Vitesse Energy (VTS): A 10% Dividend Yield and Discount to “PV-10” Make this Spin-Off a Cheap Speculation on Oil
Vitesse Energy (VTS) is a recent spin-off from Jefferies (JEF). The stock was spun-off in January.
Vitesse is made up entirely of non-operating working interests (and a small amount of mineral rights which it may soon sell) in North Dakota and Montana.
Non-operating working interests are an economic interest in the production of oil and gas from a property without the obligation to pay production costs.
Operators – mainly Civitas (CIVI), PDC (PDCE), EOG (EOG), and Chevron (CVX) – propose specific wells. They are required to offer Vitesse proportionate participation in these wells. In theory, Vitesse is not required to participate in every well. However, Vitesse has historically participated in “the vast majority” of wells proposed by operators.
Production is a mix of about 60% oil and 40% gas. However, the likely discounted future cash flows for the company are weighted far more toward oil than gas (more like 80%+ oil). Vitesse usually hedges some – but not all – of its oil production out a year or two. It does not hedge any of its gas. The price Vitesse gets on its unhedged oil is related to the WTI crude prices you can look up daily. The gas price Vitesse receives doesn’t seem as reliably related to a benchmark gas price (which may be part of the reason Vitesse doesn’t hedge gas production).
Vitesse has a solid balance sheet. It has some cash. And it has a revolving credit agreement. Net debt is low (less than $1.50 per share). Management says it intends to keep things that way. The company targets a ratio of debt-to-EBITDA less than one. Right now, it is far below that.
Management mentions three priorities. The first is to pay a meaningful and growing dividend. Right now, it’s certainly meaningful at $2 a share (a 10% yield). The second is to keep leverage low. Like I said, it’s very low right now (EBITDA is several times higher than debt). And the third is to maintain the level of production.
While owned by Jefferies, Vitesse had higher cap-ex and actually grew its reserves over time. In the future, it looks like Vitesse will prioritize dividend payments over reserve growth. But, the company has suggested it will at least maintain reserves (and may try to grow them). Also, there is some wording in places that makes it sound like the company might consider issuing stock for a big, unplanned acquisition (but that equity is not used in normal, smaller deals). The deal size here is normally very small. And Vitesse probably has an annual budget for how much it hopes to spend in the year ahead.
VTS stock is cheap versus its “PV-10”.
PV-10 is a standardized reserve valuation measure the SEC requires oil and gas companies to include in their 10-K.
Basically, PV-10 is a discounted cash flow calculation using a 10% discount rate (it’s actually a 10% real rate, because there is no inflation escalator used). The only oil and gas reserves considered are proven reserves (either developed or undeveloped) that are expected to be producing within the next 5 years. So, probable and possible reserves that aren’t proven aren’t included. And proven reserves that are unlikely to be producing within 5 years are also not included. However, proven reserves that are expected to be producing within the next 5 years but aren’t yet producing are included in this calculation. And that is a big part of the PV-10 shown for Vitesse.
The split is about two-thirds producing reserves and one-third non-producing reserves. So, if I say the PV-10 for all of Vitesse’s reserves is $30 a share, that would actually mean the PV-10 for just the already producing wells is like $19 a share (today’s stock price).
Also, the PV-10 estimate may be unrealistic in two (possibly somewhat offsetting ways). On the one hand, the discount rate used for the PV-10 is currently very high versus risk-free rates in the economy. Risk-free rates for assets of a similar lifespan as Vitesse’s reserves are probably less than 4%. They are also not protected in any way from inflation. Inflation is meaningful right now. And the PV-10 calculation does not inflate both revenues and expenses in the calculation. This results in a calculation that uses lower and lower real dollars in each year’s cash flows despite the fact that both unit costs and unit revenue (oil prices) are more likely to maintain a similar real dollar value than a similar nominal dollar value. So, the discount rate being used here is very high relative to any sort of inflation indexed risk free rates.
However, there may be some justification for that. Let’s deal first with the common sense issue of whether you should apply a high discount rate to account for the inherent risk of oil and gas price volatility, the cyclicality of the industry, etc. That’s debatable. Yes. There is extreme risk of any PV-10 being cut in half (or worse) by fairly common movements in oil and gas prices. But, on the other hand, we have no reason right now to believe that there isn’t just as great a chance of any PV-10 doubling because of upside volatility. A higher interest rate, larger margin of safety, etc. in the oil and gas industry makes a ton of sense for anyone lending money to these businesses. Lenders suffer from downside volatility but don’t benefit from upside price volatility. Common stockholders do benefit from upside price volatility. And we’re discussing an investment in the common stock of Vitesse – not its debt.
