute transactions at?

Yeah. Maybe I'll just kind of talk more from one of the key tenets that Dave talked about, that when we're looking at acquisitions, it really has to be accretive to our free cash flow yields. And so if I kind of use our free cash flow yield in that 15-ish percent range, plus or minus, depending on the day, it has to be superior to that. And so I think that's a bit of a data point to kind of point to in terms of where we need to see acquisitions to be attractive and be competitive for us. And they're probably a little bit inside that right now.

No, it makes sense. Thanks very much, guys. Appreciate it.

Thank you. There are no further questions registered at this time. I'll turn the meeting back over to Mr. Spiker.

Okay. Well, thanks, everyone, for attending the call this afternoon, and thank you for your interest in our story, interest in our company, and for the value proposition that we offer. So we had a good quarter, and we look forward to talking to you guys again throughout the coming weeks. Thank you, and good night.

Thank you. Thank you. The conference has now ended. Please disconnect your lines at this time, and we thank you for your participation.