WaterBridge: Oil and Water - [Business Breakdowns, EP.228]

29:07It's a really symbiotic relationship. TPL doesn't operate water systems. They're more of a royalty taker on these saltwater disposal wells. But then also in the wake of COVID, they were able to buy the Hanging H range. And so when I say they, I mean Five Point. So Five Point, a lot of its business, they had some really interesting midstream assets, San Mateo. They had a acid injection company called Northwind, which we should talk about later. But they raised the capital to go out and say, look, we really want to get some surface acreage to facilitate the growth of Waterbridge. The Hanging H Ranch was actually under contract by a PE-backed sponsor, and they were unable to close during COVID.

29:53David and Five Point fortunately stayed in the vicinity of the deal and were able to close on that in 2021. It was about 70 ,000 acres, really in that core of the core of the Permian Basin. So now you've got Five point with your sponsor company, Waterbridge. And then you've got the land company with Landbridge with that first toehold of around 70 ,000 acres with the Hanging H Ranch. A lot has gone on since then, but I should also mention just, I definitely want to stay on the five point is that when you look at the development of the basin, A, they've been very forward thinking with Sour Gas, with Northwind, which they just sold to NPLX.

30:35But then also they launched a new company called Power Bridge, where if you're of the belief, which we are inclined to be, that you're going to see large-scale data centers and infrastructures coming to Texas, Power Bridge is now another port co of FivePoint run by the ex-talent CEO to really facilitate that development. And so the commonality here is very forward-thinking, very aggressive, but thoughtful deal-making, and really speaks volumes to what they've been able to achieve and then our willingness to partner with them. Yeah, it's very interesting to hear. I think so many people tried to be opportunistic, particularly post the fallout of the shale boom.

31:17And that took many different routes to do it. But I don't think you saw too many successes. This one is quite interesting from an infrastructure perspective. I'm curious, from your standpoint, when you think about the different vehicles, I guess the simple answer is you'd rather invest in a pure play than have these pieced together. But do you think there's anything else beyond that separating Landbridge and Waterbridge? I understand they're two different businesses, but from a scale standpoint, sometimes it helps to bunch things together. Any thoughts on just their approach to doing that? Yeah, I think you would never get the appropriate multiple of land within a broader portfolio.

31:56And we've seen this with gold royalties. Newmont Mining bought Franco Nevada, and then they spun it back out at the end of 2007 because they got frustrated that the market would never give them credit for their royalties. You also see oil and gas companies that don't get credit for their surface acreage and their royalties. And so I think that what Five Point recognized is land is a really unique asset with very high optionality. And we need to keep that separate because it really should be capitalized at a different rate than a operated midstream asset. I think also it's important to keep water as a pure play.

32:38So there's a variety of companies out there that have water within a broader midstream business. NGL has a water business. Western has a business which is now larger acquiring Eris. And Eris probably never got the multiple that they deserved. But I think that it was really important if you want the market to appreciate and capitalize this business appropriately, you need to allow investors to isolate the water business for what it is. Does Kinder Morgan still have a water business? I believe they do, but I don't know how big of a market share. They don't really come across as having a big market share in the Permian, at least.

33:15Yeah. Okay. That makes sense. I guess it is helpful to touch on Landbridge just because you do have these two vehicles. Landbridge had this previous IPO process a year forward from where Waterbridge is at today. Can you talk through a little bit more of a snapshot of, are they doing anything beyond what you've referenced, what they do with Waterbridge? And then what has been the public market perception to Landbridge since that IPO? Yeah, it was actually not the greatest IPO. Even though the stock has done really well, I think it was originally slated to price in the 19 to 22 range, which was around 15 times trailing our forward EBITDA.

33:57It ultimately broke price and traded at 17. And people can pull up a chart. It traded 80 by year end. It's, I think, mid 50s today. But so there's a lot of different things going on there. And I think that that creates the confusion. But if you just underwrite the core business, which is assembling ranches that are very complementary in Texas and New Mexico, which can facilitate water infrastructure development. It's a very compelling investment case. Five Point has been really forward thinking and also developing these next-gen opportunities. And so they've identified six or eight facilities where basically they think it's essentially plug and play for multi gigawatt data centers in West Texas.