The only real logical argument for applying a high discount rate (such as that used in the PV-10) for a common stock analysis would be if oil and gas prices (as used in the PV-10) are unusually high right now. In that case, the risk of downside price volatility would be greater than the risk of upside price volatility (because the probability of a large oil price decline would be greater than the probability of a large oil price increase). Mirror image oil and gas price volatility is not actually a risk for a common stockholder. It’s just volatility. It’s as likely to be a big benefit as a big detriment.
What is a risk is using higher prices in the calculation than are “normal” or likely in the future. I’ll discuss this more in a second. But, for now, my point is that a common stockholder does not need to use a higher discount rate for oil wells than for other assets just because the asset’s annual earnings are going to be volatile. Yes. It’s harder to predict the outcome of the investment. But, if the price of the commodity is “normal” right now, there’s no reason to believe price volatility has a higher probability of causing you harm than benefit.
What would justify a higher discount rate? Lower confidence in something that would not be as likely to benefit you as to harm you if it turned out very different than you expect. Yes, price volatility lowers your confidence in your assessment of the business’s future earning power. But, it doesn’t lower it just to one side. It may be less certain you’ll at least hit a single in this stock. But, added price volatility makes a home run (as well as a strikeout) more possible. While this may be psychologically uncomfortable, it isn’t logical from a wealth maximizing perspective to use a higher discount rate just because this industry has volatile prices. However, that’s for producing wells.
Vitesse’s PV-10 calculation includes expected future cash flows from “proven undeveloped reserves”. In the case of those (possible) wells, it’s less certain that price volatility is as likely to help you as hurt you. Yes, it’s possible that at very high future prices, it’ll turn out that this PV-10 underestimates the amount of future development. But, it seems more likely to me that we should be extra cautious about undeveloped reserves (as opposed to already producing reserves). If prices are especially low and costs are especially high for a long enough period of time – these may be wells we’re counting that aren’t ever going to provide Vitesse shareholders with future cash flows.
The value shown in Vitesse’s PV-10 is about two-thirds from producing reserves and one-third from undeveloped reserves. Developed non-producing is irrelevantly small in this case. And, note, that proved undeveloped reserves are actually higher than 33% (one-third) of reserves in terms of volumes. But, because these are assumed to produce cash flows later in time, their discounted value accounts for a lower portion of the net present value the PV-10 calculates.
There are ways to increase our confidence in the PV-10 calculation in the sense of making sure the stock we are buying is definitely priced low versus its reserves. The easiest way is to simply throw out the discounted net present value of reserves that we have less confidence in.
Vitesse has two types of reserves: producing and undeveloped.
The actual PV-10 shown in Vitesse’s 10-K is misleading in a few ways. For example, it is based on paying no taxes since the company was an LLC at the end of last year. I’ve used a 25% tax rate in adjusting the PV-10. I’ve also deducted the company’s net debt. After doing that, I’ve divided the resulting figure by the number of Vitesse’s current shares outstanding. This provides PV-10 per share values we can look at. However, as I’ll discuss later, the numbers are still a bit misleading because as part of the spin-off a lot of stock like compensation was given to insiders which will result in more future shares outstanding than current shares outstanding. I’ll tackle that issue last.
So, the PV-10 if we count all oil and gas reserves both producing and undeveloped would be about $30 a share. The PV-10 if we included only producing reserves (valuing undeveloped reserves at zero) would be about $20 a share.
That seems like a conservative way to value the stock.
Despite this extreme conservatism, Vitesse stock does actually trade at about $20 a share right now. So, in theory, Vitesse stock is selling for about the PV-10 of only its producing reserves. There are two complications to this (in addition to future oil prices, which we can’t predict). One, the tax rate that will be paid on future cash flows. I have assumed a 25% tax rate. It is likely this will actually be closer to 20%. Two, the number of shares outstanding. I have used the current shares outstanding. In reality, about 8% of Vitesse’s economic value will go to insiders through compensation granted to them as part of the spin-off. And the board has already approved grants of up to 12% of Vitesse’s ownership. These two complications probably do not exactly cancel out. Diluting shares by 8% is very slightly worse than paying 5% more of net income in taxes. Diluting shares by 12% is meaningfully worse than paying 5% more of net income in taxes.
Finally, we should note that Vitesse can borrow quite a bit of debt relative to its market cap – though it hasn’t said it plans to have debt greater than EBITDA – and this could add value (via leverage) to the common stock. Vitesse can borrow more than one year’s worth of EBITDA on its revolving credit line. And it might borrow up to that amount. If Vitesse always borrowed about one times EBITDA in debt and this debt had a cost less than the discount rate used in the PV-10 (which it does at today’s rates) – this would add some value (and some risk) to the common stock.