34:44You've got your fiber to basically plug in your fiber optic. In some cases, you can get some grid power, but I think a lot of this is going to be direct generation. You've got the ERCOT grid, you've got the substations. Critically, you've got the water, you've also got the gas, which is really cheap for direct generation. And so they basically have it ready to go. And I think that once the hyperscalers and the other people involved here realize you can't co-locate a three gigawatt facility, let alone 500 megawatts anymore. All those things have basically been gobbled up. I think you're going to start seeing a lot more traction there.

35:22So I think with Landbridge, a lot of the narrative gotten taken over about these next gen opportunities where as great as they are, and as much as we believe in them, people ignored how great the water opportunity is today. And I think one of the thing that Landbridge has talked up is the beneficial reuse of this water. So to the extent that some is being quote recycled today, which is just being cleaned up enough to be used in refrax, which is a fairly low bar, the next iteration of beneficial reuse would be to desalany. And then can you use it to replenish the Pecos River watershed? Can you use it for crops?

36:01Can you use it for animals? And then ultimately, could it be used for industrial, whether it's power plants or cooling, things like that? And so all these things are incredibly exciting. They're call options, but I think the market maybe got a little too excited about them happening now versus T plus one, T plus two, T plus three. But anything interesting going on in West Texas land and infrastructure, rest assured that they're involved at least looking into it. Yeah, certainly from all angles, it seems like. I know if someday, I guess they can't take the name Liquid Death, but if there's some questionable name about water that I'm drinking, I'll make sure to know if it's coming out of this space.

36:43That's a long, that's T plus 25, I suppose. But I guess moving to the Waterbridge IPO, I think you captured the opportunity and the trajectory of growth. Can you talk a bit about the contracts themselves? You mentioned some references to a cut of per barrel of oil, but how does it work with the EMP when they're contracting them? When does it happen? Is it flat rate per barrel? Anything you can get into around those contracts? So generally, you are, as an EMP, are not going to even start thinking about drilling a large development right now, unless you know for a fact that your water is taken care of.

37:23In this case, they tend to be very long-term. So I believe water bridges around 11 years weighted average contract. The two main types of these long-term fixed fee contracts, there's what's an acreage dedication, which is really a preferable term. so you have 30 ,000 acres that you are controlling the drill bit on give me an acreage dedication on that and basically i will guarantee your flow at x per barrel they tend to have cpi linked escalators and so in the higher nominal growth world you have that growth working in your favor and then in our view as this becomes more and more scarce there's going to be pricing power as these contracts reset, although that's a decade out.

38:12There's also minimum volume commitments. So minimum volume commitments would say, look, I'm going to guarantee you X amount of volume. These aren't as great because you really want to know you can capture all of their water, but they can be used to basically, look, I can de-risk a large project where let me get it started with a minimum volume commitment, which again, tends to be long-term fixed fee, CPI escalators, It's just there's only a minimum guarantee. But if that can basically de-risk my project and then I can bring on new customers and quintuple the size, de-risk, it's a home run. The smallest part is spot.

38:51And you always want to leave a little bit of room for spot, which is basically somebody's in a jam. They need 20 ,000 barrels that they handled for a month. You can extract a lot of economics on those contracts. But again, they'll probably try to figure out a way to mitigate that on their own. And so it's not recurring or nearly as stable as the other types of contracts. So we think that as the market is reckoning with the fact that we're running out of easy, poor space, and nobody's denying it anymore. Some people are downplaying how big of a deal it is. Other people are downplaying, is it an issue today versus 2027 or 2028?

39:32but everybody acknowledges there is not enough disposal capacity, either from a transportation or a disposal well standpoint. As a testament to this, Devon Energy, in a first-of-its-kind transaction, has paid Waterbridge for the right to use poor space in the future. So that's them saying, we might not get to this well pad for three or four years, but we're worried you're going to fill up your capacity around it between now and then. So we're going to pay you for you to reserve that poor space for us for if and when it comes around. So if that's any indication, we think that obviously there's going to be some pricing power as they add capacity and as these contracts renew.

40:18But even at the current state, their long-term fixed fee, CPI escalator, almost utility-like types of contract streams. Yeah, that's a pretty remarkable deal for Devin to reserve that space. Just thinking that far in advance contradicts a lot of what the producers do in oil world. On the point about the minimum guarantees, should I just think about that as anything that is produced on that acreage is ultimately going to go to Waterbridge from a water standpoint? It's just a matter of you might only be at the minimum levels for a period of time if the producer doesn't choose to produce more. It's just mostly about the timeline.

41:00It's not about somebody else coming in and doing some of that disposal. A minimum volume commitment. It's just what it sounds like. They might guarantee you 20 ,000 barrels a day. But to the extent that they could find a way to do it internally or cheaper or go around you, it doesn't guarantee you all that flow. And so that's why the acreage dedication, where there's actually penalties to not using them for some of your disposal on that acreage dedication is much more powerful. And so again, it does make sense to do minimum volume commitments, but acreage dedication is much more attractive long term.

41:39Yeah, I mean, the MVCs saved some of the midstream companies, at least for periods of time. But that's an interesting dynamic. I was connecting that all of those were associated with acreage commitments. I guess how easy is switching in this case? So using an alternative provider, if that were to be the case, is there low friction associated with substituting someone in, whether it be in that example or at the end of 10 years? It's getting really, really hard to switch because again, this concept of porosity where a lot of these saltwater disposal wells, Let's say in West Texas, the acreage tends to be in the 640 acre or square miles, which are sections.

42:23So even if you're being responsible with how you're injecting on your section, you have no ability to control what your neighbor's doing, which in some cases could be just a couple hundred meters away. And you're seeing these high increasing pressurization. And so now that you're seeing more discretion around permits for the wells and issues with porosity, it's getting harder and harder to change vendors. Once you add in these longer haul pipelines that are going to be required, then it's going to be incredibly difficult because, A, there's only a few companies that are even in the business of doing longer haul pipes today.

43:10Waterbridge being the most well-known and highest regarded. But I really think it's going to end up being an oligopolistic industry where today a lot of it is controlled by the EMP. So internally, Conoco deals with their own war. But they really aren't in the business of dealing with 80 miles of easements and then drilling disposal wells and then maybe commingling some third-party volumes. I'd say the answer is it used to be very easy. Now it is difficult. And I think in the future, it's getting closer to infeasible than just difficult. And in those cases, if you have a transition towards outsourcing, does that come with potential for M &A?

43:55Do a lot of these producers that are handling it on their own, do they have infrastructure inside their businesses at this point that would be valuable to acquire? Or is this more likely come in the case of Waterbridge organically building out the infrastructure necessary to work with them? Probably the former. One of the biggest holders of Waterbridge equity is going to be Devin because Devin said, look, I'm better off contributing this asset to you, letting you run it and then let you handle my growth. In that case, they just contributed that. Aris, which has recently been sold, this hasn't closed yet to Western, one of their biggest holders was Conoco because a legacy Concho system was contributed.

44:36And so I think you're going to see more and more operators say, okay, it makes more sense. Let me just contribute my system, let you operate it. Just guarantee me I'm going to get what I need through partnering with you. It's interesting you mentioned that because it wasn't that long ago that conversations were like, hey, the big, big, big integrated players, so mostly Chevron, Exxon, Conoco, they're going to handle it themselves. And now it's actually like, well, when we did deal with them, it was some junior person in the marketing team that deals with their gathering systems and their pricing.

45:14Now it's up in the CFO's office. Because if you're talking four or five, six bucks with your LOE, this goes directly into every decision at this company. So not only has it been escalated in terms of priority for these companies, but now they're saying, look, we're pretty good at handling things when we can do it on our acreage in our footprint. But once you start adding complexity with geology and easements and multiple landowners, it increasingly makes sense to utilize third parties. So just to close the circle here, I think there's going to be very large market share growth for third parties, some of what's going to be organic, and then some of which is going to be consolidating systems.

45:57Some are EMPO, and then a few out there are still independent. Just a very interesting theme that you mentioned. Anytime you see a decision that moves from inside the operational office up to the CFO office, it's a real thing. And it has a real impact. You just have to figure out what type of impact it's going to have in the industry. So interesting to hear. And it makes a lot of sense. I guess when you think about the pricing with, I have like a few different frameworks in my head, just in terms of value capture relative to the EMP, you can only get a certain portion of whatever oil is selling at whatever they're profiting from, but you also have to earn a return in terms of whatever your costs are.