Overall, I think these three factors come pretty close to offsetting each other. We don’t know exactly what the tax rate will be. We don’t know exactly what the number of future shares outstanding will be. And we don’t know exactly how much debt costing how much in interest Vitesse will use. But, it’s not difficult to imagine that plugging reasonable figures into these three variables will still leave us with a PV-10 derived value of about $20 a share for the stock. It does seem to be roughly worth that amount.
Now, though, we have to move away from the actual 2022 PV-10. That’s because of the way oil and gas prices are calculated in the PV-10. For the PV-10 calculation, the SEC requires companies to use the average of the last 12 monthly prices for oil and for gas.
Imagine a year consisting of just 3 months. If the price per barrel was $90 in October, $90 in November, and $40 in December – the price used in the discounted cash flow analysis would be $60 (not the last trade price of $40). This makes the PV-10 less volatile than if you used a single day’s price.
Vitesse’s 2022 PV-10 uses an oil price of $94 vs. today’s price of $81.
It also uses a much, much higher price (over $6 vs. just $2 today) for gas – however, this is less meaningful for Vitesse. I can’t adjust for price changes in benchmark gas as well as I can for oil, because the “gas” valued in Vitesse’s PV-10 includes natural gas liquids and because the specific location of the gas may result in very different prices from gas traded elsewhere in the U.S. It’s possible (though I can’t estimate this with any confidence) that you could imagine scenarios where a 60% decline in benchmark natural gas prices only harms Vitesse as much as a 15% decline in benchmark oil prices. The one warning here – and it’s an important one for near-term results – is that Vitesse does hedge some oil, but doesn’t hedge gas. So, at a time – like now – when oil prices have held up and gas prices have collapsed, this hedging of one commodity and not the other means Vitesse can actually come out worse on the commodity they’ve hedged and also come out worse on the commodity they haven’t hedged.
The important long-term consideration is comparing today’s oil price to the oil price used in the PV-10 for 2022. The price used in that PV-10 is $94 a barrel. Right now, oil is $81 a barrel. This means Vitesse’s PV-10 may be overstated relative to today’s prices.
However, that’s just an issue with the PV-10. It is not an issue with Vitesse’s actual EBITDA, earnings, free cash flow, etc. from last year or what it expects in 2023. That’s because Vitesse’s past results included quite a bit of hedging. So, if you are an investor looking at something like expected EBITDA, free cash flow, etc. instead of PV-10 – for example, you’re asking “can Vitesse pay its dividend this year?” – the situation is different.
Vitesse’s actual realized price for oil after taking the hedges into effect in 2022 was $76. Vitesse still has some hedges on (and presumably will keep putting some hedges on). But, it’s clear that oil prices are above or close to the highest price Vitesse has ever actually gotten paid for oil in the past. In that sense, estimates that show Vitesse stock is trading at about a 15% free cash flow yield, a 10% dividend yield, etc. are correct. If things go as planned and oil prices stay around $80 or go higher over time – Vitesse stock is trading at a “normal” free cash flow yield of like 15%. And, yes, it can maintain its dividend as the dividend is adequately (though not particularly strongly) covered by free cash flow and the company can borrow quite a bit as well.
It’s likely investors will focus on the current level of the dividend yield, the free cash flow (or EBITDA), and the year ahead guidance. In fact, this is probably something investors will focus on more than the PV-10.
But should they? How useful is this PV-10 calculation?
It’s the best thing we have to replace values like price-to-book (which are meaningless for oil companies). But, it’s very volatile even in the case of a company like Vitesse that has barely any debt. Vitesse does hedge some oil production for a couple years. But, ignoring hedges, you should not expect the PV-10 to vary less than the price of oil itself. You can use PV-10, but unlike something like price-to-book it’s going to be so volatile it may be useless as a long-term guide of when to buy and sell a stock like this. Still, PV-10 may be more helpful than just looking at a single year’s EBITDA, free cash flow, dividend, etc. or the year ahead guidance for these things.
In other words, if you’re using PV-10 as your way of valuing this stock (much the way you’d use NCAV per share for a net-net or tangible book value per share for a low price-to-book stock) you are going to think VTS stock is very cheap or very expensive just because oil prices have changed.
Based on the oil and gas price averages used for 2022, the stock is cheap. It trades at about two-thirds of PV-10. PV-10 uses a 10% (real) discount rate. Even using today’s lower oil price, Vitesse stock does not actually look expensive vs. a PV-10. And the PV-10 uses a much, much higher discount rate (10% real) than an S&P 500 type index fund is likely to achieve in the future.