46:36So if we're going to use the hypothetical dollar per barrel of water, so four per barrel of oil, how does that equate back to their own cost line, their own margin profile? Can you just generalize what that means for them and how much fluctuation there is in terms of that pricing? Yep. So for the produced water, which is really that basic business of you take the water from the wellbore, transport it and dispose of it. they're getting about 78 cents a barrel right now on a run rate pro forma basis for handling that water. And that includes a little bit of skim oil, but about 85 % of their pro forma revenue is just handling the water.

47:208 % is skim. The remaining is mostly this water solutions business, which is cleaning it up for refrax. But again, 78 cents with an adjusted margin, an operating margin per barrel of about 44 cents. So call it about a 56 % operating margin on a per barrel basis. The consolidated EBITDA margin of the business on a run rate where they're just shy of about a$400 million run rate of EBITDA, that's running around 51%. So fairly high margin business, But to your point, okay, I was referencing dollar rates. And so one of their newer projects is getting water from New Mexico east over the state line on a new pipeline called Speedway into Texas.

48:12And this is important because New Mexico is far more stringent in their permitting. In some cases, again, notwithstanding the newer crackdown on permits, but you could get a Texas well-permitted in weeks, if not a month or two. The average permitting time in New Mexico was over two years. Wow. And a lot of people don't realize a huge part of the Permian Basin is in New Mexico. Leonetti County are juggernauts of U.S. energy growth. So it's easier to build a long-haul pipeline to get that out of New Mexico into Texas. So the big gold mine has been that lower state line, so the southern border of New Mexico.

48:55Speedway is going to take water east over the eastern border into the frying pan handle of Texas. So yes, there is a higher incremental capital investment because you're building a long-haul pipeline to get it over that border. But one of the interesting things when talking to them is they've identified about$3.5 billion of CapEx, which should contribute about a billion of EBITDA on a fully utilized basis. So call it around a 30 % unlevered return on incremental invested capital. and as you start having higher pricing power and you start having higher utilization, I would expect these numbers to drift higher.

49:43And so the reason that you can have such extraordinary returns on an incremental invested capital is the ability to control the land and then scale the business. And so it's not the same as how difficult it's going to be to capture if you're going to try to expand oil and gas pipelines. And I think that's another nuance is that the returns here and then the ability to get these systems online and then capture market share is just a completely different universe, I'd say superior to midstream. Yeah, I mean, midstream, especially once we're talking about some of the state lines that they try to cross is a totally different ballgame.

50:22The three and a half billion of CapEx, is that spread out over a long time period? Or is that all going to come quickly? So that's just what they've identified in a theoretical standpoint. I don't want to represent that as being guidance, but as an indicative case study of what hypothetically could happen if this really comes to fruition. But to the extent that that does come, I'd say probably five to 10 years, that would be spread out over depending on how quickly some of these developments come to bear. But actually, something else just popped in my head that I feel like we should touch on that I forgot.

50:56So going back to my comments earlier about, so in Texas, you have the surface estate, which is the surface, just like your fee simple ownership in your house. Then there's the mineral estate, which is the oil and gas. There's essentially eminent domain for the mineral holder where the surface owner cannot prevent you under reasonable circumstances from extracting your oil and gas. And so they can't say, no, you can't get a well No, you can't get an easement for a pipeline. There's different university land systems that publish systems around the rates for these things. But in essence, there's eminent domain for the oil and gas holder to extract their minerals.

51:39Water is not protected by eminent domain, even though it could shut in oil and gas. So a rancher could literally just say, no, you cannot cross my land hard stop. Or they could ask for some extravagant amount of money. When I say it's getting harder and harder to compete with the incumbent systems, go back to that checkerboard I mentioned of the 640 acre square miles. If you have to go 50 miles and deal with 50 different landholders asking you different rates, I mean, that just shows you how difficult it is because there's no protection around giving you egress to get rid of that water, even though it could very literally shut in your operations.

52:19Yeah, it's interesting just in terms of the nuances of that legal domain and legal rights. So yes, NIMBY rules everywhere when it's allowed to. I wanted to close on one last point just on the capex because, again, a 50 ish percent EBITDA margins. I understand that capex spend for growth opportunities is spread out. When it comes to maintenance capex, which I know is a dirty word in this midstream infrastructure space, but do you have some sense of just the maintenance costs associated with keeping, obviously, infrastructure that's dealing with very intense saltwater that would, I'm sure, corrode?

52:59Is that a heavy burden on the business? Yeah, so you definitely have maintenance of the pumps and the pipes. And it's a newer nascent industry, but we're looking, depending on the different types of equipment, you have anywhere from seven up to 28 years of useful lives. But we look at it as saying, okay, 10 to 15 % of undepreciated PP &E, just as a heuristic, probably on the high side. But again, once they build out the growth, there's really, really high free cash flow conversion to this business. And then something else going back to the growth that I think is worth mentioning. And I mentioned earlier, Five Point had an asset called Northwind.

53:47And Northwind is more of a traditional midstream business, but they specialize in AGI injection wells. So acid gas injection. The other AGI. Yeah. So this is sour gas. So if you look at the Delaware Basin, that Easter shelf is what's called sour gas. And it's sour because it has very high hydrogen sulfide. And hydrogen sulfide in high levels is extremely dangerous, deadly. It's that really sulfuric egg smell, but then at high doses, you don't smell it at all, and it can be life-threatening. But it's very difficult and expensive to deal with. So you've seen a lot of operators just ignore that sour gas window.

54:27But Northwind, Five Point Funded, went out and said, if we build these AGIs, basically, you're setting the infrastructure for people to come up there and start really drilling in earnest. And so MPLX recognized that. They bought them. And what I've heard was a very aggressive, hotly contested bidding war for north wind because people see all that growth around sour gas. Waterbridge, obviously working as a five-point port co is like, well, if this growth really comes into this Easter shelf, we want to be in a position. So not only do they acquire a lot of surface at Landbridge, but they're developing a lot of infrastructure.

55:07So they're ready to go once those drill bits come, whether it's going to be Devon, Oxy, Cotera. And so I don't want to call it de-risked, but I think there's a lot of visible growth simply from that sour gas window starting to get developed that, again, something very few people are talking about. But that's also probably a significant portion of that incremental capex and growth that I referred to earlier. Yeah, there seems to be just some interesting, non-obvious growth angles that wouldn't have stood out to me. I guess if we just transition to how you frame a business like this, thinking about any type of valuation approach that you would use.

55:47How would you go about that? And if you want to use what you've seen in the market or anything else like that, I'm always curious as this midstream-ish, not quite linked to oil prices, linked to the production, but with a very unique profile in terms of the durability of some of this stuff. So putting that all together, how do you go about framing valuation? We ultimately build everything bottom up. We look at our volume, pricing, margin, discount it back using a fairly conservative discount rate. However, ultimately, I think it's more discernible to look at, okay, what are comps and what are multiples on a static rate, and then reconcile that with your DCF.

56:30So today you're gathering and processing peer groups, so mostly natural gas, Western and PLX, One Oak, et cetera. They tend to trade around nine times forward EBITDA. The IPO process targeted a peer set to GNPs with a one-turn discount to incentivize the IPO book build. I think it did so, and then more some. So it priced at the top end of the range and they were able to upsize. I think that pricing at a G &P multiple, while I think it's necessary because it's such a nuanced idiosyncratic business, you have to use something the market has familiarity with. We think the business can grow on a fairly organic basis for 15 % or better for three to five years.

57:20So that's expanding Kraken, that's expanding Speedway, that's isolating the sour gas window. You can also bolt on some M &A assets. So Pilot, which is owned by Berkshire, is up for sale. They have a very interesting Midland Basin business that is legacy Diamondback, which could be bolted on. But for getting those more aggressive bolt-ons, again, the organic-ish growth profile around 15 at eight times with multi-decade contract and CPI escalator, 50 % even on margin. Doesn't sound right to you. It doesn't sound right to me. So what does it sound like? It sounds like waste. You look at Casella, GFL, waste management, Clean Harbor is one of the more industrial players.