So, if oil and gas prices are higher on average in future years than they were during 2022, Vitesse stock is very cheap.
It’s also reasonably priced versus tangible book value (about 1 times). It’s cheap versus its dividend (a 10% yield). And cheap on an EV/EBITDA type basis (maybe less than 4 times). So, Vitesse could be a cheap speculation on higher oil prices.
What about safety? The assets are not diversified. Their value is largely oil and some gas. And it’s completely located in one area of the country. This is an undiversified business.
The dividend yield of 10% is certainly high. And in a 2022 type price environment, it can be maintained. But, even then, I’d estimate the dividend will only be covered about 1.5 times in a good year for oil prices. Management says they want to maintain and grow the dividend. The company does earnings calls. You can read their first earnings call transcript for more comments on the dividend. The idea that this dividend is going to be a fixed dividend that’s maintained instead of a variable dividend that rises and falls with oil prices seems like an aggressive goal to me.
But, this definitely looks like it’s going to be a “short-duration” stock in the sense that you are buying in at a dividend yield of 10% and management has said many, many times that the dividend is the number one priority. The company’s priorities seem to be: 1) a very high dividend, 2) a solid balance sheet, and then only then 3) maintaining or even growing reserves. So, this will not be a growth stock except to the extent oil prices grow. Basically, the spin-off was done so these assets could throw off near-term streams of cash to investors.
Management says their focus is the dividend and the spin-off was done so that management (and other insiders, including board members) who own a lot of stock can get paid in dividends.
But, what else do we know about the management? They will have very big incentive compensation (see the 10-K for details). The level of compensation is very high, but it may be entirely meant as a one-time attempt to transfer a lot of ownership to the people running the company so they can think like founders. The top people are, in fact, founders of the predecessor entity (which was started and backed by Jefferies about a decade ago). So, this may just be an attempt to replace the skin in the game they already had before the spin-off.
Some members of the board do own stock. They are also board members of Jefferies. The best known (and largest shareholder) is Joseph Steinberg (co-founder of Leucadia which eventually merged with Jefferies).
Steinberg will own much more Jefferies than he does Vitesse. The other spin-off Leucadia did was Crimson Wine (CWGL). He still owns stock in that company. And it’s been a pretty bad performing stock for the last 10 years. So, I wouldn’t get overly excited by the idea this is a spin-off of Jefferies which was once the famed Leucadia (a company often compared to Berkshire Hathaway) and you’re investing alongside one of the founders of Leucadia. Vitesse is just something they’re separating out. It may do well. It may not. But, it’s very different from what Leucadia was or Jefferies now is.
Vitesse stock seems cheap. And it seems strongly dependent on future oil prices.
If you want to buy a U.S. oil company, Vitesse should be one you look at. The biggest operators of Vitesse’s interests are also all publicly traded.
It seems like a textbook “You Can Be a Stock Market Genius” type set-up. And it is much stronger financially than most spin-offs I’ve seen in recent years.
But, it’s a speculation on oil – just like Warren Buffett’s investments in Chevron (CVX) and Occidental (OXY).
Ultimately, if oil prices don’t work out well – Vitesse stock won’t work out well either.
How big a risk is it that oil prices will fall?
It seems like a realistic risk to me.
Short-term predictions of oil prices out a few years are possible. Analysts can look at inventories and likely changes in near-term production and try to predict what impact a decision by OPEC or sanctions against Russia or something like that will have on supply. They can also incorporate estimates of whether major oil consuming economies are headed for recession, boom, etc. and try to work these into predictions for oil demand. Likewise, today’s oil price might incorporate information about known near-term things that are likely to happen. But, neither analysts predictions nor market prices are that helpful when thinking about longer-term fluctuations in oil prices.
Inflation could have a big impact on how your investment in Vitesse works out. This is because oil prices are more predictable in the long-run in real terms than nominal terms. This wouldn’t matter much if you were giving Vitesse money and they were creating a brand new company out of it by buying oil reserves now. It does matter in this case because you are trading your present day dollars for already existing real reserves that Vitesse owns.
So, what’s a normal real oil price?
Here are some average real prices at which oil has traded in the past.
Last 3 years: $71 a barrel
Last 5 years: $71 a barrel
Last 10: $77 a barrel
Last 15: $89 a barrel
Last 20: $87 a barrel
Last 30: $71 a barrel
We could use even longer-term averages.
Generally, the real price of oil going back 50 years or so has ranged from about $30 to $120 a barrel. The median real price is about $60 a barrel. The mean real price is about $70 a barrel.
This shows an investor in Vitesse could be taking some serious oil price risk.