58:09And those companies tend to be 14 to 18 or even more, I would argue Waterbridge has better returns on invested capital and better growth. So if you're looking for a peer-based comp set, this is really more of an infra waste business than it is a midstream business. So for it to trade in line or better than infra and waste, I think as the market appreciates the growth, the margin and the pricing wouldn't shock me. And we try not to use multiple expansion in our base case. So go back to the organic growth rate, add some M &A. If the company pays down debt, buys back some stock, it's pretty easy to get excited.

58:48But then if you do add on that re-rate, which we think is more than justify, then the numbers get really compelling. It's definitely interesting enough based on what you laid out from an organic perspective alone. Yeah. And we haven't even talked about the beneficial reuse because you can't monetize it or even think about the economics today, but to the extent that you can clean this water and use it for agricultural purposes or even industrial uses, that adds another component that will probably be here someday, but definitely not within 12 to 18 months. Right. Yeah, makes sense. And then just thinking about the sensitivity of the business and where there would be most swing in terms of outcome here, what do you hone in on just in terms of the key variables, things that matter the most?

59:38To the extent that we are very comfortable that Permian production is going to be stable, to the extent that there's a shift, we think it's going to shift more west into the Delaware where there's more volume. There's also some more gas opportunities, which to the extent you believe in the AI and the power generation pieces, a lot of that macro ties in very well to just the stable, if not growing Delaware Basin production volumes. So that's your KPI, because as long as volume is stable, if not growing, then you have the addressable market established. And then it's really, can they capture volume?

1:00:15Can they push price? And the Devin agreement, the final investment decision on Speedway, the completion of Kraken is showing us that all these cross references to the thesis are in place. And so now it's just looking at the sensitivities of what is the volume growth at what price and then at what margin. And that's your toggles in terms of looking at the valuation. And then that's where it's fairly clear cut, where it gets a little bit more murky is, okay, are these returns on an incremental invested capital as high as we thought? Is the addressable market for that as big as we thought? That's the second layer to the analysis.

1:00:57this. That makes sense. Yeah. It's very interesting. I came into this with one subsegment of the oil market, the Fraxan businesses I had in mind. And I was like, how can I separate this from Fraxan? The first was I was thinking about this in the injection mindset rather than the disposal. But I think there's been plenty more to that. As we close these conversations out, we try to hit on the lessons. As you step back and try to take away the lessons from this, from Landbridge, from TPL. What would you use as a lesson that you can take from those businesses and think about elsewhere when you're investing?

1:01:33I'd say three lessons that I would say definitely come away from this experience, which is now measured in a decade is one is really develop your expertise and core competency in something. And when you do that, always have your head on a swivel looking for peripheral or adjacent opportunities. So it's easy to have blinders on and just say, all I do is traditional infra. All I do is traditional oil and gas and pipelines and midstream. But to Five Points credit, they saw water, they saw sour gas, they see data center and infrastructure. And so So by having that core competency, and then it gives you a running start to then jump into these other areas once you see that it's there.

1:02:22Number two is capital efficiency. So capital light is something that we hammer through our team and just a capital light business model that let's say you were to just cut everything and just go into maintenance capex. Is this a good business today? And not a lot of businesses are. And so that notion of being capital light from a working capital, but then also a CapEx standpoint, you tend to pay more for these businesses, but in many cases, you should. The last one is probably the ultimate capital light real asset is land. Just it's perpetual. There's optionality. It's finite. And every time I look at things with land, especially if there's a water angle, it's really easy to get excited.

1:03:06And I always remind myself how great of an asset land is. And I wish there was a bigger opportunity set, both public and private, to scale land investing. Yeah, well, you guys have done an impressive job finding the opportunities there. And it took some time with the recognition with TPL in terms of that explosion. But I think in recent years, it's just been amazing. So this has been a pleasure. I really enjoyed diving in. It brought me back down memory lane. Thank you for sharing the knowledge and getting into the nuance on this one. It was a pleasure. Yeah, this was really enjoyable. Happy to come back anytime.

1:03:41To find more episodes of Breakdowns ranging from Costco to Visa to Moderna or to sign up for our weekly summary, check out joincolossus.com. That's J-O-I-N-C-O-L-O-S-S-U-S.com.