All of our calculations of Vitesse Energy’s value have been based on higher oil prices than $60 to $70 a barrel. Our asset value calculation (showing $30 per share in total reserves value and $20 per share in producing reserves value) was based on $94 a barrel oil (about 40% higher than the long-term real average price of oil). Even our free cash flow based calculation used last year’s results and this year’s guidance which is based on oil prices in the $75 to $80 range. Last year, Vitesse’s realized price (including hedges) on oil was $76 a barrel. That’s about in line with the 30-year real average price of oil ($77 a barrel). However, it is higher than truly long-term average oil prices (going back 50 years or more) which tend to be in the $60 to $70 a barrel range.
There could be good reasons why oil costs more today (in real terms) and is likely to keep costing more in the future. Or oil could be overpriced and likely to average a lower real price in the future than it does today.
Does that mean you should avoid oil stocks trading at a discount to the value of their reserves based on today’s oil prices? Should you only buy into a company when calculations of the value of reserves are based on low enough numbers ($65 a barrel, for example).
That would be a good plan expect for the lack of opportunities in today’s market. Oil may be overpriced relative to its long-term past. But, so are stocks and so are bonds and so are houses and so are most other things you could possibly invest in.
In fact, the overvaluation of oil at last year’s average price ($95 a barrel) vs. its “normal” real price (about $65 a barrel) is actually lower than I’d calculate the current overvaluation of the S&P 500 to be. So, oil may have been 45% overvalued last year ($95/$65 = 1.45 times), but the S&P 500 is probably a lot more overvalued than that. Similarly, in real terms, bonds are extraordinarily overvalued (they only make sense if inflation comes down soon and stays very low for a very long time).
This is a pervasive problem for investors among all sorts of assets. Oil does not seem especially overvalued relative to other assets you could buy. And oil does offer better inflation protection than some of them (certainly bonds and most stocks, for instance). Also, the PV-10 approach we’ve talked about is more conservative (in the use of its discount rate) than the historical price at which stocks have traded. Stocks have not historically traded at rates that offer more than 6-7% real returns. The PV-10 uses a discount rate of 10% real. So, in a sense, you are already getting about one-third off the price of a “normal” (non-energy) stock when you buy it at its PV-10. Here, we are talking about buying at a large discount to that already more conservative price (but only if you count the undeveloped reserves).
I can imagine a lot of scenarios where buying Vitesse stock at $20 a share doesn’t work out. But, it is difficult to come up with cheaper alternatives to Vitesse right now.
There are other U.S. oil companies you could buy. For example, all the operators mentioned earlier are publicly traded and often quite cheap versus their recent EBITDA. There are also a few highly leveraged U.S. oil companies that are dirt cheap on a fully levered basis. In fact, a couple of those (because they are so highly leveraged and so cheap) definitely offer much bigger upside for their shareholders than Vitesse does. However, they also have meaningful bankruptcy risks.
Vitesse is different from bigger operators and from highly leveraged ones. The big difference is capital allocation. Capital allocation at many of these other companies is less likely to preserve the value of the free cash flow the company generates. For example, the highly leveraged companies are going to pay off debt. Almost all of that is fixed rate debt that yields way less than it would cost to borrow now. The rates on this debt are lower than the free cash flow yields on the stocks, lower than the internal rates of return they expect on their growth cap-ex, and lower than the discount rate used in that PV-10. Basically, paying off that debt may be prudent – but, it makes the cash worth less than if it was paid out in a dividend or used to buy back stock.
Vitesse has been clear about definitely paying very big dividends. And maybe even considering share buybacks. It has not committed to growing reserves much over time. A dollar of dividends paid out to you (or used in stock buybacks) is worth a lot more than a dollar used to retire cheap, fixed rate debt. So, the quality of Vitesse’s capital allocation and the economic value of the free cash flow it does generate may turn out to be a lot more solid than at some other oil companies.
And most importantly, you’re starting from a position with a very clean (almost net debt free) balance sheet and a very high dividend. This is critical in constraining management’s future capital allocation. Once a dividend is in place, companies try to keep paying it. And companies with debt – even with very cheap, fixed rate debt – often try to pay it off. But, a company with no debt to start out can’t pay down debt. It could pile up cash. But, Vitesse doesn’t seem likely to do that. So, I have much greater confidence that $1 of free cash flow at Vitesse will actually have something like $1 of economic value. At oil companies with more debt, lower dividends, etc. – I’d value $1 of free cash flow at less than 100 cents on the dollar.
For those reasons – and because it’s a very recent spin-off – Vitesse looks like a good place to start when looking for a U.S. oil company to buy.